Lilly's Growth Prospects Are Improving

Lilly’s internal pipeline is well positioned to mitigate the patent losses during the next decade. The company tends to spend over 20% of its sales on financing the development efforts of new drugs, much higher than the midteens industry average. The robust pipeline is a result of Lilly’s strong commitment to research. We believe recently approved diabetes drugs Tradjenta and Jardiance hold the highest sales potential of Lilly’s new drugs. Also, several of Lilly’s late-stage cancer drugs, such as Cyramza and necitumumab, should develop into blockbusters if additional clinical data holds up. Alzheimer’s drug solanezumab, in phase 3 development, holds major blockbuster potential but also carries more risk of failure.

Lilly’s strong entrenchment in insulin production should also help the company deal with patent losses. Unlike traditional drugs, Lilly’s insulin drugs are very hard to copy by generics and create barriers to entry for noninsulin producers because of the large up-front investments needed to create scale efficiencies. Further, Lilly’s longer-acting biosimilar insulin should help the company secure its market share.

The company is taking a hard look at its bottom line. Through a combination of cost savings and expected top-line growth, Lilly aims to reduce its research and development expenses and marketing costs as a percentage of sales to 18%-20% and 28%-30%, respectively, by 2018, which we believe is achievable if the pipeline is successful. Lilly expects to increase its gross margin through productivity initiatives and greater capacity utilization, which may prove challenging in 2017 as the patents expire on high-margin Cialis and Alimta in certain markets.

Strong Pipeline and Pricing Power Reinforce Wide Moat Patents, economies of scale, and a powerful distribution network support Eli Lilly's wide moat. Lilly's patent-protected drugs carry strong pricing power, which enables the firm to generate returns on invested capital in excess of its cost of capital. Further, the patents give the company time to develop the next generation of drugs before generic competition arises. Lilly's diversified product portfolio means the company's top drugs represent only a moderate amount of total sales, with the largest drug, Alimta, representing 13% of total sales, which sets up manageable cash flow declines as new products mitigate the generic competition. Also, Lilly's operating structure allows for cost-cutting after patent losses to reduce the margin pressure from lost high-margin drug sales. Overall, Lilly's established product line creates the enormous cash flows needed to fund the average $800 million in development costs per new drug. In addition, the company's powerful distribution network sets up the company as a strong partner for smaller drug companies that lack Lilly's resources. Lilly's entrenched insulin franchise creates an added layer of competitive advantage, as interchangeable insulin competition seems many years away due to the complexity of gaining generic approval for insulin and the high cost to build the needed economy of scale for insulin production.

Over the next three years, the company’s key patent losses include erectile dysfunction drug Cialis, cardiovascular drug Effient, and potentially cancer drug Alimta. While patent losses over the next three years will affect over 20% of total sales, the company’s strong pipeline combined with stable currently marketed drugs should lead to over 7% annual revenue growth over the same period. On the pipeline side, we expect over $1 billion in peak annual sales from psoriasis drug Taltz and rheumatoid arthritis drug baricitinib. Also, strong cardiovascular data for Lilly’s diabetes drug Jardiance (approved in 2014) should drive this drug’s peak annual sales to over $5 billion.

In the macro environment, Lilly has several headwinds but is making solid strategic moves to address the challenges. On the negative side, the risk-sensitive U.S. Food and Drug Administration is generally approving only very safe drugs or drugs in high-need areas such as cancer. Also, managed-care organizations and pharmacy benefit managers have consolidated over the past decade and are now using their growing size to demand lower drug prices and reduced coverage for less innovative drugs, forcing drug firms to push for true innovation, and reducing the power of Lilly’s distribution networks. Further, the U.S. government is evaluating comparative effectiveness programs and more aggressive price negotiations, raising the bar for future innovation. While Lilly has several headwinds, its pipeline holds several biologic drugs that hold much stronger competitive advantages than traditional small molecules. Further, the company’s pipeline is focused on more innovative treatments in areas of unmet medical need where payer coverage and pricing power remain strong. Outside the pipeline, the company’s strong insulin franchise (20% of sales) carries some of the extra protections awarded to biologics and the economies of scale needed to produce the relatively lower-priced drugs. Also, the company’s well-entrenched animal health business (17% of sales) operates in a mature and stable business that is not experiencing any significant changes.

Competition and Pricing Pressure Are Risks Lilly faces tough competition from both generics manufacturers and brand-name drugmakers. Also, governments and managed-care organizations continue to consolidate their purchasing power and exert pricing pressure. The company encounters considerable regulatory and legal risks, including product approvals, patent challenges, and liability lawsuits. Further, the patent risk on cancer drug Alimta (13% of sales) is elevated as the 2022 patent is not a strong composition of matter patent, which increases the likelihood of earlier-than-expected generic competition.

With strong cash flows derived from a stable and diversified product portfolio, Eli Lilly remains on solid financial footing. Given its strong growth prospects, we don't expect Lilly will need to make any major acquisitions to drive growth. Nevertheless, we expect tuck-in acquisitions will augment growth for the company over the next decade.