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Scale and Patent Protection Integral Parts of Lilly's Moat

Damien Conover, CFA

Damien Conover: I am Damien Conover, director of pharmaceutical research at Morningstar. I'm pleased to be joined by Dave Ricks, head of Eli Lilly's Bio-Medicines group, the largest division at Lilly.

With that, let me go ahead and ask probably what is the biggest question I think on our investors' minds. When we look at the pharmaceutical industry, we see very strong returns on invested capital, much higher than the weighted average cost of capital. Now, that's true for a lot of your peers as well as for Lilly. Can you talk about some of the drivers that really speak to why you have such strong returns on invested capital?

Dave Ricks: Sure, Damien. I think it's true--we have high returns on investing capital in the industry. They have been coming down a little bit as of late, in the last half of the last decade. And I think there are really three drivers though for that difference, maybe from other sectors. One is, there has been a lot of effort in the industry to take out costs during that period of time, and there is a big focus on doing what we do in a more efficient way. That's certainly true at Lilly, and we recently announced some long-term targets for operating expense as a percent of sales and a focus on how do we become more efficient. And that's I think a new part of the industry as growth has slowed down on the revenue line.

Second thing is, really it’s a research enterprise. And so it's difficult and risky by nature. We have to make decisions years in advance of known or unknown success and spend in some cases hundreds of millions of dollars to figure out the answer to a particular research question or a Phase III program, and I don't think that's for the faint of heart. And so we should expect returns above other industries, I think, because of the nature of innovative industry.

I think, the final thing is, it's hard -- that the barriers to entry are. Although there's not a single barrier to entry other than a patent system on a given product, to become a large pharmaceutical company, we don't see many new entrants in that field. In fact, the field is getting narrower because to have a global commercial footprint, to have a global development enterprise, and to have a research base that's big enough and productive enough to sustain those other two things take some doing and some patience. As I said, it's really a 10-year window we're investing across from a research idea to a product being launched, and I don't think that's for everybody.

Conover: Yeah. I know, absolutely. When we look at some of the strengths in Lilly's moat, we kind of see a couple of pieces. We see the economies of scale that you're talking about, kind of the size that you need to be to be able to diversify some of those risks and then also just sort of the intellectual property laws. And the strength of patent protection is--it's 20 years, but obviously you eat up a lot of those years in development. When you look at maybe those two pieces of the moat would you ascribe one of those as potentially more important than the other, or how do they work together?

Ricks: Yeah, I think they do work together. One piece of our business that is very important to understand is the scale to get in, to create an innovative pharmaceutical, and you see this in the biotech space. Other than a few key segments of diseases where the scale is not so high because of the cancer, for instance, or orphan diseases. We don't see companies going out and say, I'm going get in the cardiovascular business as a startup, because the cost of entry is extremely high and the risk is high, so you need to diversify across several platforms.

There is also scale, economies, and things like our commercial footprint. So increasingly, I think for every big company, including Lilly, the percent of revenue coming out of major markets is diminishing through time, emerging markets, so that actually just increases the complexity and scale challenge for a new entrant.

Finally, the patent laws are critical, and we spend a lot of time with policymakers in Washington and abroad ensuring that we can actually improve intellectual property protection. A recent example is the U.S. reform of the Patent Act, as well as the 12 years of data exclusivity, which were part of the Obamacare for biologics, which are reassuring for us, and yet we're not satisfied with that. I think we still think 12 to 15 years is the right window for reward based on investors being patient and taking all that risk for what as you said can be up to 10 years of development. So, we continue to push for advancement there.

In emerging markets, we're seeing some positive change in terms of adopting an intellectual property that will be important. Places like Japan have stood up and really stood behind strong intellectual property, which has turned out to be important for us.

Conover: Maybe just a followup on that. When you look at your competitors, as well as yourself, would you say that firms that have specific emphasis in certain therapeutic areas where it's harder to get a footprint may potentially have a stronger economic moat--areas like cardiovascular disease or some other primary care disease where you need a larger patient trial, more expenses, more expertise--or would you say that the diversification across both primary care and specialty care is a benefit?

Ricks: I think, all things being equal, the benefit to be diversified across both. Because one of the hardest things in our business is predicting which innovation will turn into a differentiated product. So, we can understand scientific tests that show a difference, but across a large human study and then ultimately to commercialize, what will be valued? I'd like our chances better if we didn't have one product. I'd like it if we had more.

Today, we've got 12 products in Phase III, which is one of the reasons I think we're excited about the second half of the decade for the company, but I think those rewards in the market, it's not always clear, when you have to make the investment, which category would be better than others. There are some long-term trends that we think people should read through--diabetes for instance, which is an important segment for our company--where just the underlying demographics are in your favor. And others like Alzheimer's, where you have a big population, but the unmet need can be so clearly measured.

Again, we like the chances of a new medicine in those spaces. You have to sort of analyze each segment, but all things being equal, I'd rather be in more than one.

Conover: More than one. It makes sense. One other question I wanted to just follow up. One of the trends you said early on was kind of the cost-cutting potentially at Lilly, You're making strides to reduce your R&D as a percentage of sales and SG&A as a percentage of sales in 2015-16, longer-term goals. And when I look at Lilly, I see one of the best pipelines in the industry and I think part of that pipeline has been supported by some of the costs that you currently have.

Ricks: Yeah.

Conover: How do you judge what's the appropriate cost-cutting metric versus having a very powerful pipeline?

Ricks: Well, it's a balance. I think we have to be driven by value in the long term, picking the best ideas and bringing them forward. So, we're not in a given year tightly bound to the range--I think we said 18% to 20% long term. We feel the latitude to vary below or above that, depending on the investment opportunities in front of us right then, but rather long term, we see that as a sustainable range to think about R&D cost.

One factor to consider is in this window right now, 2012-14, we are in this YZ period. We really view this is our trough revenue. So, one way the percentage will come down is just through revenue growth as we launch this pipeline, but long term also I think we have to be prudent about where we make those big Phase III bets and hold up a pretty high bar on differentiation and on the quality of the science. Our ambition is not to buy other companies, but rather grow organically. So we have to make sure the next idea is at least as good as or better than those that are already in Phase III. That's part of the discipline of setting those targets. If what you are really wondering is, in a given year will we stop investing because we go to 20.1%, the answer is no. But through time, we see that as a reasonable range in a company that will be growing.

Conover: Sure. That makes sense.

Ricks: So, the absolute number may in fact grow.

Conover: OK. Then one last question: What do you think is most underappreciated by the investment community for Eli Lilly?

Ricks: There are many things, but I think at the top of the list might be the quality of the Phase III pipeline beyond sola. I have responsibility for the solanezumab Alzheimer's drug, and we're of course excited by what we see in that initial set of data. We'll see what happens next, but there has been a huge, I think too much, focus this year from analysts on that one asset.

Of course, if that asset is approved, ultimately, we think it could be game-changing for patients and for the company, but there's other things as well--dulaglutide, the GLP-1 drug, which we just announced in October with some very positive results. We think it's a big play in our diabetes franchise. Ramucirumab, the cancer drug which came out of the ImClone acquisition, has some very strong data in first-line gastric cancer, the first readout from that. We think that's a compelling opportunity. Also in my space we have three autoimmune drugs that are either in or about to enter Phase III studies, and we all know autoimmune is a big and fast-growing, high-profit segment. So, we have a lot of shots on goal here. And I think people need to appreciate each one of those and the opportunity to grow multiple ways as we go into the second half of the decade.

Conover: OK, great. Thanks, Dave, and thanks everyone for joining me. I'm Damien Conover, director of pharmaceutical research at Morningstar. Thank you.