Is Lilly in Need of a Transformational Deal?

August 20, 2010 Is Lilly in need of a transformational deal?

Evaluate Vantage

The future has been looking particularly bleak for Eli Lilly for some time now so recent setbacks, such as loss of patent protection for key products and major pipeline failure, has not only deepened the gloom but left many observers suggesting the company needs a major rethink of its strategy. Unsurprisingly, the suggestions box has been flooded with M&A tips.

Lilly has certainly joined the trend for bolt-on acquisitions in recent years, a significant break from its long history of organically driven growth. Perhaps increasing pressure from the scale of its patent cliff and dry pipeline means the time has come for a major acquisition or merger to transform the group’s prospects. After all, despite implementing one of the most aggressive cost cutting initiatives amongst its peers, Lilly is still expected to see the biggest erosion of its bottom line over the next six years (Lilly finally bows to patent cliff pressure, September 15, 2009).

Sticking to its R&D guns

Since taking over as Lilly’s chief executive in 2008, John Lechleiter, previously head of R&D, has largely stuck to the theme of searching for the next blockbuster rather than diversifying into other areas, like some of his peers. New drugs were to come from the internal pipeline, facilitated by the now standard restructuring of its R&D operations, as well as licensed or acquired products or companies.

Yet the internal pipeline has struggled to deliver the goods for some time now, the most recent setback just this week with the failure of semagacestat in phase III for Alzheimer’s disease (Will gamma secretase Alzheimer's class survive the fall of semagacestat? August 18, 2010).

In fact the most promising candidates in Lilly’s pipeline actually come from licensing deals or M&A activity. The table below shows that 66% of the value from its biggest new product launches over the next five years is derived from external resources. Eli Lilly's Key Product Launches

WW sales in Acquired Launch Product Pharmacological Class Status Strategy 2016 Company/Licensor ($m)

Glucagon-like peptide 1 Amylin 2010 Bydureon 564 Filed In-licensed (GLP-1) agonist Pharmaceuticals

Axiron 2011 Androgen 126 Filed In-licensed Acrux (testosterone)

Pancreatic enzyme Company Alnara Liprotamase 98 Filed product (PEP) acquisition Pharmaceuticals

Ramucirumab Phase Company 2012 Anti-VEGFr MAb 403 ImClone Systems (IMC-1121B) III acquisition

Necitumumab Phase Company Anti-EGFr MAb 266 ImClone Systems (IMC-11F8) III acquisition

Metabotropic glutamate Phase LY2140023 receptor 2/3 (mGluR2/3) 249 Organic - II agonist

Phase Teplizumab Anti-CD3 MAb 233 In-licensed MacroGenics III

Tasisulam Mitochondrial enzyme Phase 128 Organic - (LY573636) modulator (ASAP) III

Phase 2013 Solanezumab Anti-beta amyloid MAb 216 Organic - III

GLP-1 PEG Glucagon-like peptide 1 Phase 72 Organic - (LY2428757) (GLP-1) agonist II

Cixutumumab Phase Company Anti-IGF-1R MAb 63 ImClone Systems (IMC-A12) II acquisition

Serine/Threonine kinase Phase 2014 Enzastaurin 165 Organic - inhibitor III

Dulaglutide Glucagon-like peptide 1 Phase 66 Organic - (LY2189265) (GLP-1) agonist III

Total 2,649

Total acquired/licensed 1,754

% acquired/licensed 66%

Yet these new product launches will not fill much of the hole left by lost sales from patent expiries from key products, biggest of all being Zyprexa which will suffer generic competition next year. Indeed, according to EvaluatePharma, 70% of pharmaceutical revenues in 2010 are “at risk” from generic competition within the next five years.

Naturally this will have a significant impact on Lilly’s profits during this period, with net income margin of 21.1% this year expected to slump to 17.7% by 2016. This profit margin is easily the lowest amongst its big pharma peers and the erosion of profitability is worse than other companies with similarly challenging patent cliff, such as AstraZeneca.

Transformational deal required? The last three years have certainly seen a flurry of M&A activity at Lilly, with the $6.5bn acquisition of ImClone by far the biggest transaction. From the pipeline table above the full benefits of the ImClone deal are yet to be realised but certainly offer hope.

Eli Lilly's M&A History - ranked by value

Acquired Company Deal Value ($m) Financing Structure Deal Date

ImClone Systems 6,500 Cash Nov-2008

ICOS 2,300 Cash Jan-2007

Share Exchange + Applied Molecular Evolution 443 Feb-2004 Cash

Alnara Pharmaceuticals 380 Cash Jul-2010

Hypnion 315 Cash Apr-2007

SGX Pharmaceuticals 64 Cash Aug-2008

Total M&A value 10,002

Yet bolt-on acquisitions are all well and good if you have plenty of time to reap the rewards, time that Lilly does not really have in abundance.

As such, a much more substantial deal could now be required and below is a table of potential mega-merger or large scale targets. While a mega-merger would be a major surprise and Mr Lechleiter has vigorously rejected such a move, remember that Pfizer’s chief executive, Jeffrey Kindler, was making similar noises just months before its $68bn merger with Wyeth.

In terms of mega-mergers, a tie up with Bristol-Myers Squibb has often passed through the rumour mill, given the similarities in size, strategy and culture that exist between the two groups.

A transatlantic deal with AstraZeneca would be a major surprise, although the similarity of their patent cliff woes and struggling pipelines could suggest a mega-merger as a defensive move, which has happened in the past.

Meanwhile a tie up with Novo Nordisk seems implausible given the huge overlap in portfolios, particularly insulin and anti-diabetic agents, which may require significant divestitures.

If not a mega-merger then a large scale deal could make sense. Intriguingly, a number of the companies listed below would present Lilly with the potential to make a dramatic shift towards diversification of its operations. Lilly is one of the few big pharma companies sticking to the pureplay pharma model and all the signs so far point to the group keeping to its current strategy of pipeline focus and bolt-on deals. Yet the old adage "desperate times call for desperate measures" could still play out. Potential M&A targets for Eli Lilly Total group revenues ($bn)

Market Cap ($bn) 2010 2016 CAGR (10-16)

Eli Lilly 39.5 23.7 21.1 -2%

Mega-merger potential

AstraZeneca 73.1 32.6 28.4 -2%

Bristol-Myers Squibb 44.7 19.5 16.8 -2%

Novo Nordisk 40.4 9.8 14.5 +7%

Transformational bolt-ons

Gilead Sciences 27.8 8.0 11.9 +7%

Baxter International 26.3 13.0 17.7 +5%

Celgene 24.8 3.3 6.2 +11%

Allergan 19.4 4.7 7.3 +8%

Covidien 19.4 10.5 14.9 +6%

Genzyme 16.8 4.9 7.3 +7%

CSL 14.9 4.0 6.5 +8%

Biogen Idec 13.3 4.5 4.9 +1%

Shire 12.5 3.3 5.3 +8%

Fresenius 11.3 19.7 25.7 +5%

Hospira 8.7 4.0 5.5 +5%

Forest Laboratories 7.9 4.3 3.7 -3%

Warner Chilcott 7.2 2.9 2.3 -4%

Vertex Pharmaceuticals 7.2 0.1 1.8 +55%

Mylan 5.4 5.5 8.5 +8%