Big Pharma’s Most Undervalued Stock

Large pharmaceutical companies have been ignored by investors for some time now. After decades of gangbuster growth and blockbuster drugs to treat depression, high blood pressure and many other common ailments, many are facing competition from generic drugs as the patents protecting the exclusive right to sell these blockbuster drugs expire.

The primary concern for investors in the industry is that these firms will not recover from the resulting loss in revenue. The respective firms are working to address the “patent cliff” in a number of ways, including mergers, divestitures, cost cutting efforts and developing new drugs to offset lost sales.

Eli Lilly’s (NYSE: LLY) predicament is among the most dire in the industry — but its approach to making it through is one of the boldest. Its largest drug, Zyprexa, goes off patent next year; Cymbalta, Gemzar and Humalog will expire in 2013; while Evista will expire in 2014. These drugs represented 57% of last year’s sales, while three other drugs that account for another 18% of sales will expire in 2016 and 2017. The situation may be dire, but investors have become too negative on its forward prospects.

The company is working on developing new markets and uses for its existing drugs, but it has some serious work to do to get new drugs into the marketplace. At a recent investment conference I attended, Lilly explained that it took its eye off the ball back around 2004 and that it wasn’t as focused on drug development as it should have been. This was probably due to the fact that it wasn’t overly worried about sales, which have grown nearly +10% annually since that time. But given the current wave of expirations, Lilly has already begun to turn things around, and product development has tripled from 2004’s levels in pretty quick fashion.

Currently, more than 40% of Lilly’s pipeline is in the Stage 1 development process. This demonstrates that there is quite a bit of work to do to move these drugs further along. But much of the pipeline is focused on biologics, or biotechnology compounds, which are drugs that are notable for being difficult to replicate, even when they go off patent. Lilly has also sought to acquire players in this space, recently acquiring ImClone Systems to gain control of its cancer treatment drugs.

Going forward, Lilly plans to go it alone and is not currently planning any large merger and acquisition activity. It has detailed at least 10 compounds that should be in Phase 3 clinical trials by the end of 2011, which should have a good chance of making it to market, as success rates are much higher once a compound has made it through the first two clinical phases.

Until the top-line environment improves, Lilly is committed to cost savings. The company is currently in the midst of a $1 billion cost cutting campaign, much of which will come from the culling of employee headcount at its headquarters. The company is also cutting back on capital expenditures. Back in 2004, capex was $1.9 billion, but fell to less than $800 million last year. Other initiatives are to improve manufacturing productivity and shift production to more affordable regions throughout the world.

Despite the sales headwinds during the next few years, Lilly has committed to at least maintaining its dividend. The current dividend yield is 5.5% and costs the firm slightly more than $2 billion a year to maintain.

For the full year, Lilly expects high single digit revenue growth and earnings from continuing operations between $4.65 and $4.85 per share. It expects to end the year with $3.5 billion in cash on the balance sheet — more than enough to cover the dividend obligations — and has also been working to pay down debt. Lilly expects to grow earnings in the double digits through 2011.

Action to Take —> Based on current profitability and through next year, Lilly’s stock looks like a certifiable steal given its P/E ratio of 9. However, past 2011, earnings will start to reflect the lost sales and should dip below $3.50 per share. But still, based on the current share price, this will still be a low double-digit P/E ratio.

The wild card is new sales, but Lilly has a number of avenues, given its product pipeline and focus on biologics. The company detailed the potential launch of 24 development drugs just as patent expirations peak between 2013 and 2016, and the CEO also recently detailed ambitions in faster-growing emerging markets and animal health products. The company plans to more than double sales in each of these areas.

A commitment to cost cutting is also noteworthy, as is maintaining the dividend, which provides a 5.5% annual yield while shareholders wait for top-line trends to improve. It may take a few more years, but investors should reasonably expect double-digit total returns from the stock, with limited downside risk.