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Fellow Fools,

I have been reading the Lilly annual report over the past few days and I'm struck by the lessons it contains for the entire industry. LLY does not seem to be followed much here at TMF, but I think it may present one of the most interesting situations in pharma today.

First, some background: Lilly is one of the oldest and most respected pharmaceutical firms but because it has not been a merger or mergee it has steadily become relatively smaller than the other significant industry players. I believe it first became prominent because of insulin but most recently its fortunes had ridden on Prozac. Prozac revolutionized pharmacotherapy in psychiatry but it was always used to a much greater extent in the US than overseas; in fact it has never been approved in Japan, the second largest pharmaceutical market. Still, Lilly's sales and profits were extremely dependent on Prozac and for years the company worked to prepare for when in would go off-patent. Their strategy, as best I can decipher it, was basically two-fold: develop one of the stereoisomers of fluoxetine in hopes it could replace Prozac (fluoxetine is racemic--an optically neutral mixture of both its R- and S- enantiomers), and dramatically increase resources in R&D. The stereoisomer program failed during clinical development. The research program progressed well but at the last minute the company faced GMP compliance problems at their manufacturing facilities which threatened to delay FDA approvals.

The problem was compounded by the increasingly rapid uptake of generics which hit Prozac faster and harder than I can recall any other generic switch (with the possible exception now of the combined generic-and-OTC switch for Claritin) when generic fluoxetine appeared in August, 2001. The 2002 Annual Report really comes at the cusp of what will either be a transition to a new phase of growth fueled by a range of significant new products or a fall down into the black hole that is consuming BMY and SGP.

Here is my take on the lessons in Lilly's 2002 Report. As you read keep in mind that I have a small position in LLY but it is in the range of what I own of PFE, JNJ, and MRK (along with additional morsels of SGP and BMY which I am loathe to admit outside parentheses):

1. Generic competition no longer means slowed growth for the product in question, it means the gutting of those sales. The decline in Prozac sales in the 4th quarter of 2001 was 66% in the US. That was just the beginning. Prozac sales in the US in 2002 declined a further 73%. Try running any business where your most lucrative product in its most important market has back-to-back declines of that magnitude.

2. Generic competition is still less significant outside the US than inside, but Europe is learning to adapt generics more quickly. Prozac sales outside the US declined "just" 3% in 2001 followed by a 15% decline in 2002. This was cold comfort to Lilly because the combined effect (US + outside US) was a decline of 63% in worldwide sales for 2002.

3. Measures of profitability in pharma can change very quickly. ROE was an extraordinary 55% in 2000 at Lilly but it was down to 35% in 2002. Gross margin was roughly stable but that reflects the fact that it measures the margin from sales versus cost of goods sold (before the more significant R&D and marketing & administration costs in pharma) rather than the productivity of invested capital. Income is down from $2.83 in 2000 to $2.51 in 2002 despite share buybacks.

4. R&D investments matter. My beef against MRK for the last few years is that it has invested relatively lower funds in R&D relative to pharmaceutical sales (i.e. minus Medco) compared to its peers. Lilly has done the opposite. Among big pharma it leads the industry with almost 20% of sales invested in R&D. And it works! Lilly had more new drug approvals or approvables for really new drugs than any other major pharmaceutical firm in 2002, and 2003 also looks to be a good year. If anything, the problem Lilly now faces is to fund several major launches within a short time period.

5. It is a delight to see management face up to problems. Lilly has been frank about getting over the Prozac hurdle in its last three annual reports and this one is no different. Management is also straightforward in discussing their GMP problems and the increased investments being made in manufacturing compliance. SGP would be wise to take a page from Lilly's book here.

There is still a lot of uncertainty ahead. Freshly launched products may have unforeseen safety problems that require their withdrawal (all when I have looked at this in the past I came up with a risk of around 3-5% only). Lilly could further bungle its GMP compliance, or Zyprexa --on which the company is currently dependent to the extent it used to rely on Prozac-- sould somehow be lost in its current patent challenge. The launches the company faces this year may even hurt profits further because of the need to significantly increase marketing expenses for a successful launch. However, this annual report is one of the most encouraging I've read this season and the company truly seems to be delivering on their pipeline. I think Lilly deserves a lot more attention.

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