The main thrust of this analysis is concentrated in three parts. The first two parts are based on free cash flow (current and historical) and the third is based on historical price action as a gauge of investor sentiment.
The three methods used in this analysis are:
For those new to this analysis please link here for an introduction:
- OE and COE
- SIA
- CapFlow
The main goal of my analysis is first to determine a sell price. With that in mind, we attempt to buy the stock at half its sell price and then hold it for 5 years (provided that no macro- economic negative catalysts force us to sell). Due to the fact that we bought it at par, we can potentially achieve an average annualized return of 15% per year. This may enable us to double our money every 5 years. Occasionally we do find a stock that is not selling at par, but is actually selling at a discount. When this happens, gains are usually higher.
Analysis of Eli Lilly (LLY) with a brief comparative commentary on Apple (AAPL) (after multiple requests to do so from readers)
Investing in the Pharmaceutical industry these days requires one to think outside of the box. If you listen to the mainstream financial press or the majority of Wall Street Analysts, you would think the industry is doomed to failure. We on the other hand love to invest in industries where investor sentiment is very negative and where there is blood in the streets. Eli Lilly is a company that has been a growth stock superstar for decades and until recently has been untouchable for the value investor. But that is no longer the case and I would say the exact opposite scenario is present. Not only can the value investor invest in Lilly with confidence, but the Graham deep value investor can do so as well.
In analyzing the company, I was amazed to find it trading at such extreme discounts to its buy price and in a million years would have never expected to be able to pick up Lilly shares at these prices. But talk is cheap so let me give you some numbers.
Here is my analysis of Eli Lilly using my proprietary system:
The following is an Owners Earnings (OE) table of Eli Lilly from 1973-2010 (with Estimates)
The first thing you’ll notice in the table above is the tremendous amount of Owners Earnings (OE) that the company has generated over the years. But what is truly amazing is how much they have pumped out in the last four years. From 2007-2010 (through a major recession) Lilly generated $17.14 in OE per share or about $19.50 billion in OE. When you figure that the company only has a market capitalization of $38 Billion, it becomes clear they are pumping out some amazing numbers in OE. Apple for example has generated about $25 billion over that same period but trades at a $317 billion market capitalization. So basically Lilly is trading at 1.93 to 1 while Apple is 12.68 to 1 (Price to 2007-2010 OE). Apple is generating tremendous amounts of OE and they clearly have investor sentiment in their corner, while Lilly’s investor sentiment is sort of like a ghost town.
All this is happening because of the expected future patent expiration of key drugs in Lilly’s portfolio and the worry of investors is that growth will be hard to come by in the future. If we take the worst case scenario and say in 2012 that Lilly’s OE will drop down to $3.5 per share, the company at its current price of $34.95 would still be trading at 10 times their OE and still be pumping out over $4 billion a year in OE.
Instead of following my usual pattern of generating my sell prices from 2010 estimates let's use the $3.50 2012 OE number for LLY as our guide and do a worst case scenario analysis. Therefore, as we like to sell at thirty times our Price to OE (P/OE) we get 30 X $3.50 = $105 as our P/OE sell price.
Since we are going out to 2012 in our analysis, let's add another $8 (2011 + 2012) to our Cumulative Owners Earnings (COE) final number and we get $56.19. Since we like to sell at two times our COE we have 2 X $56.19 = $112.38 as our COE Sell Price.
Before we get to the SIA Sell price let’s discuss what management is doing to control costs in preparation for what will be tough times for the industry coming up. The following (click to enlarge) is the CapFlow chart for LLY:
As you can see from the chart above, management has streamlined the company over the last three years with record low CapFlows. The 11% figure is the lowest figure of any year of the 38 under analysis.
So management is clearly prepared for the tough times, but I find it hard to believe that with so many years of being able to prepare for many of their patent expirations coming due, that Lilly does not have some serious drugs in the pipeline. After all with so much free cash flow at their disposal, the odds are that they should at least get one blockbuster drug to show up. With over $6 billion in cash to work with, Lilly can literally buy a blockbuster if they need to.
So with the OE numbers out of the way, let’s turn our attention to investor sentiment and discover what our Statistical Indicator Analysis (SIA) Sell Price is for Lilly? The following are the long term and medium term SIA charts for Lilly (click to enlarge):
You can clearly see that Lilly was an untouchable stock for years and that it is now trading at a deep discount to its SIA. Its current SIA comes in at $45.37, so with a current stock price of $34.95, we get a result of 0.77 or that Lilly is selling at a 23% discount to its SIA.
We talked about Apple and its OE before, but let’s look at a chart of Apple’s SIA (click to enlarge) to show you what happens when investor sentiment is fully behind a stock:
For purposes of disclosure I have had my clients invested in Apple over the last year and a half as their P/OE numbers have never hit my 30 times sell target, but with the recent news on Steve Jobs (one of my idols) and that the stock is trading at 5.43 times its SIA (as shown above), I just could not afford to take the risk any longer. I have had many requests to do a Mycroft Research (MR) Analysis of Apple and I guess this is as good an opportunity as any. The three sell prices for Apple are:
- P/OE = 30 X $19.10 = $573,
- COE Sell Price = 2 X $58.46 = $116.92
- SIA Sell Price = 2 x $63.21 =$126.42
Added together, that come to $816.34/3 = final sell price of $272.11.
I would conclude that anything above that price is the “Steve Jobs Premium”.
The OE growth rate for Apple is blazing hot and that’s why I kept it so long, I have three i-Phones in my house and love their products, but the risk after looking at the SIA chart above was just too great, especially after hearing about Steve Jobs’ recent medical leave. To show you what can happen after a stock or commodity breaks 4.0+ times its SIA, here is the chart for Crude Oil when it hit 4.10 times its SIA at its peak:
I wish all Apple shareholders good luck, but it just got too hot in that kitchen for me.
Lilly on the other hand takes us to the opposite extreme in terms of investor sentiment for a stock. Let us now get the final buy and sell prices for Lilly:
We have the three sell prices, so we can now determine our final sell and buy prices.
- 1) P/OE = $105 (30 times OE per Share)
- 2) COE = $112.38 (2 times COE)
- 3) SIA = $90.74 (2 times SIA)
- Total = $308.12/3 = $102.70= Sell Price
Buy Price = $51.35
Conclusion: Remember that we are using the reduced OE estimates for 2012 for a worst case scenario and we still have Lilly trading at a 32% discount to our buy price. So with Lilly and Apple you have two extremes going on simultaneously. As a prudent man, I will go with Lilly and take my 5.6% dividend and wait for a turn around and at the same time wish my idol Steve Jobs a quick recovery.
Disclosure: I am long LLY but have no position in AAPL
Disclaimer: Always remember that these are the results of our research based on the methodology that I have outlined above and in other articles previously published. This research is provided as an educational tool and should not be considered investment advice, but just the results of our research. There are many ways to analyze a stock and you should never blindly follow anyone’s work without doing your own due diligence or by seeking the help of an investment advisor, if you so need one. As Registered Investment Advisors, we see it as our responsibility to advise the following: We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong. Please note, investments involve risk and unless otherwise stated, are not guaranteed. Past performance cannot be used as an indicator to determine future results. Strategies mentioned may not be suitable for everyone. We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of Peter “Mycroft” Psaras, and should not be construed as personalized investment advice. Information expressed does not take into account your specific situation or objectives, and is not intended as recommendations appropriate for you. Before acting on any information mentioned, it is recommended to seek advice from a qualified tax or investment adviser to determine whether it is suitable for your specific situation.
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