Eli Lilly and Company

Moat: 4/5

Understandability: 2/5

Balance Sheet Health: 4/5

Eli Lilly and Company is a global pharmaceutical firm that discovers, develops, manufactures, and sells products to people worldwide, with a focus on diabetes, oncology, immunology, and neurodegeneration.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview

Eli Lilly operates within the global pharmaceutical industry, which is characterized by high barriers to entry, due to stringent regulatory requirements and lengthy and expensive research and development (R&D) processes. The industry also relies heavily on intellectual property protection, particularly patents and exclusivities, for which the expiration or potential invalidation of such protections represents a key risk to profitability.

  • Therapeutic Areas: LLY’s revenue streams are primarily driven by sales of products in the following therapeutic areas:
  • Diabetes: Including insulin and GLP-1 receptor agonists for the treatment of type 1 and type 2 diabetes.
  • Oncology: Focusing on treatments for various forms of cancer.
  • Immunology: Specializing in drugs for immune diseases.
  • Neuroscience: Developing therapies for diseases like Alzheimer’s and depression. * Notably, while their primary focus is on these areas, they do offer products in other fields.
  • Geographic Diversification: LLY has a global presence with revenues generated from various geographic markets, with sales from the U.S. being about 70% of its total revenue.
  • Competitive Landscape: The pharmaceutical industry is highly competitive, characterized by intense rivalry between established companies and smaller startups, and with the threat of generics and biosimilars challenging branded drugs.

What Makes LLY Different

  • Strong R&D Pipeline: LLY’s sustained investment in research and development is a core aspect of its business and crucial to the success and sustainability of its economic moat. Their investment in research is on the high side in terms of percentage of revenue compared to many other Pharma companies. This strong focus on innovation allows LLY to identify promising compounds and develop and commercialize new products.
  • Focus on Chronic Diseases: LLY has a focus on drugs to treat chronic illnesses such as diabetes and Alzheimer’s. These diseases typically involve long-term treatment regimens that result in steadier, long term demand and helps secure future revenue for LLY.
  • Global Reach: With operations in numerous countries, LLY has a large global distribution network and is able to penetrate markets at scale.
  • Strategic Acquisitions: LLY has made a number of strategic acquisitions that have allowed them to expand their pipeline and market reach while gaining a strategic advantage through IP. These transactions have not been without their challenges.

Financial Analysis

Recent financial data shows a strong increase in revenue and profits driven primarily by the sales of Mounjaro and other high-growth drugs.

  • Profitability: LLY demonstrates strong profitability.
    • Gross margin was 76.8% for the year ended December 31, 2022 and for the first nine months ended September 30, 2023, gross margins are slightly up by 1 or 2 percent.
    • Operating margins and return on invested capital metrics are not currently clear due to a large amount of “asset impairment, restructuring and other special charges” that affects earnings.
  • Cash Flow: LLY is a free cash flow generating company. This provides the company the ability to reinvest in the business, make strategic acquisitions, and return cash to shareholders.
  • Balance Sheet:
    • The company has an adequate amount of cash and short-term investments at around $7.3B in June 2023 which helps the firm stay flexible.
    • While the company’s debt is slightly high- more than $19B, most of its debt is at a fixed rate, which is good for stability. The company has debt maturing at different points in the future, but most of the debt is long-term debt.
    • The company has a huge amount of goodwill and intangible assets on its balance sheet-$56B at Q3 2023 which is almost equal to its total liabilities- making it a bit difficult to calculate underlying business performance accurately.
    • Overall, it is relatively healthy, and can be considered fairly stable, which provides a score of 4.
  • Accounting: The firm’s financial reporting is generally transparent with clear and concise notes on its income statements and balance sheets, which makes things easier for investors. They have made changes in their reporting, as a result of accounting updates by the Financial Accounting Standards Board.
  • Financial stability: The company has been consistently profitable for many years, generating a lot of cash, and has a decent return on capital. This helps create a stable financial position for LLY and provides flexibility in future opportunities.

Moat Assessment

LLY possesses a wide economic moat, supported by its intangible assets and high switching costs. However, that moat could become more narrow, given a number of factors that are currently affecting the healthcare industry. We will explain that further in the sections below.

