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My Favorite Pharma Stock Is Stronger Than Ever

Friday, January 17, 2014 - 10:00am

What do you call 10,000 baby boomers turning 65 every day for the next 20 years? If you're a big pharmaceutical company, you might call it an ATM.

Investors got a taste of this in the late '90s when drugmaker Pfizer (NYSE: PFE) introduced the erectile dysfunction wonder drug Viagra. Money was made as competitors came out with "me too" products, and Big Pharma threw itself into R&D for products tailored to serve this huge (65 million-plus) and aging market.

However, after a rally at the end of the 20th century, pharma stocks came back to earth with the rest of the market and spent almost a decade chugging sideways. But as markets crawled out of the wreckage of the financial crisis, pharma stocks have quietly broken out and moved higher.

Five years ago, I began including shares of Eli Lilly (NYSE: LLY) in my clients' equity portfolios. At the time, the meat-and-potatoes metrics of the stock were impressive: single-digit trailing and forward price-to-earnings (P/E) ratios, a dividend yield over 5%, a mountain of cash, skilled and committed management, and a full, promising new product pipeline -- which is the difference between life and death in the pharma business.

Not to brag, but I think I did OK:

Although the stock has climbed over 133% resulting in a five-year average annual return of better than 26% not including dividends, it's still a great investment.

The Right Stuff
My interest in LLY was piqued five years ago after I read a profile of Lilly's CEO, Dr. John Lechleiter. (I've written several times about Lilly since then.)

Lechleiter is a lifer who's spent his entire career at Lilly, having started out as a chemist in the research and development lab. In an industry where the top marketing dog typically rises to the best digs in the C suite, the fact that Lilly's boss came from R&D should intrigue investors.

Another fun fact: Lechleiter lives in downtown Indianapolis, about a mile from Lilly HQ. Weather permitting, he walks to work every morning. That speaks volumes about his stewardship.

Considering the boss is an R&D guy, it's no surprise that Lilly's pipeline and R&D spending reflects as much. The company has 39 drugs in the pipeline: 26 are in Phase II review, and the rest have reached Phase III. This year, the company expects approval on three new diabetes drugs.

Lilly spends over 23% on R&D, one of the highest R&D-to-sales ratios in the industry; 2013's budget exceeded $7 billion. That's a huge number. You invest $7 billion into the business, something good has to happen -- and analysts estimate that Lilly's pipeline efforts will add $7.2 billion to annual sales in five years.

The new drug pipeline is crucial as high margin drugs come off patent, meaning that generic equivalents will become available to consumers. Lilly is losing patent protection on two important names: Cymbalta, used to treat depression, and osteoporosis drug Evista. There is, however, a silver lining -- the patent losses will bring SG&A expenses (for selling, general and administrative costs) down 10% or better for the year. This will also lower the company's tax rate by 10%.

Healthy Numbers
Despite the off-patent headwinds facing Lilly, the numbers are healthy. The company is sitting on $5.6 billion in cash and has a modest long-term debt-to-capital ratio of 27%. The company's cash flow is also solid at over $5 billion annually or around $5 a share, a level that Lilly has maintained during the past five years.

The $1.96 annual dividend has grown at a rate of only 2.5% in that time, but it still amounts to a generous yield of 3.8%, and management's ability to manage cash prudently can sustain that.

The company has also been buying back shares at a healthy pace. Last year, Lilly completed a $1.5 billion share buyback which was preceded by a $3 billion buyback program that was initiated in 2000.

Risks to Consider: The biggest concern facing Lilly investors is the patent loss of two major drugs, but the company seems prepared, thanks to a pipeline of promising new products. Also, the Affordable Care Act (aka Obamacare) continues to cloud the entire health care industry with uncertainty, though Big Pharma seems to have been spared some of the pain.

Action to Take --> LLY is trading near $55 with a trailing P/E ratio of 12.7 and a dividend yield of 3.6%. Based on the company's strong and consistent cash flow, low debt and promising new drug pipeline, a 12-month price target of $68 is attainable. The P/E multiple would need to expand only to around 15. The result for investors would be a 27% return (30%-plus including dividends). I consider Lilly a core long-term holding; any near-term weakness in share price should be seen as a buying opportunity.

P.S. As my colleague Nathan Slaughter likes to point out, companies that can reward shareholders and manage their debt like Eli Lilly does make much better investments than companies that focus only on one or the other. That's why he's working on a special research project on how investors can use a strategy we call "Total Yield" to capture the highest returns with the least amount of risk by combining the three ways companies return value to shareholders. To reserve a free copy of this report -- and to get the names and ticker symbols of some of the highest "Total Yield" stocks on the market -- simply follow this link.

Adam Fischbaum does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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