On this episode of The Motley Fool's Industry Focus: Healthcare, host Kristine Harjes is joined by Motley Fool contributor Todd Campbell to explain how diabetes treatments are driving growth at Eli Lilly & Co. (NYSE:LLY) and why investors ought to pay attention to Lilly's decision to spin off its animal health business, Elanco, later this year.

The two also weigh in on GlaxoSmithKline's (NYSE:GSK) new research and development focus on genetics and how Glaxo hopes to profit from a $300 million investment in the DNA screening company 23andMe. Is Elanco's stock a buy when it IPOs, and does Glaxo's investment in 23andMe make it worth owning? Listen in to find out if these big pharmaceutical companies deserve a spot in your portfolio.

A full transcript follows the video.

This video was recorded on July 25, 2018.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is July 25th. I'm your host, Kristine Harjes, and I'm joined by fool.com contributor Todd Campbell via Skype. On this Healthcare episode, we're covering big pharma earnings and announcements. First, we'll talk Eli Lilly, ticker LLY, and then we'll move to GlaxoSmithKline, ticker GSK.

Eli Lilly is, first and foremost, a diabetes-focused company, and they are massive. They also make drugs for cancer and some other diseases and, as will become important later in our discussion, they have a pretty sizable animal health division. Lilly reported earnings yesterday, and shares got a 5% lift.

Campbell: Eli Lilly launched the very first commercial insulin for diabetes patients. They did that back in 1923. So, it's probably not surprising to find out that today, they remain the second-largest producer of diabetes drugs. They actually get about 44% of their revenue from diabetes treatments. I think, to set the stage, it might be helpful for our listeners to get a quick reminder of what exactly diabetes is. Is that cool with you, Kristine?

Harjes: Go for it.

Campbell: Great. In normal, healthy patients, when the liver produces the simple sugar glucose, or we ingest glucose from eating carbohydrates, beta cells in our pancreas create insulin. That insulin converts glucose into glycogen that gets stored in the liver or in the muscles, and can be used for energy later on. In type 1 patients, the pancreas doesn't produce insulin. In type 2 patients, we've built up a resistance to the insulin we do produce. That's a problem because as blood sugar gets high in the bloodstream, it can wreak all sorts of havoc in the body. You can have nerve damage, it can damage your kidneys, and you can also end up with cardiovascular disease. 

There are about 30 million people in the U.S. alone with diabetes, and there are about 90 million people in the U.S. in prediabetes or elevated blood sugar levels. As a result, this is a massive market, it's a mega blockbuster market. As you mentioned, Eli Lilly, big company. With 44% of their revenue coming from diabetes, that works out to a little bit better than $10 billion per year just in diabetes drugs.

Harjes: Because diabetes is such a complex disease, there are a couple of different drug types that a a company might produce in the diabetes space. For example, Eli Lilly produces a rapid-acting insulin called Humalog. They also have a long-acting insulin called Basaglar, which is actually a biosimilar to the brand name long-acting insulin, Lantus, which is a Sanofi drug. That one was huge, it had $7 billion in peak sales before it lost patent protection. Now, the biosimilar Basaglar is coming after that. It's taking off like a rocket, by the way. This last quarter, their sales grew 133% year over year, and that's after 2017, when their sales surged 402%. So, this drug is really growing at bonkers levels.

But that's not where they stop. They don't just stop with insulin. They also have drugs that work to help manage the disease by either boosting insulin production, which is the case with GLP-1 drugs. They also have Jardiance, which is an SGLT2 inhibitor. What that does is increase glucose excretion from the urine. These are all different approaches to managing and treating this disease. If you take it all together, as you mentioned, Todd, this is a gigantic business unit for Eli Lilly, and it's growing. Their volume growth in the last quarter was up 31% year over year.

Campbell: Right, and that was due to the launch of those next-generation diabetes treatments, the SGLT2 inhibitors, and Basaglar, which is a massive opportunity. As an aside, one of the reasons that you and I talk a lot on the show about biosimilars and the potential opportunities for biosimilars over time, as a reminder, biosimilars are inexact copies of brand name biologic drugs that are made in living organisms, but they work as effectively. So, the FDA allows them to be prescribed instead of that brand name drug once it loses patent protection. 

If you look at Eli Lilly's total sales in the second quarter, pretty good growth for a company this big. Up 9% year over year to $6.4 billion. You mentioned the diabetes volume growth. That's important. We talk a lot, and you hear a lot in the media, about price increases driving growth for a lot of these companies. They had 9% year over year volume growth across the entire company in the second quarter. Diabetes revenue growth is, obviously, incredibly important. 

It'll be really interesting to see where we go from here in diabetes for Eli Lilly, because Sanofi fired and shot back across Eli Lilly's bow by launching its own biosimilar to the rapid-acting insulin Humalog earlier this year. Humalog sales were $2.9 billion in 2017. It's Lilly's biggest diabetes drug. I'm very interested to see whether or not Admelog can chip away at sales as quickly as Basaglar has chipped away at Sanofi's Lantus.

