Eli Lilly and the Cyclical Business of Drug Development

| About: Eli Lilly (LLY)
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What people seem not to have noticed with Lilly’s acquisition of Avid Radiopharmaceuticals is the significance of the company’s diversification into the diagnostics business. Until now, Lilly had been purely involved in drug discovery. True, it has collaborations with drug developers, in particular GE (NYSE:GE) for molecular diagnostics, and Almac for a companion diagonostic to its cancer drug, Alimta; but Avid will be its only wholly owned diagnostics business. This is particular important considering Lilly has eschewed generics and is determined to solve its patent problems without a big merger.
Lilly's problems are well known: patent expirations of four of its blockbusters by 2014 will lead to a loss of $11 billion, or about half its current revenue. At the same time, productivity has been sagging- with recent setbacks in late stage Alzheimer's disease and Diabetes candidates.
Avid brings to Lilly a diagnostic for detection of Alzheimer’s disease based on the molecular imaging compound florbepavir. This radiotracer is injected into patients and through PET scans, allows physicians to detect levels of amyloid plague, a hallmark of Alzheimer’s disease. Florbepavir is now under regulatory review. Marketing approval will bring Lilly annual revenue potentially worth hundreds of millions of dollars; this is the value placed on on a seperate Alzheimer’s imaging compound Bayer has licensed from Avid.
Based on the near term financial returns of florbepavir alone, it would appear Lilly’s $800 million purchase of Avid is worthwhile. But there is potential for more. Avid is also developing diagnostics for Parkinson’s disease as well as well as diabetes. These combined efforts play to Lilly's strengths in both neurology and diabetes. The diagnostics may improve Lilly’s drug discovery efforts as well as augment drug sales in these indications.
Drug development is a highly cyclical business. Research requires long timelines, with unpredicable outcomes; even when a drug makes it on the market, it has a finite life before generic competition ensues. Discoveries are not evenly spaced out, a bumper crop of hits in one year can lead to over a decade of success- but chances are, a lack of major approvals in the intervening years will lead to a sales gap as the these hits go off patent. This cycle has become inevitible as the realities of R&D meet with limitations imposed by regulators.
Many big phamas attempt to solve this problem through mega-mergers to replenish their pipeline as theirs begin to weaken. Lilly has decided to take its lumps and ride out the storm as its blockbuster go off patent in the next several years. Revenue and income will suffer as a result, however the company believes it has a pipeline rich enough to begin rebuilding after its 2014 low point. Investors are less optimistic after its recent pipeline failures.
Buying into management’s view, in a few short years, Eli Lilly will be a growing company. This may indeed be the case- several late stage molecules, if successful, have blockbuster potential. The problem is 10-15 years down the line, Lilly will likely be back to where it is today, facing another patent cliff.
But by diversifying into diagnostics with the acquisition of Avid, Lilly can put a damper on this cycle. Revenue from this segment is less prone to fluctuation than drug development. Though historically slow growing, this is no longer the case. Avid, I believe, will turn out to be a very successful investment.

Disclosure: No Position