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Poor Pipeline Management Imperils Lilly's Future Cash Flows

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Taking big, risky swings is OK for a biotech, but it's generally a poor way to run a big pharma company. That is one of my core problems with Lilly (NYSE: LLY  ) , as I believe management has frittered away valuable resources on high-risk pipeline candidates and under-innovated in crucial markets like oncology and diabetes. Lilly has a healthy balance sheet and a good sales effort, and management may have to lean heavily on these to generate worthwhile growth.

Q4 wasn't as strong as it seems
Lilly had some good-looking numbers in the fourth quarter, but I don't think the business is as strong as the numbers might suggest. Revenue was down 3% as reported, and about 6% stronger than analysts expected, but that strength was built on some significant price hikes in the U.S. business and better-than-expected sales in declining products. By my calculations, more than two-thirds of the revenue beat came from products like Cymbalta and Strattera that are not going to be long-term growth opportunities at this point. 

Gross margin fell about three points from the year-ago level and missed expectations by more than a point. Operating income performance was also mixed, as SG&A spending was in line with expectation (down 1%), but R&D spending was higher. All told, operating income fell 22% as reported (close to 2.5% better than expected) and the operating margin fell six points.

Pipeline problems – the diabetes business
With Sanofi (NYSE: SNY  ) and Novo Nordisk (NYSE: NVO  ) , Lilly is one of the largest drug companies in the diabetes therapeutic space and one of the "Big Three" insulin producers.

I have some concerns about the company's position in the insulin space. First, Sanofi has sued to block a biosimilar version of Lantus and the 30-month mandatory stay should give the company time to transition patients to U-300 and mitigate the impact of biosimilar Lantus. Second, there have been some warning signs regarding the safety of Lilly's development-stage basal insulin product, and I think investors would do well to ask why partner Boehringer Ingelheim elected not to partner for this product. Although Humalog is a very strong product today, I have to wonder if Lilly is losing momentum (and future sales) to Novo Nordisk, with its FIAsp products in late-stage trials and oral insulin in early studies.

I also have issues with the company's non-insulin diabetes business. Dulaglutide looks superior to AstraZeneca's Bydureon, but I think it has a steep hill to climb to seriously challenge Novo Nordisk's Victoza. Data from a non-inferiority study (AWARD-6) should be available soon, and the results here could go a long way toward determining just how competitive dulaglutide will be. Sanofi is hoping to compete in the GLP-1 space as well, but withdrew its U.S. application in October pending the results of a CV outcomes study (intending to resubmit in 2015) and may not be very competitive outside its LixiLan combination with Lantus insulin. 

Last and not least, I'm not all that bullish on empagiflozin, the company's SGTL-2 inhibitor. The problem here is mostly timing – the product is well behind Johnson & Johnson's Invokana and will be behind AstraZeneca's Farxiga by a couple of months assuming a March/April approval. While Lilly has a very strong sales force in diabetes, payers have become increasingly harsh on undifferentiated products and I believe it will take a lot of work for this drug to stand out in the market.

Pipeline problems – the oncology business
It is my opinion that Lilly's oncology business is also at risk of slipping into the trap of offering older, undifferentiated solutions into a market that will have many new alternatives. Ramucirumab showed surprisingly good efficacy in advanced gastric cancer, and this is likely enough to support $1 billion in revenue.

Beyond that, though, Lilly has one of the weakest immuno-oncology platforms and many of the company's targets/approaches appear old. I am concerned that Alimta and necitumumab are going to be supplanted by the anti-PD-1/anti-PD-L1 therapies under development at Bristol-Myers (NYSE: BMY  ) , Merck, and other pharmaceutical companies. Lilly does have the resources to acquire/partner its way into immuno-oncology, but I fear that if the company waits too long they will fall too far behind.

Bristol-Myers' nivolumab showed a 42% one-year survival rate in a Phase I study, with a median overall survival of 9.9 months. That compares well to Phase III data on Alimta of 10.3-months of median overall survival, particularly when you consider the nivo study was in pre-treated patients and the Alimta study was in treatment-naive patients. Assuming that the data for nivo and other anti-PD-1/PD-L1 therapies hold up, Lilly will be hard-pressed to maintain momentum in lung cancer.

The bottom line
I question the decision of Lilly's management to invest in high-risk programs like the third Phase III study of solanezumab in Alzheimers when core franchises like diabetes and oncology need more innovative compounds. Lilly's iffy pipeline is why I don't project any long-term growth for the company – I expect new products like dulaglutide, ramucirumab, baricitinib, and new insulins can offset revenue lost to patent expirations, but I don't see much growth unless earlier stage programs often good surprises.

With basically no FCF growth, I believe Lilly is worth around $50 today. The company has the balance sheet to bulk up its long-term revenue prospects, but I think investors considering Lilly have to really ask themselves whether they believe this is a management team that can build value over time.

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Stephen D.

I'm an ex-Wall Street sell-side and buy-side analyst who has spent most of the last 10 years writing on a wide range of industries and investment ideas.

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