Eli Lilly & Co. reported a particularly uneventful third quarter on Oct. 20, slightly outpacing analyst estimates. Yet, a small decline in profits due to an increase in costs foreshadowed the steep patent cliff the big pharma will face in the near future.

With its top antipsychotic, Zyprexa (olanzapine), set to lose patent protection in just a few days, Lilly expects a "rapid and severe decline" in revenues for the $4.5 billion blockbuster as generics flood the market.

"With Lilly entering its patent cliff, we expect profitability to continue deteriorating as the company loses several major contributors to its margins," wrote Morningstar analyst Damien Conover in a recent note.

Earnings fell to $1.24 billion, or $1.11 per share, from $1.3 billion, or $1.18 per share, in the year-prior period. Earnings excluding one-time charges were $1.13 per share, beating analysts' average estimates of $1.12.

Lilly has been trying to stay ahead of its patent losses without conducting a large merger like some of its peers (Also see "No Big Surprises From Lilly: Management Sticks To Its Guns On Strategy" - Pink Sheet, 30 June, 2011.). The big pharma has been pouring money into research and development, as well as its pipeline, pushing costs up 10% in the third quarter compared to the previous year. R&D costs increased by 5% to $1.28 billion, or 20.8% of revenues - a larger percentage than most of its peers spend on R&D.

The operating expenses increase was due to costs associated with the diabetes alliance with Boehringer Ingelheim, the unfavorable effect of changes in foreign exchange rates, higher sales and marketing expenses to support launches of new products and new indications, as well as the pharmaceutical manufacturer fee associated with U.S. health care reform -- about $45 million, said Lilly Director of Investor Relations Ronica Pletcher during a quarterly conference call.

The Indianapolis company currently has more than 60 drugs in its pipeline including 10 compounds in Phase III. It will have to bear the hit to its sales as its pipeline matures; Lilly is expecting late-stage results from its Alzheimer's disease drug solanezumab next year. The company also expects to have 10 molecules in Phase II development by the end of this year.

In the meantime, Lilly is depending on the sales of just a handful of blockbuster drugs, including the depression drug Cymbalta (duloxetine) and the insulin for diabetes Humalog. Sales of Cymbalta increased 29% during the past quarter to $1.2 billion, largely driven by higher demand in both the U.S. and international markets. The popular antidepressant will lose patent protection in 2013. Humalog sales rose 20% to $593.2 million.

Also, helping to cushion the blow during the three year patent cliff are higher sales in Japan, where Zyprexa does not go off patent until 2015, as well as demand for the Lilly's animal health business. Volume growth in Japan was up 15%, driven by the recent launches of Cymbalta and osteoporosis drug Forteo (teriparatide).

Lilly has been in the midst of a restructuring effort for the past couple of years as its tried to cut costs and lessen the blow from expired drugs. Chief Financial Officer Derica Rice said during the call that most of the costs related to marketing Zyprexa are minimal due to its maturity and the bulk of the cost is the sales force. Despite the drug going off-patent, Zyprexa's sales force will remain intact; the same reps are used to market Cymbalta.

"Since 2009, we have upped the pace of right-sizing our organization for the post-Zyprexa period, significantly restructuring everything from our senior management layers to our back office operations, to our sales and marketing organization," added Rice. "We fully expect to meet our goal of reducing our expenses of $1 billion by the end of this year. This will essentially complete our restructuring efforts. While we will continue to drive incremental productivity, we have no plans for a major restructuring."

Lilly narrowed its guidance for full-year earnings to a range of $3.89 to $3.94 per share from its previously forecast range of $3.85 to $3.95 per share. Revenues for the third quarter rose 9% to $6.15 billion, topping Wall Street expectations of $6.06 billion.

- Lisa LaMotta (l.lamotta@elsevier.com)

Lilly Prepares For Zyprexa Expiration; Increases R&D Spend

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