  • Rating: 4/5

  1. Intangible Assets:

    • LLY’s brand reputation for producing reliable drugs is very strong and allows for premium pricing of its medicines.
    • LLY has a massive portfolio of patents which gives LLY an edge over generics and competitors.
  2. Switching Costs:
    • Patients suffering from diabetes, heart problems, cancer, and other life-threatening or severe diseases, have relatively high switching costs, since a lot of them are reluctant to switch to something new, and many depend on a specific drug for years.

  3. Network Effects: While not the primary source of LLY’s moat, in some cases such as with their diabetes medications and some other drugs, there are network effects, because of the long term use of their medication by patients and health workers who are used to it.

  4. Cost Advantages: LLY does not have cost advantages that are sustainable.

Risks to the Moat & Business Resilience

  • Patent Expirations and Competition: One of the primary risks for LLY is the expiration of patents. Generics or biosimilars can erode revenues from their brand-name products. LLY is actively countering this risk with development of new molecules and methods, and making acquisitions that provide access to new patents and technology to protect and expand its core business segments.
  • Drug Development Risks: Pharmaceutical research and development is costly and unpredictable. There is a large possibility that new products may fail to gain regulatory approval or not perform as well as projected. LLY’s response to this, is having a well-diversified research portfolio and focusing on multiple different therapeutic areas that are not correlated to each other.
  • Regulatory and Pricing Pressures: Drug pricing and reimbursement are a constant cause for debate and regulations from both local and federal governments affect how much money the company earns from the products. These regulations also require companies to follow a long and arduous process before releasing products. LLY is actively trying to reduce prices for its insulins so patients and other parties can have better access. Also they are focusing on areas where pricing is better controlled by the company as opposed to external bodies. They are also trying to reduce costs to improve profitability.
  • Global Economic and Political Changes: LLY operates across various regions and is not immune to geopolitical risks, which could result in disruptions and uncertainty, and could affect their supply chain. The company is actively managing relationships with suppliers, and seeking to improve its geographical diversity, to lessen these risks.
  • Litigation and Lawsuits: The company is involved in various legal proceedings, including legal actions, government investigations, and environmental proceedings, most of which are related to a certain number of their existing products, and could have a material effect on their business and profitability. The company must continue to implement a range of measures to protect itself.
  • Manufacturing and Supply Chain disruptions: The company’s ability to reliably provide its medicines to its customer depends on access to key materials and an efficient production process, and is a vital aspect to protecting the moat and profitability of the company. LLY is trying to expand its manufacturing capacity in an effort to maintain better and more sustainable operations.
  • Inflation: Current inflationary pressures can affect prices of raw materials, supply chains, and labor costs, which could in turn lower profitability. LLY is trying to minimize the impact of inflation with strategic measures to reduce costs, and increase its pricing power where possible.

Understandability Rating

Rating: 2 / 5 LLY’s business model is complex due to the long R&D cycles and legal and regulatory requirements. To understand the company, investors must be familiar with the pharmaceutical industry, which involves understanding intricate details about R&D processes, clinical trials, market dynamics for specific drugs and therapy areas. Also it needs a good understanding of government regulations in healthcare in the US, and internationally. A layman investor may find it difficult to go through all the company specific details required to effectively value it.

Balance Sheet Health Rating

Rating: 4 / 5 LLY shows an overall healthy balance sheet with a good cash balance and acceptable debt levels for a company of its size, but the company could be slightly more conservative by reducing debt, and focusing more on organic growth.

Recent Concerns/Controversies and Management Response

  • COVID-19 Effects: While COVID-19 has increased business and sales significantly, mainly due to government buying of antibody treatments, sales growth is slowing down in 2023, and expected sales are set to be less than average going into the future.
  • Management response: LLY recognizes and accepts that COVID-19 revenue will continue to slow down in the future, so they are working to expand existing pipelines and creating new ones. LLY is also actively taking advantage of revenue from COVID-19 products by reinvesting it in R&D and other revenue-generating measures.

Conclusion

LLY’s business has strong growth prospects due to its diverse range of products, and its economic moat is durable due to its IP and switching costs. The company is also actively responding to issues such as price regulations, high competition in some areas, and supply chain constraints, therefore showing stability. However, investors must keep in mind the complexities of the business and the many challenges that the company may face. It’s important to note though that management is doing everything it can to mitigate risks by increasing investment in R&D, managing the supply chain, and other methods.