Positive Data Boosts Outlook for Lilly

We are increasing our fair value estimate for Eli Lilly LLY to $142 per share from $130 on the basis of positive adjuvant breast cancer data for Verzenio. The data positions Lilly’s drug to enter the large adjuvant breast cancer setting ahead of key competitors Ibrance (from Pfizer PFE) and Kisqali (from Novartis NVS). While Verzenio was the last major CDK 4/6 breast cancer drug to enter the metastatic (late-stage) breast cancer market, it looks poised to be first in the adjuvant (early-stage) setting.

The strong data should help support Lilly's wide economic moat by significantly expanding the sales potential of a drug that had been relegated to likely gaining only a small slice of the late-stage market before this positive adjuvant data. Additionally, the recent setback for Ibrance in the adjuvant setting could mean that Lilly will have a first-mover advantage in the adjuvant setting for a long duration. However, Pfizer has another phase 3 study with Ibrance in a high-risk adjuvant patient group (similar to Lilly's positive study) set to report in the second half of 2020, and if successful, this may limit the duration of Lilly's first-mover advantage. Also, Novartis should complete an adjuvant study with Kisqali by 2022, opening up another potential competitor in the early-stage setting.

Eli Lilly’s positive data in the adjuvant setting holds the potential to almost double the overall market size for CDK 4/6 drugs from the current $10 billion opportunity in metastatic disease. As a reminder of the importance of adjuvant therapy for valuations, the majority of sales for certain breast cancer drugs comes from the adjuvant setting; Roche’s RHHBY breast cancer platform (Herceptin, Perjeta, and Kadcyla) derives close to 70% of sales from the adjuvant and neoadjuvant settings. However, the data from the Lilly study focused on high-risk adjuvant patients (close 30% of the early-stage market), so Verzenio will not likely target the full early-stage market.

Well Positioned for Strong Long-Term Gains Eli Lilly's innovative culture and strong financial commitment to developing the next generation of drugs set the company apart from its peers and fuel its long-term growth. Following a very steep patent cliff in 2014, Lilly's growth prospects are improving as the company is launching several new blockbusters and patent losses are fading.

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 Trulicity, Tradjenta, and Jardiance and immunology drugs Taltz and Olumiant hold the highest sales potential of Lilly’s new drugs. Also, several of Lilly’s cancer drugs, such as Cyramza and Verzenio, should develop into blockbusters if additional clinical data holds up.

Lilly’s strong entrenchment in insulin production should 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 reach operating margins of 31% in 2020, which we believe is achievable. Lilly expects to increase its gross margin through productivity initiatives and greater capacity utilization. Overall, we view the strong traction of recently launched high-margin drugs in immunology and oncology as supporting overall profitability gains.

Patents, Economies of Scale, and Distribution Network Support Wide Moat Lilly's patent-protected drugs carry strong pricing power, which enables the company 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, Trulicity, representing 13% of total sales; this 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. Lilly's recently launched biologic drugs create higher hurdles over traditional small molecule for biosimilars to gain market share following the eventual patent expirations.

Given decelerating patent losses and a strong pipeline, we believe Eli Lilly’s moat trend is stable. Over the next five years, the company’s key patent losses include erectile dysfunction drug Cialis, osteoporosis drug Forteo, and potentially cancer drug Alimta. While patent losses over the next five years will affect close to 10% of total sales, the company’s strong pipeline combined with stable currently marketed drugs should lead to over 3% 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 Olumiant. Strong cardiovascular data for diabetes drug Trulicity should drive this drug’s peak annual sales to over $4.5 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 companies 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 (17% of sales) carries some of the extra protections awarded to biologics and the economies of scale needed to produce the relatively lower-priced drugs.

Competition and Pricing Pressure Are Risks Lilly faces tough competition from generics manufacturers as well as 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 (10% 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. Strong data from Novo's NVO new GLP-1 drug will likely weigh on growth prospects for Trulicity. Overall, we rate the company's fair value uncertainty as medium.

With strong cash flows derived from a stable and diversified product portfolio, Eli Lilly remains on solid financial footing. We expect debt/EBITDA to fall from close to 2.3 times in 2018 to close to 1.7 times by 2023. We expect debt/capital to fall from close to 57% in 2018 to 45% in 2023 as cash flows accrue over the years. With 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.