Eli Lilly: An Update


Last October 8, I wrote my first article focusing on Eli Lilly (LLY), Eli Lilly Surges On Pipeline News: Analysis And Trading Thoughts. My analysis was that the company was doing a top-notch job in growing through a series of patent expirations and a suddenly-deflationary US diabetes market. My trading thought was that with the stock having surged to the $114-115 range back then, it was ahead of itself. I treated LLY as a short term trading vehicle.

Here we are 14 weeks later, and LLY has done very well to be up in price since then. Pfizer (PFE), for example, has dropped over 6%, and a close comparator to LLY, namely BMS (BMY), has plunged more than 20%.

The first few sections involve discussions of the two main reasons I think LLY is a better long trade now when it is at the same $114-5 price point than it was in early October - but there are important caveats that come toward of the end of the article. Note, LLY closed Tuesday at $117.09, though it was in the $114-5 range when I began writing this article Monday. The following discussion shows what I view as some very impressive strengths of LLY, but also enough weaknesses that I continue to rent this name rather than commit to it as I first did with AbbVie (ABBV) two years ago.

Favorable point #1 involves:

Trulicity - a big CVOT win

In November, LLY made an important announcement on its single most important growth vehicle, the biologic Trulicity, an injectable anti-diabetic:

Trulicity® (dulaglutide) significantly reduced major adverse cardiovascular events (MACE), a composite endpoint of cardiovascular (CV) death, non-fatal myocardial infarction (heart attack) or non-fatal stroke, meeting the primary efficacy objective in the precedent-setting REWIND trial. Eli Lilly and Company's once-weekly Trulicity is the first type 2 diabetes medicine to demonstrate superiority in the reduction of MACE events in a clinical trial that included a majority of participants who did not have established CV disease.

Reducing MACE via a cardiovascular outcomes trial (CVOT) is finally becoming routine in the latest-greatest generations of diabetes drugs. The first such drug was Jardiance, a LLY drug it gained via its alliance with Boehringer Ingelheim. Victoza followed, as have a small number of others. Trulicity competes directly with Victoza and Novo Nordisk's (NVO) next-generation version, Ozempic. However, Victoza's CVOT studied patients at very high risk. LLY took a broader tack, and appears to have succeeded, as it headlined in the above press release and clarified in the body of the write-up:

Only 31 percent of REWIND trial participants had established CV disease

The REWIND trial's international scope, high proportion of women, high proportion of people without established cardiovascular disease and inclusion of participants with a lower mean baseline A1C suggest that the findings will be directly relevant to the typical type 2 diabetes patient seen in general practice throughout the world.

The main weakness and risk that comes from investing in this sort of press release is that details will be provided in June. All we have to go on is this sort of assertion provided in the press release (emphasis added):

"The REWIND study was ambitious, assessing whether Trulicity could protect people with type 2 diabetes from experiencing an initial cardiovascular event, and prevent future events in those who have established cardiovascular disease," said Hertzel Gerstein, M.D., MSc, FRCPC, professor of medicine and deputy director of the Population Health Institute at McMaster University and Hamilton Health Sciences, and REWIND study chair. "The MACE reduction demonstrated by Trulicity, across a broad range of people with type 2 diabetes, is compelling and we look forward to analyzing and reporting all of the data."

[Back to Lilly now] REWIND is distinct compared to other CV outcome trials due to the limited number of people with established CV disease who participated in the trial, allowing Trulicity's CV effect to be measured in a broad population of people with type 2 diabetes. Importantly, REWIND had a median follow-up period of more than 5 years, the longest for a CV outcome trial in the GLP-1 receptor agonist class.

Why is this so important that I quoted extensively from one press release? Because assuming we are being guided appropriately, REWIND offers LLY opportunities to play both offense and defense, while creating a franchise that could extend into the late 2030s.

Trulicity's challenges and opportunities

As LLY laid out in its 12/19/18 investment community review, it and NVO dominate the fast-growing sub-sector of diabetes drugs known as GLP-1 agonists, with Trulicity competing to a draw with NVO's old drug Victoza and the young one Ozempic (slide 26 of the PDF presentation). Per LLY's 2017 10-K, Trulicity as a biologic is protected from biosim competition until 2026. Usually a patent extension is granted to expire two years after regulatory exclusivity ends, so I am thinking of this drug as remaining immune to biosim competition until either 2026 or 2028 in the US. In its Q3 report, LLY reported $816 MM in revenue from Trulicity that quarter, up a powerful 55% yoy, with similar growth rates in the US and ex-US. So this is an important drug already and in several years, could be poised to challenge the $10 B annual rate if the CVOT data are truly strong.

However, NVO has a major competitive threat on two fronts to Trulicity. The first is sometimes overlooked, but could come to the fore as more approvals are gained. This is the weight loss indication for Victoza under the somewhat strange name of Saxenda. Ozempic is expected to achieve a weight loss indication, as well. NVO is making a major focus on both diabetes and obesity, aka' diabesity,' and has an advantage over LLY here.

