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Lilly's Pipeline of Plenty


By Herman Saftlas When a blockbuster drug and major profit generator like Prozac goes off-patent, it usually signals anxious times ahead for company management and investors. But Eli Lilly (LLY), which changed the shape of the antidepressant market with that breakthrough prescription compound, has strategically managed the 2001 loss of patent protection on its former $2.5 billion (annual sales) cash cow through heavy investments in research and development. Lilly's efforts should soon begin to pay off in the form of lucrative new products and accelerated earnings-per-share growth.

Lilly, whose new-product filings last year have already distinguished it from the Big Pharma pack, should lead its peers in terms of new drug launches and earnings growth over the 2003-07 period, thanks to the planned introduction of eight blockbuster products over the next two years. These new drugs could eventually add over $4 billion to Lilly's annual sales by 2007, of which 28% could be brought down to the bottom line (equal to over $1.00 a share).

PLEASANT SURPRISES. The shares have been highly volatile during 2002, largely because of investor concerns over Food & Drug Administration-cited quality-control manufacturing problems at several plants. However, we at S&P believe these issues will be cleared up in 2003. Lilly carries S&P's highest investment ranking of 5 STARS (buy).

In a surprise move on Nov. 27, one that came months ahead of expectations, the FDA approved two important new Lilly drugs: Strattera (atomoxetine HCl) for attention-deficit/hyperactivity disorder (ADHD) in children, adolescents, and adults; and Forteo, a treatment for severe osteoporosis. These approvals relieved investor concerns that no new Lilly drugs would be approved until all of its manufacturing problems were resolved. Both Strattera and Forteo will be produced at facilities free of manufacturing issues.

Strattera has a unique competitive advantage over rival ADHD drugs: It's the first FDA-approved ADHD drug not classified as a stimulant under the Controlled Substances Act. That will enable Lilly to more effectively market the drug with samples and direct-to-consumer advertising, while parents and users will have the option of phone-in refills. These features are not allowed for controlled substances.

DISTINCT DIFFERENCES. ADHD, which affects some 3%-5% of school-age children and 4% of adults, remains a very underprescribed market -- only about 37% of impacted children and less than 5% of adults are treated. Lilly hopes to significantly expand that market. We see Strattera sales of about $250 million in 2003, expanding to close to $1 billion by 2006.

Forteo also has a significant edge over competing osteoporosis therapies. Unlike conventional treatments that work to reduce bone loss, Forteo is an anabolic agent that increases skeletal mass, lowers fracture risks, and stimulates the body's own bone-making process. The drug's label will have a "black box" warning because of some incidence of osteosarcoma (bone cancer) in laboratory animals. However, no incidence of osteosarcoma was seen in humans taking Forteo. With premium pricing -- an annual cost per patient of over $6,000 -- we expect Forteo sales to exceed $500 million by mid-decade.

The next big FDA approval for Lilly should be Cialis -- another drug that will not be produced at facilities associated with quality-control issues. A novel treatment for erectile dysfunction, it was developed in conjunction with ICOS Corp. Studies have shown Cialis to work faster and last longer than Pfizer's popular Viagra. Recently approved in Europe, Cialis should achieve peak sales in the $2 billion range.

A NEW APPROACH. Another potential $2 billion product is antidepressant Cymbalta, a serotonin norepinephrine reuptake inhibitor (SNRI) that differs from conventional selective serotonin reuptake inhibitors (SSRI) such as Prozac, Zoloft, and Paxil. Believed to be more potent than the SSRIs, Cymbalta treats both mood and the painful physical symptoms associated with depression. Lilly is also studying Cymbalta for the treatment of stress incontinence. Produced at Lilly's Indianapolis plant, FDA approval hinges on resolution of manufacturing problems.

Unlike most of its peers, none of Lilly's principal drug products face any generic threat over the next five years. Even though the patent expires at the end of 2003 on the growth hormone Humatrope, no generic challenge is expected since that product is a biologic and, to date, no generic biologics have yet been approved.

Lilly's most important single drug, Zyprexa, a treatment for schizophrenia and bipolar disorder, accounts for about 31% of the U.S. antipsychotic prescription market. Although the number of prescriptions written over the near term may flatten somewhat due to the entry of Bristol-Myers' rival Abilify, we still see Zyprexa sales growing at a percentage rate in the low teens in 2003. One edge Zyprexa has over Abilify is that it can be prescribed for a broader range of conditions. Sales should also be helped by its proven record of efficacy, expansion into new markets, and anticipated FDA clearance of a new injectible formulation.

BLOCKBUSTER POTENTIAL. Other key growth drugs include Humalog human insulin for type 1 diabetes, Actos for type 2 diabetes, Gemzar anticancer therapy, Evista for osteoporosis, and Xigris for sepsis. Despite recent sluggishness, Xigris should achieve blockbuster status over coming years, helped by regulatory approvals in Europe and new studies demonstrating its effectiveness in treating severe sepsis.

After four consecutive quarters of declining earnings due to generic erosion in the Prozac line that started in August, 2001, Lilly posted modestly higher EPS in the third quarter of 2002, excluding nonrecurring items. It had expected a stronger performance, but results have been hurt by those manufacturing quality-control issues, which were first cited by the FDA in 2001. With negative Prozac comparisons penalizing results for the first seven months of the year, total revenues for 2002 are expected to dip about 3%, to $11.1 billion, and diluted EPS will probably slip 1% to $2.55, from 2001's $2.58 (before nonrecurring items in both years).

Expenses associated with rectifying manufacturing problems and the heavy cost launching of new products are likely to restrict earnings growth to about 6%, to $2.70 a share, in 2003. However, sales growth should accelerate over the 2003-06 period, driven by rising contributions from a steady stream of new products. Coupled with rapidly growing equity income and cost efficiencies, pretax margins are expected to expand from 32% in 2002 to 36% in 2005. We project compound annual EPS growth of over 20% over the 2003-2007 period.

CRUNCHING THE NUMBERS. Examining Lilly's 2001 results on an S&P Core Earnings basis, its use of stock-option grants as a form of employee compensation is roughly comparable with the overall drug-industry average on a percentage-of-earnings basis. Had Lilly expensed all options, EPS in 2001 would have been reduced by 7.3%, vs. an average decline of 7.5% for the overall Big Pharma sector. Expensing pension costs would have reduced EPS by an additional 7.8%, somewhat lower than the industry average hit of 8.8%.

We believe Lilly's premium multiple to the overall Big Pharma sector (24 times estimated 2003 EPS, based on a recent share price, vs. the group average of 20%) is justified in light of its extended patent-protected portfolio and unmatched pipeline potential. Our 12-month target for the stock is $78, or about 18% above the recent price, and is derived by applying the present multiple to our 2004 estimate of $3.25. Judged by the price-earnings ratio and three-year projected growth-rate basis, Lilly recently traded at a 20% discount to the industry average. And finally, LLY was selling at a 25% discount to its intrinsic value based on our discounted-cash-flow model. Analyst Saftlas follows pharmaceutical stocks for Standard & Poor's


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