Tickers in this Article: LLY, NVO, SNY, PFE, GSK, AZN, BMY
By no means is it easy to be a large-cap pharmaceutical company these days. The cost of developing new drugs has skyrocketed, patent expirations have gutted revenue growth and troubles with regulators and advocacy groups have weighed on shares. All of that said, pessimism seems to be at too high a level. Investors may want to consider the virtues of clipping coupons and waiting for companies like Lilly (NYSE:LLY) to come out from under the current cloud.

Tutorial: Fundamental Analysis

Q1 - Okay, But Not Great
Large cap companies often move with the agility of supertankers, so quarter-to-quarter financial changes tend to be slow and modest. Lilly reported 6% revenue growth this time around, with 5% growth in volume and flat pricing. Lilly gets a bit less than half of its revenue from overseas, and this was the growth driver this quarter - foreign sales jumped 13%, while U.S. sales rose just 1%. (For more, see Measuring The Medicine Makers.)

Of total pharmaceutical sales growth of 5%, major drugs like Zyprexa, Cymbalta and Alimta were significant contributors (growing 6%, 13% and 10% respectively). Unfortunately, that also serves to highlight the risk from generic competition that is soon coming for Zyprexa and then coming three years later for Cymbalta.

The profitability side of things was less impressive. Gross margin did improve a bit (about 30 basis points), but higher spending on R&D and SG&A limited adjusted operating income growth to 2%. A lower tax rate also helped to improve results.

Bad News First - a Difficult Competitive Environment
Lilly certainly has more than a handful of challenges. Diabetes care has long been a meaningful business for Lilly, but matters are not going the company's way of late. The company is losing momentum to Novo Nordisk (NYSE:NVO) and (to a lesser extent) Sanofi-Aventis (NYSE:SNY) in insulin, while FDA delays for Bydureon also reduce near-term growth prospects and arguably forced the company into an alliance with Boehringer Ingelheim to tide it over.

Arguably worse, there is nothing in the near-term pipeline that looks like another Cymbalta. True, drugs can surprise once they are on the market, but Lilly's immediate prospects seem to be heavily weighted towards lower-potential drugs or drugs where Lilly has to share the proceeds.

But It's Not Over Yet
The good news for Lilly shareholders can be found in the fact that the company has not abandoned R&D and - relative to the likes of Pfizer (NYSE:PFE) - still spends quite a lot of its money this way (though Pfizer spends more in absolute terms). What's more, while the company is facing unimpressive revenue performance for several years, the company should nevertheless remain in shape to pay quite healthy dividends.

Longer term, Lilly may also be poised to benefit from a relatively poor funding environment for biotechnology. If biotechnology companies cannot find the capital they need in the public or venture capital markets, they may have little choice but to sell to the likes of Lilly. Granted, the same is true for other pharmaceutical companies like Glaxo (NYSE:GSK), AstraZeneca (NYSE:AZN) and Bristol-Myers (NYSE:BMY), so it is not as though Lilly has free choice of the lot.

The Bottom Line
Even assuming measly free cash flow performance (mid-single-digit declines for five years, followed by just 2% growth thereafter), Lilly is undervalued by more than 10%. Factor in a healthy dividend and prevalent skepticism, and patient contrarian investors may have a relative value opportunity here. (For more, see Pharmaceutical Phenoms: America's Best-Selling Medicines.)

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