The other, probably more major threat comes from NVO's oral Ozempic. The GLP-1 agonists are all injected, which is a turn-off for patients as well as adding costs and inconvenience. Through very clever, out-licensed formulation efforts, NVO claims it has demonstrated safe and effective use of Ozempic in a once-daily oral form based on multiple Phase 3 studies. The final study was a non-inferiority study against placebo for MACE, with impressive results (emphasis added):

The primary endpoint of the PIONEER 6 trial was defined as the MACE composite outcome of the first occurrence of cardiovascular death, non-fatal myocardial infarction or non-fatal stroke and showed a hazard ratio of 0.79 in favour of oral semaglutide compared with placebo. The 21% reduction in MACE in favour of oral semaglutide did not reach statistical significance.

The MACE results demonstrated by oral semaglutide were driven by a statistically significant reduction in cardiovascular death of 51% (HR 0.49, p=0.03), while non-fatal myocardial infarction (HR 1.18, non-significant) or non-fatal stroke (HR 0.74, non-significant) were broadly similarly distributed between the two treatment arms. In addition, a statistically significant reduction in all-cause mortality of 49% (HR 0.51, p=0.008) in favour of oral semaglutide was observed.

Assuming FDA approval next year, it will be interesting to see how FDA allows this non-inferiority study to be promoted. But, it's consistent with findings from the marketed, injected Ozempic as well as Victoza; Victoza and semaglutide are structurally very similar in how they bind to the GLP receptor.

I expect oral Ozempic to reach the US market in or around Q2 next year. I expect Trulicity's label to reflect a MACE indication late this year or else early next year, which could keep its sales growing at a near-hypergrowth rate. Oral Ozempic could pose a major threat to Trulicity, at least to its growth rate.

This is a very interesting and consequential battle.

What I suspect is happening with this class of drugs is what happened with the Merck (MRK) - PFE statin wars that began in the '90s. Both companies prospered as each company's flagship, Zocor and Lipitor respectively, showed surprisingly good effects on large numbers of patients.

Longer term, these GLP-1 results could be even better than the statins for the companies and for society. That's because both NVO and LLY have next-gen drugs in development, which is why I see each company as having very interesting profit growth potential into the decade of the 2030s.

Now for the second positive for LLY I want to discuss.

LLY projects strong growth in 2019 despite patent expiries

Per the PDF provided in the December investment update, slides 14-15 are the two key background slides, showing such matters as clinical trial results to be announced this year and upcoming losses of exclusivity. Then on slide 17, preliminary 2019 guidance is provided. The GAAP data is already out of date due to the Loxo (LOXO) deal (discussed below), but I'll go with this presentation at this point in the article.

The good news is that LLY projects good sales and underlying profit growth yoy despite increasing R&D by about 7%. Other matters such as operating margin are projected to improve as part of an ongoing efficiency drive. Part of the EPS gain will come from a 7 point projected drop in the tax rate to 16%. GAAP EPS were projected to be $5.57 at the midpoint of the range provided. Given that LLY has been on an earnings roll, I'm going to project $5.70 excluding the effects of acquisitions such as the big LOXO deal. LLY has risen since I began writing this article, but at the $114 share price that put it at precisely 20X my projected GAAP 2019 EPS.

However, LLY has been spending close to 22.5% of revenues on R&D, which is high for the industry; PFE, for example, is around 15%. So because R&D is elective and performed by majors such as LLY out of profits, I always perform an exercise in which I estimate EPS at an R&D spend rate of 15%.

In this case, out of a $5.7 B projected R&D spend, I therefore subtract 1/3 of that, or $1.9 B. Applying the projected 16% tax rate to that gives $1.6 B. Weighted shares outstanding were 1.026 B in Q3. These calculations lead me to add about $1.55 EPS to the $5.70 I have been carrying for 2019, bringing the adjusted GAAP EPS to $7.25. At Tuesday's closing price of $117 that gives an adjusted P/E of 16.1X. Again, this is theoretical based on assumptions of lower R&D spend than will happen and the tax implications if LLY did not perform that spending (and did not repurchase stock with the savings).

Now to some concerns, beginning with a word on LLY's LOXO deal and some implications.

Is LLY turning into a serial acquirer?

Returning to slide 17 of the December presentation, LLY shows that for full-year 2018, its GAAP EPS was around $2.85, but non-GAAP EPS was around $5.60. The major difference related to acquisition accounting. But, an expense is an expense. When a company tells investors to, in effect, ignore the upfront cost of a deal, it never goes back years later if the deal pays off and also says to ignore the profits that stem from the deal.

Now it's only January and LLY has destroyed the GAAP projections it voluntarily provided investors with on December 19. From its Jan. 7 presentation, what LLY gets for a net $7.2 B acquisition price in a deal that LLY expects to close in March:

  • a piece of Vitrakvi, a new precision oncology drug marketed by Bayer (OTCPK:BAYRY)
  • a Phase 2 asset, another precision oncology drug, LOXO-292
  • two Phase 1 assets, one of which is pledged to Bayer
  • scientists.

