LLY

Business Context and Reporting Period

This Form 10-Q covers Eli Lilly and Company for the quarter and nine months ended September 30, 1999. The company operates primarily in pharmaceutical products, with animal health operations deemed immaterial. A significant strategic shift occurred in early 1999 with the sale of the PCS health-care-management subsidiary to Rite Aid Corporation for $1.60 billion, allowing management to focus on pharmaceutical innovation.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 10% in Q3 and 9% for the nine-month period compared to 1998. Growth was driven by volume increases (9% in Q3, 10% in 9M) and price increases (2% in Q3), partially offset by unfavorable exchange rates.
• Profitability: Net income rose 41% in Q3 and 26% in the nine-month period. Excluding non-recurring items, net income and EPS increased approximately 15-17% year-over-year.
• Product Performance:
  • Growth Drivers: Zyprexa (up 27% Q3), Gemzar (up 72% Q3), ReoPro (up 24% Q3), and diabetes care products (up 30% Q3) led sales growth.
  • Declines: Prozac sales decreased 13% in Q3 due to wholesaler stocking patterns in the prior year and increased competition. Anti-infectives sales declined 2% in Q3 due to competitive pressures.
• Balance Sheet: Cash and cash equivalents more than doubled to $3.29 billion, primarily due to the $1.60 billion PCS sale proceeds and $825 million in new debt issuances. Total debt increased by $795 million.

Guidance, Outlook, and Risks

• Outlook: Management expects continued strong sales growth for Zyprexa and Evista in 1999. Prozac sales are expected to decline slightly in 1999 and 2000 due to competition and patent expirations outside the U.S. R&D expense growth is anticipated to be less than sales growth for the full year.
• Year 2000 (Y2K): The company estimates total Y2K costs between $160 million and $175 million, with 80-85% incurred by September 30, 1999. Contingency plans are in place for critical vendors and inventory imbalances caused by potential consumer panic buying.
• Legal Contingencies:
  • Patent Litigation: Six generic companies have filed Abbreviated New Drug Applications (ANDAs) challenging Prozac patents. While Lilly believes the claims are without merit, an unfavorable outcome could materially affect financial results.
  • Product Liability: Numerous lawsuits exist regarding diethylstilbestrol and Prozac. The company has accrued for estimated exposure, with most defense costs covered by insurance.
  • Environmental: Gross environmental liabilities are approximately $277.3 million, with estimated insurance recoverables of $226.9 million.
• Unusual Items:
  • Q1 1999 Charges: $150 million pre-tax charge for foundation funding commitments and $61.4 million asset impairment charge.
  • Q3 1999 Gain: $67.8 million pre-tax gain from the sale of Lorabid marketing rights.
  • Q3 1998 Charge: $127.5 million expense for acquired in-process technology (ICOS collaboration).

Investor Verification Checklist

• Verify the status of Prozac patent litigation against Barr, Geneva, and other generic manufacturers, as this poses a significant risk to future revenue.
• Confirm the sustainability of Zyprexa and Gemzar sales growth rates, which are driving current profitability.
• Monitor the impact of Y2K-related inventory stocking on Q4 1999 and Q1 2000 sales comparisons.
• Review the company's ability to maintain gross margins as product mix shifts and older products like Prozac and Axid decline.
• Assess the adequacy of insurance recoverables for environmental and product liability claims given the potential for carrier insolvency.