Harjes: Right now, it doesn't seem like that'll be the case. Sanofi's biosimilar is there, it launched earlier this year, but Humalog sales actually grew 13% year over year within the quarter. For now, at least, it's hanging on just fine. 

One of the interesting parts of Eli Lilly's earnings was an announcement regarding its animal health division, which makes medicines for both companion animals, meaning pets, and also livestock and animals that would be not quite as companion-y. This is not a huge shock. They signposted back in October that they were thinking about options for this animal health business. Now, they're saying that they're going to IPO a minority stake in it, which will be something less than a 20% stake, in this company, and it'll be available for people to buy into. What do you think of this, Todd?

Campbell: This is a really interesting move. Investors might want to pay attention. Remember, Pfizer spun out their animal health business, which is, how do you say it?

Harjes: Zoetis.

Campbell: The ticker symbol is ZTS. They spun that out a few years ago, and it's been a wonderful investment. So, you might want to keep an eye on what happens with Elanco going forward. The reason that Lilly's spinning it out is that it's growing relatively small year over year. That's dragging down the overall performance. I think what you have a lot of these big pharmaceutical companies looking at is saying, maybe it makes sense to get rid of some of these slow growers, focus more on these next generation solutions like biologics. I think that's why you're seeing them unlock value by spinning out Elanco. As you mentioned, later this year, less than 20% equity will be available in that through an IPO. They plan to get rid of the rest of their shares, depending on market conditions, throughout the course of 2019.

Harjes: I don't know about you, Todd, but I'm assuming that right out of the gate, this company is probably going to get a pretty favorable valuation mostly because of how successful Zoetis has been. Zoetis carries a substantially higher price to earnings multiple that Pfizer itself does. It has a market cap at this point of $40 billion. When you think about Elanco, which is the Eli Lilly division, that's a company that does about 13% of Eli Lilly's total revenue. It's pretty substantial company, bringing in about $3 billion a year. The animal health market generally is expected to grow about 5% annually for, as far as we can tell, the foreseeable future. It has a lot less generic competition than human pharmaceuticals. It also has a shorter product development cycle, because it's animals as opposed to humans, so you don't have as high of fences set by the FDA to get drugs to market.

The IPO is expected at the end of this year. I'll definitely be interested to see both how the market reacts initially, and also what Eli Lilly's plans for that other over 80% of the company is. They've indicated that they don't intend to hold on to that forever.

Campbell: Right. Of course, that could create some drag, as those shares come to market, on the performance in the first year. Maybe that provides an opportunity for investors to start building up their exposure to it. 

What's interesting is, Eli Lilly is doing some prep work and has been doing some prep work. They've been exiting some products within that business to try to and goose sales for once they IPO it. If you look at their pro forma after exiting those businesses, their pro forma growth for Elanco was about 8% year over year to $792 million in the second quarter. 

The devil will be in the details. People are going to want to watch closely for when the S-1, which is the document that's filed with the SEC for an IPO, is filed. Read through it. It's going to be pretty insightful.

Harjes: Next up -- GlaxoSmithKline, the British pharma giant, reported earnings just this morning. Todd, what's the scoop?

Campbell: Pretty meh. [laughs] The sales were flat on an as-reported basis at £7.3 billion pounds for the quarter. If you back out currency conversion, they grew 4%. But you never know what currency is going to do, up or down, or whatever. It is what it is. You're talking about low single-digit growth one way or the other for GSK, not an overly exciting report that's moving the needle for investors.

Harjes: [laughs] So, if it's not that exciting, why are we talking about this?

Campbell: Because there was one little tidbit in GlaxoSmithKline's release that I found incredibly fascinating, and I think maybe you will, too. The company has decided to refocus its research and development approach. As part of that, they're investing $300 million in the DNA testing site, 23andMe.

Harjes: Which is super interesting. We don't talk a lot about 23andMe because it's a private company, but I am fascinated by this organization. Even dating back to when I was at the latest JPMorgan Healthcare Conference, seeing their CEO speak, she's amazing. This is a very cool company. It has the largest database of genetic information out there because of consumers saying, "Yes, please, sequence my genes," and they hold on to that data. About 80% of the people who have participated have opted into research. If 23andMe has five million customers, that gives you four million people's genomes that have been sequenced. 

And now -- this is causing a little bit of alarm, so far, that I've seen in the Twittersphere and elsewhere -- you have this commercial company, GlaxoSmithKline, buying the rights to use that data to help grow their portfolio and their pipeline.

Campbell: These are exclusive rights, too. About three years ago, 23andMe established an R&D team to try to figure out whether or not they could take some of the information that they're gleaning from processing all this DNA -- again, you have to opt in to this. They're not just using this data, you have to opt in to say it's OK. Like you said, about 80% of people have agreed to it. I would agree to it, too, because frankly, anything we can do to develop cures and treatments that work better, I'm all for. 

This is really an interesting decision, because it gives GlaxoSmithKline exclusive access to that treasure trove of data. Glaxo's CEO, who joined relatively recently, Barron, he had this to say about it. He said, "By studying genetically validated targets, we think we can cut the cost of development in half; or, putting it in a different way, develop twice as many medicines for the same price." That's a pretty big statement. 

