Eli Lilly Stock: Powering Ahead, But Too Strong (NYSE:LLY)

Shares of Eli Lilly (NYSE:LLY) have been on fire over the last couple of years as the company has seen conversion of the pipeline into actual profitable growth. Back in January 2020, I observed that Eli Lilly pursued more M&A to bolster pipeline momentum, as the company announced a billion purchase for Dermira, after making an $8 billion deal for Loxo Oncology in 2019.

Back To Early 2020

Hard to imagine, but the huge pharmaceutical juggernaut Eli Lilly traded around $140 in January 2020, and shares had already seen quite some momentum up to the point in time.

Eli Lilly was a $22 billion business at the time, posting solid $7-8 billion in EBITDA as net debt of $11 billion (post the Loxo deal) translated into very reasonable leverage ratios of around 1.5 times. Yet additions to the pipeline and product portfolio were desperately needed with expiration for its second best-selling drug Alimta on the horizon. Fortunately, the company saw FDA approvals come in during 2019 as the full year adjusted earnings guidance was hiked to $5.80 per share.

The company guided for 2020 sales to rise towards $24 billion, with adjusted earnings set to come in near $7 per share, a solid guidance. With shares trading at 20 times adjusted forward earnings, valuations were a bit full in my opinion, as I was not happy to accept all the adjustments to non-GAAP earnings.

I was hopeful to buy shares near the $100 mark, but shares hardly moved lower as the pandemic sent the world in turmoil a couple of weeks later. Shares were flattish through most of 2020, but ever since have seen a huge rally. Shares now trade within the imminent highs at $330 per share, marking some 130% returns, a huge outperformance versus the market, certainly a big accomplishment for such a big company.

What Happened?

2020 was a year which was dominated by the pandemic of course, but despite this turmoil, Lilly announced a $880 million deal for Prevail Therapeutics late in the year, truly a bolt-on deal of course. Despite the pandemic, the company grew 2020 sales by 10% to $24.5 billion as adjusted earnings rose to $7.93 per share, far ahead of the initial outlook for the year.

Part of this momentum was driven by a $871 million revenue contribution (all realized in the fourth quarter) by Bamlanivimab, its Covid-19 drug. Even if we adjust for that, sales grew 6% as the company has seen quite a few small drugs make a big relative contribution, setting the company up for a decent 2021.

Given the uncertainty around the pandemic, the company issued a comforting guidance with sales seen between $26.5 and $28.0 billion in 2021, accompanied by solid profitability. In the end, sales rose 15% in 2021 to $28.3 billion, of which $2.2 billion by Covid-19 related drugs. Adjusted earnings improved further to $8.16 per share, all pretty solid.

Amidst continued approvals, the company guided for flattish sales at $27.8-$28.3 billion in 2022 with adjusted earnings seen at midpoint of $8.50 per share. Net debt stood at $13.0 billion by year-end 2021, far from an issue amidst the continued improvements in profitability.

Following the first quarter earnings report, the company has offered a mixed bag for investors. Full year sales are now seen between $28.8 and $29.3 billion, a billion dollar higher than originally guided for, yet the lower end of the adjusted earnings guidance was cut by thirty-five cents to $8.15 per share on the back of larger IP and development charges.

The reality is that while the company has seen solid operating results, the share price advancements have far outweighed the modest increase in earnings per share over the past couple of years. This means that a 20 times adjusted earnings multiple early in 2020 has expanded to roughly 40 times adjusted earnings. This came as earnings have basically only risen from just below $7 per share to just over $8 per share, but why have expectations risen such a big deal?

Pipeline In Action

While Eli Lilly has been doing alright in terms of sales growth over the past couple of years, even if we factor out the Covid-19 contribution, the market is pricing in major advancements in its future results. The company has two major candidates to grow into the valuation, one being a diabetes and obesity drug Tirzepatide, and Donanemab, its Alzheimer candidate, both of which could fetch over $10 billion sales once approved, according to analysts.

The great news is that Mounjaro (Tirzepatide) was approved by the FDA in May for diabetes, as the off-label use as a weight loss indication could be even greater. Promising is that the current Covid-19 antibody bebtelovimab appears efficient with current Covid-19 strains, as Alzheimer data on donanemab will at least take another year, as cures and approvals in this area have been historically very hard (as this statement is a massive understatement).

The trouble is that a great deal of the promise has been priced in now, at some 40 times adjusted earnings. Assuming a swift increase in Tirzepatide sales to add $10 billion in sales with a similar margin profile, we might see 30-40% topline and bottom-line growth, but even in that case we still see a business trading around 30 times earnings. Further growth is clearly anticipated by investors beyond a big launch in Tirzepatide, as this really feels like a stretch.

So unless the Alzheimer approval rolls in, or great other homeruns are seen, Eli Lilly simply feels a bit rich after great valuation multiple inflation has been seen already. After all, the valuation multiple from 20 to 40 times earnings has effectively added some $150 billion to the valuation of the firm already over the last couple of years.

This move higher has reduced the risk-reward in a huge manner, and while some initial takes in 2020 are easily too conservative, I see no reason to join the momentum craze right here.