5 Things Eli Lilly and Co's Management Wants You to Know

By most financial metrics Eli Lilly  (NYSE: LLY  ) had a painful second quarter, with revenue falling 17% year over year and earnings per share down 39%. But given that the stock has rallied 18% year-to-date, let's dig in further and try to understand why optimism around the stock continues.

We knew this was coming
CEO John Lechleiter discussed Lilly's challenges and opportunities during the company's second-quarter earnings call:

Even as we feel the full brunt of our patent expiries, we continue to execute our strategy. Our performance is in line with our expectations and we are on track to meet the goals we have shared with you for the year. And the steady advance of our pipeline only strengthens our confidence in our innovation-based strategy.

The best part of a patent cliff, if there is one, is that you can see it coming from a mile away. Under Lechleiter's leadership, Lilly wasn't caught off-guard by the revenue and earnings slump when Zyprexa, Cymbalta, and Evista lost patent protection. It set goals to dampen the blow. According to Lechleiter, that strategy has been working.

But what about the future? Softening the fall is one thing; reigniting growth is another. Will Lilly look to grow internally or follow its Big Pharma peers with blockbuster M&A?

M&A madness

As it relates to M&A activity, our stance and strategy has not changed in this space. We continue to be very interested in looking for those opportunities that can augment our current organic footprint, both commercially as well as scientifically. And that really lies in the space that you have seen us play in historically, looking for in licensing deals and sometimes it's easier to do small M&A transactions to get access to those technologies. We continue also to be not interested in doing the large-scale M&A.

The unambiguous statement from CFO Derica Rice sets Lilly's strategy apart from peers engaged in a flurry of tax-inverting, growth-stimulating acquisitions. Prompted by another question, Rice indicated that a $20 billion deal "is a pretty large number," putting a ceiling on potential future deals, including those large enough to enable tax inversion (moving a company's corporate home to another country to reap a lower tax rate).

With the gauntlet thrown, Lilly must now deliver on internal innovation. Let's look at which programs Lilly's management is most excited about.

Diabetes leads the way
Diabetes is likely the greatest driver of Lilly's immediate potential revenue growth. Anchored by strong Humalog sales, new drugs dulaglutide and empagliflozin have the potential to turn Lilly into a strong diabetes play. Here's Lechleiter on dulaglutide's competitive advantage.

If approved, dulaglutide will be the only GLP-1 receptor agonist that is both once-weekly and ready-to-use. We believe it could provide patients and physicians an important new treatment option for Type 2 diabetes.

Senior Vice President Enrique Conterno also referred to dulaglutide as a "significant value proposition" when compared to Novo Nordisk's Victoza and GlaxoSmithKline's Tanzeum. Despite the reduced price of Tanzeum, Lilly's management seems to think its drug's premium profile deserves a premium price and market share.

Oncology, with caution
From Lechleiter:

I think the fact that we had three potential cancer drugs that fell out of Phase 2 is somewhat a factor of just the abundance of cancer opportunities that we have in Phase 2. It reflects the ongoing nature of the business decision making related to data that we have gathered and other priorities that we have set. I think going forward, you are going to see Lilly much more focused on the clinical progression of the molecules where we believe we have a competitive lead and that we believe offer the greatest opportunity for Lilly.

If Lilly is truly committed to growing primarily by internal innovation, its approach will have to be extremely disciplined. Ushering drugs from conception through preclinical and clinical studies to regulatory filing and marketing requires constant analysis of research and development investments and potential returns. In dropping drugs during Phase 2 development, Lilly is signaling a willingness to cut its losses and refocus capital toward drugs promising the greatest returns.

Cost-cutting
In addition to cutting costs by strategically pursuing only the most promising pipeline assets, Lilly will look to enhance operational efficiency to further accelerate earnings growth. Rice provided some guidance on what we can expect from future operating margins:

What we said is that, no later than 2019 or by 2019 we will achieve a total operating expense as a percent of sales somewhere in the 48% to 50% range. Getting back to the historical levels of profitability that you have seen from Lilly pre-patent expiration. We still expect to at least meet that timeline.

The numbers for the quarter suggest that Lilly has a long way to go in the next five years. For second quarter 2014, operating margin was 18%, a sizable decline from the 26% captured in the same quarter a year ago.

The big picture
This conference call quite clearly laid out Lilly's strategy moving forward. In contrast to its acquisition-crazed industry peers, management has committed to growth by internal innovation and expense control. With executives expressing no doubts surrounding the strategy, the question for investors will be, "Can management pull it off?" In future coverage, we'll dissect the good and the bad in Lilly's pipeline to see if it has the juice to jump-start growth.

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