Eli Lilly (LLY) will eventually cut their dividend

Eli Lilly (LLY) has shut down the development of experimental bone drug aroxifene, one of their most promising new treatments, after a five-year study found the drug didn’t reduce nonspinal fractures or cardiovascular events or improve cognition. The study also found that the drug increased the risk of blood clots, hot flashes, and “gynecological-related events.”

The drug was in the final stages of testing and Lilly had hoped to start selling it in 2010. Lilly said it will take a three or four cent charge to third quarter EPS related to the drug’s development, but the company reiterated its previous 2009 earnings forecast.

Another pipeline failure makes Lilly’s patent cliff, the biggest in the industry, seem all the more concerning. The drug was not expected to be a blockbuster, so the news has not significantly impacted shares, but management was long bullish on this product which exposes the company’s difficulties in navigating the industry’s largest patent cliff.

The weakening pipeline increases pressure for a transformative deal that can help support its revenues as the Phase II pipeline opportunities are limited. There are high hopes for Effient to become a blockbuster, but enthusiasm for the drug will be tested on August 30 when competitor data from Bristol-Myers Squibb (BMY) and StraZeneca (AZN) will be released.

Using 2010 earnings estimates, Lilly trades at a 36% discount to the healthcare sector, which is already at a 27% discount to the S&P 500. Despite the nearly 6% dividend yield, the company’s payout ratio is over 1.0, which means they are paying out more than they are earning. Toss in a debt-to-equity ratio of just over 90% and the increasingly likelihood of a major acquisition, and it becomes impossible to believe that Lilly can maintain their attractive dividend payment.

There isn’t much to be excited about in the near-term for Eli Lilly investors. I expect Lilly to announce a cut to their dividend the day that they make an acquisition if not sooner. Even an acquisition will bring some new integration risks to the table. The company will need to show that it can more effectively utilize their equity base to offer a better return to its investors and better employ the company’s assets to become more profitable before I become interested.

--

Peter J. Lazaroff, Investment Analyst