Eli Lilly - Challenges Remain

Eli Lilly and Company (LLY - Analyst Report) turned in a solid year in 2007 and again in 2008. 2008 sales increased by 9% on strong sales of Cymbalta, Alimta, Byetta, Cialis and the Animal Health business. EPS grew even faster, at 13%, as operating margins widened on stronger gross margins and modest SG&A leverage. For 2009 Lilly expects EPS between $4.00 and $4.25 on revenue growth in the mid-single digits.

While we've been mildly surprised by the annual performance in 2007 and 2008, for the reasons that we've discussed above, we don't believe the stock will outperform.

Strong sales from key products such as Cymbalta, Cialis and Alimta will be the fundamental strength to EPS growth from 2008 through 2010. The addition of ImClone will add incremental revenue growth but will be highly dilutive to GAAP EPS for at least the next several years.

Longer-term, we are unconvinced that ImClone will be the catalyst that Lilly needs to grow revenue and EPS following Zyprexa's U.S. patent expiration in 2011. While we model EPS to grow at a two-year CAGR of about 7% from 2008 through 2010, we then expect EPS to remain relatively flat to slightly negative into 2011 and 2012 as the contraction in Zyprexa sales more than offsets growth in Cymbalta, diabetes and new products sales.

Barring significant cost-cutting efforts or additional revenue catalysts, 2013 will be the beginning of a very challenging period.  We model EPS to fall 4% in 2013 as operating margins contract and Cymbalta loses U.S. patent protection during the year.

The company's relatively weak late-stage pipeline and dilution from ImClone will hang over the stock and limit upside to the shares. Based on the stock trading at a discount to industry peers and the fact that key drugs continue to post solid growth we do not believe there's much downside risk to holding the name. We maintain our Hold recommendation and $36 price target, which represents 8.5x our 2009 EPS estimate of $4.22.