Lilly Has A 20% Downside; Pfizer Safer

Includes: LLY, PFE
by: Takeover Analyst

Eli Lilly & Co. (NYSE:LLY) is due to experience increased stock volatility surrounding the solanezumab Phase III data points. While the Alzheimer's therapeutic has significant market potential that will drive high risk-adjusted returns, I find that greater risk/reward can be found elsewhere. Pfizer (NYSE:PFE) is one undervalued healthcare company with sky-is-the-limit upside and low downside (see here).

From a multiples perspective, Eli Lilly is at the absolute low-end of peers. It trades at a respective 9.7x and 11.3x past and forward earnings while offering a dividend yield of 4.8%. Pfizer trades at a respective 16.7x and 9.1x past and forward earnings while offering a dividend yield of 4.2%. The former's cheapness is not without reason as analysts rate the company closer to a "sell" than a "buy." Pfizer, meanwhile, is rated around a "strong buy."

At the third-quarter earnings call, Lilly's Vice President of Investor Relations, Phil Johnson, noted several favorable regulatory developments:

"The European Commission granted final approval for Trajenta for adults with type 2 diabetes. EU launches have begun, starting with the U.K. Launches in other European countries are expected over the balance of 2011 and the first half of 2012. Despite initial impasse, we hope to reach an agreement with local authorities that allows Trajenta to be made available to German patients.

The FDA approved Cialis for once-daily use for the treatment of men who have signs and symptoms of benign prostatic hyperplasia or BPH, and men who have both erectile dysfunction and signs and symptoms of BPH. Cialis is the only medication approved by the FDA to treat both ED and BPH.

Just last night, the FDA approved BYETTA for use with insulin glargine. Europe's CHMP issued a positive opinion for use of ALIMTA as a continuation maintenance therapy in patients with nonsquamous non-small-cell lung cancer after initial treatment with ALIMTA plus cisplatin".

Unfortunately for value investors, the market has already accounted for much of the above - shareholder value has gone up by more than 8.5% over the last three months. Going forward, the main value driver will be solanezumab, which has a great deal of risk but considerable potential. Phase III results will be released in 3Q12 and analysts are expecting failure. The trial will proceed irrespective of futility analysis data. As the product has passed several DSMB tests, it is in unlikely to have clinically serious harmful effects. A safer play on Alzheimer's can be found in Pfizer, which has a 50% interest in bapineuzumab. Both had doubtful Phase II data, but Pfizer has less to lose in failure.

In addition, Lilly conceded control of eventide to Amylin (AMLN) and its Boehringer Ingelheim partnership will continue to be dilutive until 2013. Over that time period, ROIC is expected to decline by around 1,176 basis points to 38%.

Consensus estimates for Lilly's EPS are that it will decline by 8.4% to $4.34 in 2011, decline by 16.6% in 2012, and then grow by 10.5% in 2013. Assuming a multiple of 14x and a conservative 2012 EPS of $3.51, the rough intrinsic value of the stock is $49.14, indicating 20.6% upside. If the multiple were to decline to hold steady and 2012 EPS turns out to be just 5.8% below consensus, the stock could fall by 18.8%. Accordingly, I recommend holding out at least until 3Q12, which is gearing up to be an inflection point as Phase III data emerges.

Pfizer, on the other hand, has much less downside (see here). Although its pipeline is known for being weak, the silver lining is that this sets the bar low and magnifies upside. Tofacitinib is a major catalyst for the company and has broad applications - everything from preventing organ rejection to treating rheumatoid arthritis. Fundamentals are also proving solid: emerging market, animal health, nutrition, grew by 12%, 15% and 24%, respectively. These results were so strong that management guided full-year estimates upward.

Consensus estimates for Pfizer's EPS are that it will be roughly flat at around 2.2% annual growth. Assuming a multiple of 16x and a conservative 2012 EPS of $2.29, the stock has significant upside.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in PFE over the next 72 hours.