Eli Lilly: A Potential Game Changer For Weight Management And Cardiovascular Health

In our April analysis of Eli Lilly (NYSE:LLY), we assigned a Buy rating to the stock, positing that the market might be undervaluing its innovative diabetes medication, Mounjaro, particularly in its potential as a weight loss solution. Our assessment indicated a potential underestimation in market forecasts, hinting at a more favorable valuation for the stock than perceived. Following our initial coverage, Eli Lilly's shares have performed impressively, becoming one of the market's standout performers. This can be attributed to robust earnings coupled with emerging data underscoring Mounjaro, and its subsequent advanced version retatrutide in the pipeline as potentially transformative for patients predisposed to cardiovascular ailments. Notwithstanding the stock's notable appreciation, we reaffirm our Buy thesis, holding that the market is likely undervaluing the cardiovascular opportunity.

The landmark research around Novo Nordisk's weight loss medication, Wegovy, is a pivotal development bolstering our thesis. In its clinical evaluation with 17,604 participants, Wegovy showcased a remarkable 20% risk reduction in heart attack, stroke, or heart-related mortality among obese or overweight individuals with cardiovascular disorders. This pioneering achievement marks the first time a drug has manifested such protective attributes. Such a milestone validates the potential of weight loss drugs in cardiovascular care and underscores the prospective significance of Eli Lilly's incretin medications, namely tirzepatide and retatrutide.

Given Wegovy's success and its anticipated implications for Eli Lilly's portfolio in a similar therapeutic area, we project a promising trajectory for the obesity treatment sector. Our subsequent analysis will further dissect the repercussions of these pharmaceutical advancements on Eli Lilly and elucidate the investment opportunities therein.

Game Changer: Understanding the Select Trail

Novo Nordisk's weight loss drug, Wegovy, has recently gained significant attention due to the results from a clinical trial demonstrating its ability to reduce the risk of heart attack, stroke, or heart-related death by 20% in individuals with cardiovascular disease. This achievement is particularly noteworthy, being the first time a weight loss drug has shown such protective effects. The clinical trial, known as "Select," involved 17,604 adults who were either obese or overweight and suffering from heart disease. Those with diabetes were excluded from the trial. The participants were administered either Wegovy or a placebo in conjunction with standard care aimed at preventing major adverse cardiac events.

The success of Wegovy, reflected in the 20% reduction in heart risk, exceeded many experts' expectations, particularly considering the historical failure rate of weight loss drugs, with some even resulting in harm. Consequently, we believe the accomplishment of Wegovy is a 'landmark' in the field.

We are optimistic that these trial results could revolutionize the perception and treatment of obesity. If the study's findings are corroborated, it could motivate a greater number of doctors to prescribe Wegovy, potentially enhancing insurance coverage for the costly medication. Presently, Wegovy is priced at $1,349 a month before insurance, posing a financial challenge for many U.S. patients seeking coverage for it. However, the encouraging results from the "Select" trial could stimulate improved insurance coverage, particularly as it adds to the evidence that weight loss is more than just a cosmetic concern.

It's crucial to understand the Wegovy study to comprehend the implications it may have on Eli Lilly's incretin drugs. The success of Wegovy could potentially set a precedent for the success of other drugs in the same class, opening new possibilities for the treatment of obesity and related cardiovascular risks.

Why LLY Stands to Benefit

The encouraging results from the clinical trial of Novo Nordisk's weight loss drug, Wegovy, could have significant implications for other drugs in the same class, including Eli Lilly's incretin drugs, tirzepatide (Mounjaro) and retatrutide.

We believe that the medical community has long recognized obesity as a risk factor for negative cardiovascular outcomes. Traditional treatments for obesity, such as bariatric surgery and intensive lifestyle modification, are known to lead to cardiovascular benefits, but these methods are not effective for all patients. The recent success of Wegovy in the "Select" trial illuminates a new path: GLP-1-mediated weight loss can also yield cardiovascular benefits, a revelation that is particularly good news for patients.

For Eli Lilly, the breakthrough is even more promising. The company is marketing tirzepatide, a drug that has shown unprecedented levels of weight loss. Recent trials (SURMOUNT-3 and -4) reported a 26% body weight loss, a truly remarkable figure. We believe existing data suggests a correlation between the level of weight loss and benefits on cardiovascular outcomes, leading to the hypothesis that greater weight loss could result in even greater benefits. This gives rise to optimism for the forthcoming cardiovascular trial of tirzepatide.

The focus for Lilly's trial will be understanding the mechanism that links GLP-1 with cardiovascular benefits. The most straightforward hypothesis, yet to be refuted, is that these benefits come from weight loss. It's anticipated that most, if not all, of the benefits can be attributed to improvements in body mass index (BMI). And with improvements in BMI usually come normalization of lipids, lower blood pressure, and other positive health outcomes—all of which have been observed with tirzepatide.

We believe that these findings could help connect the dots on weight loss. The challenge lies in convincing the medical community, patients, and doctors to recognize the inherent value of addressing obesity and promoting weight loss. Given the potential cardiovascular benefits, this is a challenge worth tackling. The success of Wegovy and the promising results from tirzepatide trials position Eli Lilly favorably in the quest to combat obesity and its associated health risks.

Financial & Valuation

Note: All historical data in this section comes from the company’s 10-K filings, and all consensus numbers come from FactSet.

