3 Reasons Eli Lilly & Co.'s Stock Could Rise

Eli Lilly & Co.  (NYSE: LLY  ) has faced some tough times with the loss of patent protection on a handful of its best-selling products. Its recent financial performance, with earnings tumbling 38% in one year, could scare away any investor. A closer look, though, suggests that Lilly still has a lot going for it. Anticipating these troubles, Lilly has set itself up for a turnaround with big opportunities in diabetes, animal health, and oncology. Let's dig into those opportunities and how they can help drive the business and the stock in the future. Remember, though, as with any investment, Lilly's turnaround will not come without risk, and sound execution of the strategy laid forth by management will be key.

Source: Eli Lilly & Co.

Big markets, big opportunities

Eli Lilly's late stage pipeline is stocked with eight phase 3 programs targeting markets as massive as diabetes, oncology, and autoimmune disorders.

In diabetes, Lilly already boasts one of the best-selling mealtime insulins in Humalog, which brought in $2.6 billion in 2013. Humalog will now be joined by Jardiance, which was recently approved by the FDA as a SGLT-2 inhibitor to improve glycemic control in patients with type 2 diabetes. The FDA is also reviewing the application for dulaglutide, Lilly's GLP-1 agonist that performed just as well as Novartis' Victoza in a phase 3 trial but has a more convenient once-weekly dosing schedule. Those products will help Lilly gain additional share in a market affecting at least 29 million Americans.

Oncology is equally as lucrative a market, and Lilly's newly approved Cyramza could carve out a space in the battle against gastric cancer. Approved in April, Cyramza is the first FDA-approved drug for the treatment of patients with advanced gastric cancer with unsatisfactory responses to chemotherapy. While that presents an important market for Lilly, greater opportunity for growth exists in label expansion. We learned earlier this year that Cyramza improved overall survival in patients with non-small-cell lung cancer and will likely learn its effects in patients with colorectal cancer by year's end.

Perhaps Lilly's most exciting recent result was the success of autoimmune drug ixekizumab in the treatment of plaque psoriasis. Psoriasis and other related autoimmune disorders provide the market for some of the world's greatest selling drugs, including TNF-alpha inhibitors Enbrel from Amgen, Humira from Abbvie, and Remicade from Johnson & Johnson, which, combined, brought in $21.8 billion in 2013. Like other members of the new class of IL-17 inhibitors, Lilly has now presented evidence that ixekizumab is more effective at treating psoriasis than Enbrel. Beyond psoriasis, Lilly is now also testing ixekizumab in other indications for which TNF-alpha inhibitors are indicated, such as psoriatic and rheumatoid arthritis.

Improving health of Elanco animal health

Lilly's Elanco animal health unit appears to be a bright spot in the company's portfolio. Coming off a 2013 of 6% revenue growth, Elanco posted 11% revenue growth in the most recent quarter. While that accelerating growth is important, it was overshadowed by decreasing margins and a 7% decline in segment profits.

Looking for a second boost to revenue and any opportunity to make the segment more profitable, Lilly recently made an uncharacteristically large acquisition, purchasing Novartis' Animal Health unit for $5.4 billion. Once made official in 2015, the acquisition will send Elanco toward the top of the animal health industry behind only Pfizer spinoff Zoetis. With $1.1 billion in revenue in 2013, Novartis Animal Health will instantly boost segment revenue by 50%, while enabling an estimated 10% reduction in combined operating expense.

The secondary benefits are even more appealing. Novartis Animal Health will bring a new and diverse set of vaccines and anti-parasite medications to expand Elanco's portfolio. More importantly, the deal will give Elanco more access to emerging markets where their products can support growing dairy and aquaculture industries.

Margin expansion

The loss of revenue from Lilly's blockbusters has been catastrophic, but the financial effects were amplified on their way to the bottom line. As sales volume decreases, management has been forced to refocus its sales and administrative cost structure. It has also had to ramp up R&D spending as a percentage of revenue to retool its pipeline with late-stage drug candidates to replace lost revenue. Combined, the impact on operating income has been more substantial than the decline in the top line would suggest.

In its most recent quarter, Lilly posted operating expenses at 58% of revenue, or an 18% operating margin. But in its conference call, CFO Derica Rice reaffirmed management's commitment to attaining operating expenses of 48%-50% of revenue by 2019. All else being equal, those cost control measures have the potential to raise operating margins to 26%, much closer to the TTM operating margins of industry peers like Johnson & Johnson (27%) and Pfizer (32%), and boost operating income by a hefty 44%.

Returning to growth

With a combination of pipeline potential, strategic expansion, and cost controls, Eli Lilly has set itself up with opportunities to right the ship in 2015 and beyond. An investment in Lilly is an endorsement of the turnaround strategy, which will require management to execute on multiple fronts. If you think the company can knock down the strategic pins it has arranged for itself, then it is likely a return to bottom-line growth can carry the stock higher. I believe some of these goals are obtainable, but the confluence of events necessary to make Eli Lilly a winning investment are less than certain.

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