Don’t Miss the Best Pharma Value on the Market

Big Pharma needs some big ideas. If it can’t find them — and turn them into the next blockbuster drugs — then it will be in Big Trouble.

The clock is always ticking for the nation’s drug makers. That’s because drug patents last only 20 years. The kicker is that the clock starts the day the patent application is approved, not the day the drug is actually approved to be sold. A company may only have exclusive rights to sell its drug — and recoup its hundreds of millions in development costs — for 10 years.

Consider Lipitor, the top-selling drug in the world. Pfizer’s (NYSE: PFE) cholesterol treatment is set to lose its patent in June 2011. After that, it will have to compete with cheaper generic versions for sales. (One of our “Top 10 Stocks for 2010” is an example of a company on the other side of the scale — it’s already profiting from biogeneric drugs in Europe and will be the prime beneficiary of a breakthrough in the U.S.)

Pfizer sold $3.1 billion worth of Lipitor worldwide in the third quarter alone. Generics, however, can cost up to 80% less than brand-name drugs. If Pfizer can’t replace that lost revenue by the time the patent expires, its bottom line will suffer, and investors will adjust the value of the shares accordingly.

Between 2011 and 2014, an unprecedented wave of patent expirations will hit drug makers, putting about $137 billion in revenue at risk. The industry’s term for this problem is the “patent cliff.”

Some drug companies, such as Pfizer and Wyeth (NYSE: WYE) or Merck (NYSE: MRK) and Schering Plough, are merging, aiming to replenish development pipelines and achieve enough cost savings to stave off the decline in revenue.

Eli Lilly (NYSE: LLY) on the other hand, has chosen to stand pat since its acquisition of the biotech firm ImClone in 2008. The company is instead trying to develop its pipeline in-house. So far, it has yet to see the fruits of its labor, and Wall Street’s reaction has been punishing.

Eli Lilly’s patent cliff is formidable. Several billion-dollar drugs will lose protection in the next few years. The schizophrenia drug Zyprexa is first on the chopping block: Its patent expires in 2011. Then the antidepressant Cymbalta, cancer drug Gemzar and osteoporosis drug Evista. Together, these drugs represent nearly half of Lilly’s annual revenue, about $11 billion.

#-ad_banner-#But investors shouldn’t count Lilly out yet. There’s still plenty of time and opportunity.

The $6.5 billion ImClone acquisition gives Lilly a promising pipeline of six cancer drugs, with four in late-stage clinical trials. One drug has been shown to block blood-vessel growth in cancerous breast tumors and, if approved, could easily become a blockbuster.

Lilly has 25 drugs in late-stage trials and $3.9 billion in cash on hand to funnel into research and development. Together, this pipeline is one of the best in the industry. Any one of these drugs could become a blockbuster, and some likely will.

There’s also the alternative: another acquisition. Lilly chief John Lechleiter has mentioned this as a possibility.

Lilly’s valuation couldn’t be more enticing, either. The shares are trading for 7.6 times earnings, compared with about 25 for the S&P 500. The company’s average earnings multiple during the past two years is 10, and even though that seems low, it’s still a -24% discount to current prices. Best of all, the threat of the patent cliff is likely priced into the shares already, so there’s not much downside.

Meanwhile, investors have a rare opportunity to capture a 5.5% yield from a company that has paid a dividend for the past 120 years. Lilly’s trailing twelve month earnings per share are $4.59. The company pays $1.96 over four quarters each year in dividends, which equates to a payout ratio of 42% ($1.96/$4.59 = 0.42). Given that modest ratio, and the company’s $3.42 a share in cash, the dividend looks safe.

Compare that to other drug companies:

Company (Ticker) Dividend Yield P/E Payout Ratio
Eli Lilly (NYSE: LLY) 5.5% 7.7 43%
Bristol-Myers Squibb (NYSE: BMY) 5.1% 12.7 53%
Merck (NYSE: MRK) 4.0% 11.2 45%
Pfizer (NYSE: PFE) 3.8% 8.5 37%
Novo Nordisk (NYSE: NVO) 1.7% 19.3 35%

With its modest payout ratio, high dividend yield and low valuation, Eli Lilly looks to be the best value in the pharmaceutical sector. Investors should consider the shares as both a long-term income pick and a value play. The company’s commitment to develop a robust pipeline in-house may prove to be a costly endeavor, but if successful, it could pay off big time.