Recommendation: We recommend a short position in Eli Lilly (LLY $73.74).
Eli Lilly is a global Pharmaceuticals company operating primarily in the United States with a $78.89B Market Capitalization (Yahoo Finance). It has a diversified list of products including popular drugs such as Cialis, Cymbalta, and Methadone among many others. It also has a respectable list of drugs on its "pipeline" including the Alzheimer's drug Solanezumab.
It's multiples are higher than similar companies. Its 2015 EV/EBITDA ratio was 19.26, relative to the Pharmaceutical Industry average of 13.70 (Stock Analysis on Net). As we'll discuss, its PE is also higher than industry comparables (See Figure 3 in next section).
The market expects that Eli Lilly will see high profits and revenues in the next few years to justify its high R&D expenditure (Figure 2). This allows Eli Lilly to trade at a higher PE ratio than comparable industry stocks. In particular we have the following observations regarding how the market is treating Eli Lilly versus its competitors:
- The market's price for Eli Lilly assumes a very high percent target growth rate (See Figure 1). A high one-year target growth rate indicates that investors see the stock as risky relative to owning shares in its competitors.
- Investors expect Eli Lilly's market-leading 26.8% 2014 R&D spending to pay off in earnings growth. This is evidenced by Eli Lilly's high 32.32 PE ratio (Figure 3).
- Eli-Lilly has several drugs in the pharmaceutical "pipeline" that investors see as surefire profit makers. Market commentators like Barrons are very bullish about the prospects of these pipeline drugs but medical experts are less convinced (see below).
Figure 1: April-to-April One-Year Target Growth among pharmaceutical leaders.
Figure 2: Research and Development Expenditure.
Investment Thesis and Catalysts:
Eli Lilly has higher R&D spending and higher multiples than other comparable companies. This means that the market has high expectations for Eli Lilly's projected earnings that are justifying their willingness to take lower returns now.
However, it is unlikely that Eli Lilly's past R&D investments will pay off as much as the market expects. This is for several main reasons.
- 60% of Eli Lilly's sales come from the U.S. market (Source: 2015 10k). This is slightly higher than the industry average.
- U.S. regulations are likely to not favor pharmaceutical companies in the medium to long term. Pharmaceutical R&D spending is justified by companies' assumptions that their drug will maintain near constant profitability during their 20-year patent (Forbes). This makes Eli Lilly's current share price highly dependent on U.S. pharmaceutical regulations 10 years from now.
- Both Democratic candidates for office, Hillary Clinton and Bernie Sanders are fighting for governmental regulation on pharmaceutical company pricing of new drugs (Stat News).
- Even Republican Presidential candidate leader Donald Trump has expressed his desire for Medicare to negotiate prices with pharmaceutical companies, a practice that is common in other countries but not practiced in the United States whose consumers typically pay far more than other countries for drugs (Reuters).
- There is evidence to support that a change in political climate will have an adverse effect on pharmaceutical and biotech companies. Last September, after Turing Pharmaceuticals raised the price of Daraprim, a drug that treats parasitic infections, from $13.50 to $750 overnight, Hillary Clinton tweeted a link to a New York Times article about the "price gouging" in biotech, and promised to unveil a plan to take on "outrageous" price increases. Following the tweet, the iShares Nasdaq Biotechnology ETF (NASDAQ:IBB) closed down nearly 5% by the end of the day (CNN Money), indicating that investors were perturbed enough by her comment to sell.
- If regulation of pharmaceutical companies does occur, Eli Lilly will be a likely target for federal investigators because of its 2009 marketing fraud and ghostwriting scandal where the company was found guilty and paid $515 million in criminal fines. Specifically, the company was found guilty of pushing doctors to prescribe its antipsychotic drug Zyprexa to elderly patients with dementia, despite a preponderance of medical evidence that the drug was not effective in treating these patients (Huffington Post).
- Eli Lilly has also invested a considerable proportion of its revenue in Solanezumab, a neuroprotector for patients with Alzheimer's disease. While the drug attracted extensive media coverage as a possible 'breakthrough' treatment, the medical evidence currently available suggests that these claims are unsubstantiated. In addition, Solanezumab is much more expensive than other drugs for Alzheimer's disease currently on the market; the current estimated treatment cost is $10,000 per year (BioWorld). In comparison, Aricept, which is one of the most commonly used medications for Alzheimer's disease, costs $4,000 a year; generic versions are even cheaper.
- The U.S. government has recently demonstrated that it minds when Pharmaceutical companies overprice their drugs. The drug company Valeant recently came under scrutiny for, among many other things, hiking up prices for drugs (Wall Street Journal). Since Eli Lilly's business model (especially for its aforementioned dementia drug Solanezumab) depends on this type of price hiking, the Valeant scandal makes it likely regulators will not allow Eli Lilly to completely capitalize on its pipeline drugs.
With these observations in mind, it is reasonable to crudely estimate that Eli Lily's PE ratio should actually be in the 20-25 range which still places it above the industry average but devalues the present value of its pipeline drugs by approximately a factor of 50%. Pending FCF analysis and an in depth pipeline review, this is the best estimate we can give. These assumptions give Eli Lilly a forecasted value of $46-$57 in the medium to long term (6 months to 4 years) when clearer plans on government regulation will likely be released.
Closing Thoughts: Drug prices can't continue to increase relative to other goods indefinitely. Eventually policymakers will realize that the United States drug market is fundamentally anticompetitive and will respond with either increased regulation or by instigating negotiation tactics in buying drugs for Medicare. Given what we've observed about the policy environment it seems that pharmaceutical regualtions may come sooner than the market anticipates. This offers an opportunity in shorting a company like Eli Lilly who's market valuation is most susceptible to future regulations because of its high R&D spending, history with fraud, and dependence on high margins for future drugs like Solanezumab.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.