In our analysis of LLY's recent earnings, the company reported a strong FY Q2, which saw the stock trade up by 14.9% the day after earnings were announced. The company's revenue growth was robust, up 28.1% year-on-year to $8,312 million, beating consensus estimates by 9.6%. LLY's gross margin was a healthy 79.8%, and the operating margin showed a notable improvement, moving from 20.5% a year ago to 27.1%. Further, the company's EPS for the quarter was $2.11, up an impressive 69% year-on-year and beating consensus by 6.6%.

Looking at broader financial trends, LLY's revenue has been growing at a compound annual growth rate of 8.5% over the past three fiscal years. Sell-side consensus forecasts are optimistic, projecting revenues will continue to grow by 16.6% this fiscal year to reach $33.3 billion and by 16.2% the next fiscal year to $38.7 billion, driven by blockbuster drugs such as Mounjaro. However, it’s notable that over the past three fiscal years, LLY's EBIT margin has slightly decreased by 0.8 percentage points from 27.5% to 26.7%. Despite this, consensus estimates forecast a significant expansion of the EBIT margin by 356 basis points this fiscal year to 30.2% and by 351 basis points next fiscal year to 33.8%.

Over the past three years, LLY has spent a modest 1.3% of its revenue on share-based compensation (SBC), and the company has effectively used share repurchases to decrease diluted outstanding common shares by 0.8%. With the combination of revenue, margin, and share dynamics, EPS has been growing at a CAGR of 9.5% over the past 3 fiscal years, outpacing its revenue growth. Looking ahead, consensus forecasts suggest EPS will increase by 22.2% to $9.71 this fiscal year and by 29.0% to $12.52 the following fiscal year.

Free cash flow (FCF) for this current fiscal year is forecasted to be $6,991 million, representing a 21.0% FCF margin. This shows a slight decrease in FCF margin compared to four fiscal years ago when it was at 30.8%. However, over the past four completed fiscal years, the company's average FCF margin was 25.9%, indicating a generally strong cash generating ability. Further, the company’s capex as a percentage of revenue averaged at 5.4%, suggesting the business has moderate capital intensity.

LLY's return on invested capital stands strong at 25.1%, suggesting that the business could recycle capital at attractive returns.

The stock has performed incredibly well, yielding a return of 77 percentage points more than the S&P 500, or 89.5% in absolute return over the past year. The stock is trading at a healthy 102% above its 52-week low of $296.32 per share and 47.4% above its 200-day moving average. Despite the positive performance, the short interest is low at 0.7%, suggesting that market sentiment towards the stock is generally positive.

Turning to valuations, the stock is currently trading at a rolling forward 12-month P/E of 51.1x. This is significantly higher than its 5-year mean of 23.7x and well beyond the 2-standard deviation range of 6.2x to 41.2x, indicating that it is trading at a historically high valuation. Compared to its peers MRK and PFE, which are trading at forward 12-month P/Es of 15.9x and 10.2x, respectively, LLY appears to be significantly more expensive. However, we believe LLY's portfolio and pipeline will drive accelerated growth going forward, justifying its valuation.

Risks

Investors considering LLY should be mindful of the multifaceted risks associated with the company's shares. One primary concern lies in the heavy reliance on a limited number of products for the majority of Lilly's revenue. In 2022, products like Trulicity, Verzenio, Taltz, Jardiance, Humalog, COVID-19 antibodies, and Humulin jointly made up 69% of total revenues. Trulicity's contribution was particularly noteworthy, accounting for 26% of total revenues. The company's future strategy includes a growing focus on GLP-1s, such as Mounjaro, which further underscores the concentration risk.

Additionally, the launch of certain key drugs, including the diabetes and weight loss drug Mounjaro and the Alzheimer's drug donanemab, come with a high degree of uncertainty. Factors such as insurance coverage and pricing may affect Mounjaro's sales, and the market acceptance of donanemab is uncertain despite its potentially large market base. These two drugs are expected to constitute nearly half of Lilly's sales in the coming decade, further highlighting the importance of these launches.

In addition to the aforementioned risks, Lilly operates in a fiercely competitive environment, contending with both generics manufacturers and brand-name drug companies. The company is also subject to significant regulatory and legal risks, which include product approvals, patent disputes, and liability lawsuits. The pharmaceutical research and development sector is inherently fraught with uncertainty and expense, with a high failure rate. The process of transforming a drug from discovery to market can span over a decade and cost more than $2 billion, with the potential for failure at any stage.

Conclusion

Understanding the success of Wegovy not only has implications for the pharmaceutical industry but also provides a potential roadmap for the future of obesity treatment. This breakthrough could redefine the way we look at weight loss, moving it beyond a cosmetic concern and placing it firmly in the realm of crucial healthcare issues, which could improve insurance coverage of these drugs. The promising results from the trials of tirzepatide and the potential cardiovascular benefits could position Eli Lilly favorably in this new landscape.

However, it's important to remember that these developments come with their own set of challenges and risks. Investors should consider the company's heavy reliance on a limited number of products for revenue and the inherent uncertainties that come with the launch of key drugs. Furthermore, the pharmaceutical sector is marked by intensive competition, regulatory and legal risks, and high R&D cost and failure rates. Nevertheless we remain optimistic about the opportunities they present.