Investors brace for lean years from Lilly

October 12, 2013

For Eli Lilly and Co., this year may be as good as it gets for a long time.

In a new round of predictions this month, Wall Street analysts indicated they expect Lilly’s revenue to fall next year and to remain below 2013 levels until 2020.

In between will be seven lean years for the Indianapolis-based drugmaker, in which its executives focus on producing profits more through reducing expenses than growing sales.

Lechleiter Lechleiter

Lilly CEO John Lechleiter has tried his best to follow the biblical Joseph by storing up new drugs for these lean years. But a string of R&D failures has left Lilly with nothing that even remotely approaches the $5 billion in annual sales of Cymbalta, Lilly’s best-selling drug, which will see its U.S. patents expire in December.

That’s certainly not attractive to investors, who were looking for a new strategy or new product from Lilly during its investor day on Oct. 3. Not hearing anything, investors backed away from Lilly shares, letting them fall 5 percent in the following week—to their lowest level this year.

lilly-fever.gifIt’s also ominous for the Indianapolis area, where Lilly employs more than 10,000 workers, paying compensation of nearly $1.5 billion every year, and does business with about 1,000 local contractors, spending nearly $1 billion per year.

“We think it will be difficult to put up revenues similar to 2013 until maybe 2019 or 2020,” wrote UBS analyst Marc Goodman in a note to investors Oct. 3. “And that is not good enough to drive more [profit than] we have today.”

Like Goodman, nearly all Wall Street analysts have downbeat long-term outlooks for Lilly. Collectively, they expect the company’s revenue to plunge 14 percent next year and then remain down by double-digit percentage points in three of the four years after that.

Likewise, analysts predict Lilly’s overhead spending will drop 12 percent next year—after already declining nearly 10 percent since 2011, the year Lilly saw its major patents expire on its former best-selling drug, Zyprexa.

Many of these cuts have come via layoffs. Since 2010, Lilly has cut 5,600 workers, or about 13 percent of its work force, including more than 2,000 at its Indianapolis headquarters. The company has slashed its U.S. sales force 30 percent and its management ranks 25 percent.

Lilly even will trim its spending on R&D 13 percent over the next five years, from a record $5.4 billion this year to a low of $4.7 billion in 2018, according to an average of six analysts’ estimates.

Many of those reductions will come as Lilly concludes large clinical trials that are spread around the world. But with an estimated 60 percent of workers at Lilly’s headquarters focused in some way on research, there is sure to be a local bite as well.

Derica Rice Rice

Lilly executives like to tell their long-term story differently. They acknowledge that 2014 will be a “trough” year, but promise the company will “return to growth” in 2015 and beyond.

“These actions position us to emerge from this wave of patent expirations both leaner and more agile, more customer-centric and poised to successfully launch our next wave of innovation,” Lilly Chief Financial Officer Derica Rice told analysts and investors during an Oct. 3 presentation at Lilly’s headquarters in Indianapolis.

Squeezing out profits

lilly-factbox.gifLilly executives also spent time Oct. 3 touting that, even as revenue stagnates, they have worked out ways to improve overall profitability.

Lilly has three diabetes products that could launch in the next year or two. Those drugs—dulaglutide, empagliflozin and insulin glargine—all could generate $1 billion in sales by 2020, according to analysts’ forecasts.

The company is working now to institute standard technical operations at all its insulin plants so it can manufacture its existing as well as its soon-to-come insulins at any one of the plants. That will allow Lilly to double insulin output without increasing its current manufacturing capacity—saving $1 billion in the process.

In addition, because Lilly expanded its diabetes sales force when it launched Tradjenta in 2011, the company believes it can launch those three new diabetes products, and perhaps a fourth one also in the pipeline, with its existing diabetes sales staff.

“We expect to leverage this footprint as we launch new products,” Enrique Conterno, president of Lilly’s diabetes business unit, said on Oct. 3.

Lilly has a similar sales strategy as it prepares to launch new cancer drugs from its pipeline.

Those are important steps for Lilly to attempt to grow profits even with stagnant revenue, and they drew wide praise from Wall Street analysts.

“We think Lilly continues to do the right thing for the long term, from investing in R&D through the tough years to aggressively cutting costs to right size the organization,” wrote Goodman, the UBS analyst. “With that said, it will still be a difficult few years for the company, and we think it is a little early to own the stock.”

Analysts expect Lilly’s profits to plunge 33 percent next year and then grow by less-than double digits in three of the following six years.

Lilly will try to make its profits and its stock more attractive to investors by spending $1 billion a year over the next five years to buy back its shares. According to Barclays Capital analyst Tony Butler, Lilly will get that money by repatriating profits from overseas—which will be taxed at a lower rate during Lilly’s lean years.

However, Butler noted, a company that props up profits through cuts instead of through growing revenue never gets investors too excited.

“That is not a basis on which most investors choose to invest,” Butler said in an interview. He recommended that investors wait to see Lilly launch new drugs or make good on its expense-reduction promises before buying the stock.

In a research note, he added that Lilly is “climbing out of the trough,” but “not just yet.”

Betting on the pipeline

One thing that could change analysts’ outlooks is if Lilly’s experimental Alzheimer’s drug, solanezumab, were to make history as the first effective treatment for the disease. But as solanezumab goes through another large clinical trial, the earliest it could hit the market would be 2017.

Another long-shot drug that could single-handedly alter Lilly’s outlook is evacetrapib, a cardiovascular drug that aims to lower bad cholesterol and raise good cholesterol at the same time.

Goodman, the UBS analyst, said he remains “very skeptical” about both drugs. So do most other analysts.

Quite intentionally, Lilly has staked its future on finding new breakthrough drugs, like solanezumab and evacetrapib. Lilly executives boasted on Oct. 3 that they have shunned some of the ways other drug companies have steeled themselves for patent expirations on blockbuster drugs: large mergers, diversification into generic drugs and into other “non-core” businesses.

“We have reaffirmed Lilly’s commitment to innovation as our best path forward,” said Lechleiter, who became Lilly’s CEO in April 2008. “We continue to believe this is the best strategy to create value for patients, physicians, payers, and for shareholders.”

But investors have seen too many failures out of Lilly’s pipeline to put much faith in drugs in development until they are submitted to regulators.

So far this year, Lilly has submitted four more molecules to regulators, which could increase its success record substantially. Analysts give most of those drugs good chances for approval—although even if all four hit the market, they will still not replace this year’s loss in Cymbalta revenue until 2020, according to analysts’ predictions.

Barron’s magazine, which had recommended Lilly’s stock back in January, this month predicted the stock was now bound to lose more ground. Based on analysts’ forecasts of Lilly’s earnings in 2014, noted Barron’s writer Johanna Bennett, Lilly shares are among the most expensive of all pharmaceutical stocks.

“To be sure, Lilly’s well-stocked pipeline could deliver potent revenue growth,” Bennett wrote. “But given the stock’s valuation, Lilly is an expensive gamble on a company that has yet to prove itself.”•


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