Let's think about this. On Dec. 19, LLY advised investors to think about $5.60 in GAAP EPS for 2019. Based on about 1 billion shares outstanding, that's about $5.6 B in profits.

Yet at the same time, it was negotiating a friendly takeover of LOXO for a net price of $7.2 B. That's a problem for me regarding trust in management. Also a problem is the following statement from LLY's chairman - who is also the CEO and president - at the recent JPMorgan conference:

We issued guidance in December for 2019, which just this Monday with the Loxo acquisition, I guess suspended in a sense. But I'll recap it recognizing that we'll restate that as soon as we get the accounting figured out with the Loxo acquisition.

How difficult it is to figure out the accounting here? LLY says in the above documents and presentation that most of the value it ascribes to LOXO comes from the Phase 2 program (LOXO-292). I'm not an accountant, just a guy who looks at a lot of this sort of stuff, but until LLY figures out just what it is purchasing and how to account for it, I'm assuming that most of the $7.2 B net cost will be charged against current earnings. So, all else being equal, that suggests to me that LLY may have a break-even year in 2019 using GAAP EPS. That in turn would imply about a 90X GAAP P/E if 2018 and 2019 GAAP EPS are averaged.

Getting back to LOXO-292, this is a highly specialized RET inhibitor. I claim zero, and I mean no, expertise on this particular topic. But I can read trade journals, and this is one resource I found from last July:

RET Inhibitor Prominence Rises in NSCLC

The list of ever-expanding actionable driver mutations for non–small cell lung cancer (NSCLC) will now include RET, as there are 3 highly effective therapies now in development, according to a presentation by Paul Baas, MD, PhD, at the 19th Annual International Lung Cancer Congress...

The phase I LIBRETTO-001 study exploring LOXO-292 continues to enroll patients with advanced RET-altered solid tumors. The full estimated enrollment for the trial is 180 patients and the primary completion date is August 2019.

The article goes on to speak favorably of LOXO-292 but also describes two competitors, BLU-667 (Blueprint Medicines (BPMC)) and what I assume is now a Roche drug, called RXDX-105 when Ignyta was developing it. Roche acquired Ignyta nearly one year ago.

I wonder just how secure LOXO-292 will be as a category-killer (within its limited niche) even assuming it becomes the first RET inhibitor to reach the market. In other words, is LOXO really worth more than $7 B to any company, especially a smaller major such as LLY?

Conclusions (Part 1) - a mixed bag for LLY; is it mostly a momentum stock?

This article focuses on some of the new and, to me, most important items out of recent news flow regarding LLY. There's a big company and large pipeline out there not discussed herein, and the Elanco (ELAN) spin-off (animal health) to consider as well.

All that said, I see offsetting considerations with LLY. Negatives include the following:

Structurally, I mistrust large companies where one person holds all three top posts. Corporate culture is also a problem in that LLY knew very well on December 19 that it was close to a deal to acquire LOXO but still chose to offer up an optimistic GAAP EPS forecast for 2019. Ignoring LOXO, the forward P/E is above 20X, and while LLY has several young growth products, most of its sales still come from mature or declining drugs. Finally, obviously, there are political and economic issues surrounding who pays what price for expensive biologics and other cutting-edge pharmaceutical products.

On the positive side, LLY has my vote for one of the very top pharma turnarounds in recent years. It is well-positioned in diabetes, and possibly soon in obesity as well. On the charts, it is in strong position, showing that investors have been herding to it in preference to just about every other very large cap pharma stock. That could mean, for example, that "somebody knows something." Could LLY itself be a takeover target? Is there something really special in the pipeline that the "smart money" knows? I don't know, but to an extent, I respect uptrends from a trading standpoint.

What does all this suggest regarding LLY shares?

Conclusions (Part 2) - a good trading stock as the Plunge Protection Team works its wonders

When a sector is in fashion, why not buy the best-performing name in it? In this case, Big Pharma has defensive characteristics at this time that the global economy is challenged. At the worst, LLY can be converted to a dividend growth play if the stock heads south, and as I showed above, its P/E is unremarkable when its core R&D spend (not counting acquisitions) is normalized to that of PFE and its peers.

In that spirit, I bought LLY Monday between $114 and $115. Surprisingly, I found myself up more than $3 or so in less than one full trading day and sold that stake. I kept a separate half-sized position with a marginally higher basis, which is for sale depending on the technicals. So long as the Federal Reserve is draining liquidity from the system at its current $50 B per month rate, I'm happier taking a quick buck in stocks I'm not fully committed to rather than letting the profits run.

That's my point of view on LLY. Yours may differ, and as usual, I differentiate between my situation and those of people who own LLY at much lower entry prices.

Thanks for reading; please feel free to share your thoughts in the comments thread below.

Disclosure: I am/we are long LLY,NVO,CELG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Not investment advice. I am not an investment adviser.