I love dividends, so it's not surprising that I'd be attracted to Eli Lilly (NYSE: LLY ) . Its shares sport a pretty hefty 5.2% dividend yield. But as patent expirations loom for numerous big pharmaceutical companies, investors are concerned about nearly every stock in the industry.
Can Lilly's stock bull through the tough times and still offer great returns? Let's take a closer look.
Earnings expectations
As I outlined in a previous article, comparing Wall Street analysts' expectations to the company's actual growth can give you a good baseline for growth expectations.
|
Time Frame
|
Annual Growth Rate
|
| Analysts' estimates |
(4.7%) |
| 10-year historical |
6.1% |
| 5-year historical |
12.2% |
| 3-year historical |
11.3% |
| Last 12 months |
7.7% |
Source: Capital IQ, a Standard & Poor's company. Historical growth based on operating earnings.
Obviously, analysts see tougher times ahead than Lilly has experienced over the past decade -- and they're most likely right. In the next few years, Lilly will see patents expire on a number of its major revenue generators, including Zyprexa, Cymbalta, Humalog, and Gemzar. Will that be a big deal? You bet. Those drugs alone accounted for half of Lilly's total revenue.
But the revenue from those drugs won't simply disappear. We need to address exactly how fast we can expect the revenue from those drugs to drop as generic competition enters the market. To figure this out, I studied how off-patent drugs performed at other pharma companies. I assumed that revenue would drop 50% for the year right after the patent protection loss, and 20% per year after that.
Running through this exercise suggests that revenue could fall 9% per year over the next five years. Of course, this doesn't make any assumption about growth beyond those off-patent drugs; I think it's safe to guess that there will be at least some growth elsewhere.
In all, this is a very rough approach, but it does suggest that analysts' estimated 5%-per-year drop in earnings looks fairly reasonable.
For my model's baseline, I decided to be slightly more pessimistic than Wall Street, assuming 6%-per-year drop in earnings. On the upside, I assumed a 3%-per-year decline, while I set a downside case of a 10%-per-year drop.
Pinning down valuation
Valuations are a moving target, but, as with growth above, using a range of values can give us a view of our potential returns without requiring Miss Cleo-style prescience.
In creating our range, we can start with where the stock is trading now, and its historical trading range has been. Right now, Lilly's stock changes hands at 7.9 times adjusted trailing earnings. This lands way at the lower end of Lilly's valuation range over the past decade, which typically had the stock trading at 16 to 26 times trailing earnings.
For broader context, we can also look at how similar companies trade.
|
Company
|
Forward P/E
|
Estimated Growth
|
Price-to-Earnings / Growth (PEG)
|
| Johnson & Johnson (NYSE: JNJ ) |
13.3 |
6.1% |
2.2 |
| Pfizer (NYSE: PFE ) |
9.0 |
2.7% |
3.3 |
| Merck (NYSE: MRK ) |
9.5 |
4.2% |
2.3 |
| Abbott Labs (NYSE: ABT ) |
10.9 |
8.6% |
1.3 |
| AstraZeneca (NYSE: AZN ) |
7.0 |
(1%) |
NM |
| Bristol-Myers Squibb (NYSE: BMY ) |
12.8 |
1.3% |
9.8 |
Source: Capital IQ, a Standard & Poor's company.
There is a pretty clear split between the valuations of these companies. For the most part, the companies that rely primarily on the sales of patented drugs -- Merck and Pfizer for instance -- trade at single-digit multiples similar to Lilly's. J&J and Abbott, on the other hand, have been awarded higher valuations by investors because they have more diversified businesses that don't face quite the same risk from drug-patent expirations.
These low valuation multiples result from investors' expectations that earnings will fall as patents expire. Thus, I think it's pretty safe to assume that the multiples will climb in the years ahead, as investors digest how deeply patent expirations actually reduce earnings, and get more comfortable about the future. However, I don't think that Lilly's valuation will climb back to the heights of its recent past. The market is less frothy than it was, and five years from now, Lilly investors will still be looking ahead to patent expirations from the likes of Altima and Cialis.
For my model, I set my upper-, mid-, and low-case assumptions for earnings multiples at 16, 14, and 10, respectively.
Dividends and share count
Finally, we need to consider how much we'll get paid through dividends, and whether changes in share count will affect our bottom line.
I always worry that a company will issue boatloads of shares and dilute my ownership stake. In recent years, Lilly's share count has crept up slightly on an annual basis as the company halted share repurchases, but the magnitude of those increases isn't worrisome.
As for dividends, Lilly's current yield is very attractive, but with earnings due to fall, I don't think we can expect much more than that in the years ahead. Optimistically, I could see dividends edging up by 3% or so per year, but I think it's much more likely that the payout rate will stay fixed.
The verdict please!
With all that data factored in, here's how my three scenarios turn out:
|
Scenario
|
Annual Earnings Per Share Growth
|
Earnings Multiple
|
Annual Dividend Growth
|
Expected Annual Returns
|
| Upside |
(3%) |
18 |
3% |
16.2% |
| Mid-case |
(6%) |
14 |
0% |
10% |
| Downside |
(10%) |
10 |
0% |
0% |
Source: Author's calculations.
These aren't overly impressive results. In order for me to get excited about a stock, I normally like to see returns exceeding 12% in the mid-case scenario.
Could Lilly's stock be a double over the short-term? In the optimistic case, the answer is a definite "yes." As a current owner of Eli Lilly, I'm satisfied to hang on with mid-case returns of 10%. However, for new money, I think there are better opportunities in the healthcare space (like Abbott!).
Of course, the future is an ever-changing picture. You need to keep on top of what's going on at Lilly to see which set of numbers the company and stock can fulfill. Happily, you can do just that by adding the stock to your Foolish watchlist. Don't have a watchlist yet? Start one up by clicking here.
RSS Headlines
Fool UK