Essentially, if you can validate your targets using DNA analysis better, enroll patients based on DNA analysis, so that you're only enrolling the patients most likely to respond, wow, you could probably get drugs to market more quickly, more successfully. That's really important, because historically, 90% of drugs that head into clinical trials end up in laboratory dustbins rather than pharmacy shelves.

Harjes: Hal Barron had a lot of interesting things to say. He's actually a fairly new member of their team, he's the head of Pharma. The CEO is Emma Walmsley.

Campbell: Oh, yeah, my bad, sorry!

Harjes: He had all these great quotes about how knowing what the drug is going to target and validating it leads to having a significantly greater chance of ultimately demonstrating benefit in patients. This is very exciting. This is GlaxoSmithKline saying they are going to make genetic sequencing and genetic targeting the heart of their R&D efforts. 

And really, they kind of need it. There has been pressure on this company for a while to break up their pharma unit from their consumer unit. This is a company that is straddled with a lot of debt, so the $300 million stake in 23andMe is an interesting decision for that reason, as well. Ultimately, their pharma unit has a pretty limited pipeline. If they were ever going to break into two companies, they need to turn that around before it has legs to stand on.

Campbell: It's interesting to think about how this deal even came about happening. Richard Scheller, 23andMe's head of Therapeutics, he actually used to work with Barron and Genentech. They're obviously very comfortable with each other. It's going to be interesting to see how development of medicines occurs. 

There's a little interesting backstory that might be helpful for investors to know. The FDA had initially balked in 2003 at 23andMe sharing this genetic data regarding whether or not you might end up with Parkinson's or something with patients. Just because you have the genetic propensity for it doesn't necessarily mean you will develop it. That all cleared up this past year, earlier this year, when the FDA gave it the green light to share information, I think it was on ten different diseases, including Parkinson's and late onset Alzheimer's disease. That cleared the way for GlaxoSmithKline to step up and say, "OK, the FDA has given us their blessing for this data to be shared with patients. Now, let's go ahead and leverage that data to create some new drugs." Parkinson's disease, that's actually going to be their first target, they said.

Harjes: Yeah, super interesting. This is a company that's definitely firing on all cylinders. According to PitchBook estimates, this $300 million funding could value the company at around $2.5 billion, which is huge, especially for a private company. It's a good reminder to me to not neglect private companies. We don't always have as much visibility into them, but they're still part of this business universe that we cover. 

A couple of interesting stats that I stumbled into about venture capital in healthcare. We're about halfway through 2018. So far this year, the total deal value for venture-backed IPOs in the U.S. stands at $6.9 billion. A disproportionate number of IPOs that have come out have been part of the healthcare industry. It's important to keep an eye on what's going on in the private markets with funding of these various companies, because a lot of them will end up coming public. Of the 41 venture-backed companies that are based in the U.S. that have IPO-ed in the last six months, 27 of those 41 were healthcare companies. VC in healthcare is pretty hot, and something to keep an eye on.

Campbell: You mentioned what the estimates are right now in the valuation for 23andMe, that's a pretty nice return for those existing investors. Last fall, when they did their last funding raise, I think they estimated the valuation of the company was about $1.5 billion. We don't know what percentage Glaxo bought, but it's obviously a fairly significant percentage. Unfortunately, we can't go out and buy that stock. 

That raises the question, should we buy GlaxoSmithKline's stock based on its deal with 23andMe? I think that's a tough argument to make. GlaxoSmithKline is such a large company -- it's actually bigger than Eli Lilly, which we talked about earlier in the show. And, it's going to take some time for drugs to come out of this collaboration, if they ever do, to move the needle for the company. In the meantime, GlaxoSmithKline is still facing the threat of generic Advair, Advair being their top-selling asthma drug. Generic versions of that have been delayed so far by the FDA, but that's not going to continue forever. At some point, we will see generic versions of Advair become available, and that will throw about $2 billion worth of GlaxoSmithKline's sales into question.

Harjes: Yeah, this company is in a pretty tough spot. They have debt to equity through the roof. Most investors in them right now are likely income investors that are looking at the 5.3% dividend -- and yet, that is threatened by the financial issues that the company has. Management has said they plan to tie their dividend to cash flow generation soon. As an income investor, I might start to cut some ties with this company, and that's not going to be good for the stock, if that does happen. So, things to keep an eye on. I do appreciate that Glaxo is making the effort to look way down the road and try to right their ship for the future. As long-term investors, that's what we like to see companies doing. For me, at least, this stock not a buy at the moment.

Campbell: Yeah, of the two stocks, I think Eli Lilly makes more sense.

Harjes: Yeah. As always, people on the program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Today's show was produced by Austin Morgan. For Todd Campbell, I'm Kristine Harjes. Thanks for listening and Fool on!

Kristine Harjes has no position in any of the stocks mentioned. Todd Campbell owns shares of Pfizer. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.