Is There Opportunity In The Latest Eli Flop?

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eli Lilly

So yesterday morning we learnt that Eli Lilly and Company (NYSE:LLY) was dumping its lead cholesterol candidate after it failed to produce any level of statistically significant efficacy in phase III trials. The announcement came premarket, and Eli stock lost nearly 10% before the bell rang. The company closed out the day about 8% down on last week’s close, with more than 26 million shares traded – five times average daily volume. Needless to say, markets were expecting big things from the dropped candidate, and it failed to deliver. As we head into a fresh day’s trading, the question now is why did Eli drop evacetrapib, and what impact might it have on the company and its strategy going forward? Additionally, where can we look to take advantage of the announcement? Let’s take a look.

First, the drug in question. Evacetrapib is one of a range of drugs that have been/are being investigated by a number of big pharma organizations that falls under the category of cholesteryl ester transfer protein (CETP) inhibitor. There are a few different types of cholesterol, some good, some bad. CETP transfers cholesterol from high density (a good type) to low density (a bad type). By inhibiting this process, drug companies hoped to be able to improve cholesterol levels and – in turn – reduce heart disease and other cardiovascular issues.

Pfizer (NYSE:PFE) was the first company to try and bring CETP inhibitors to market, with its candidate torcetrapib way back in 2006. In a startlingly similar fashion to Eli, however, the company announced a discontinuation of a phase III in December of that year, citing an increased mortality rate as the root cause. While Eli hasn’t yet announced the specifics of its latest failed trial, it has not mentioned mortality as a driver behind the decision; instead, insufficient efficacy based on the advice of an independent review panel. From a social perspective, the fact that the drug didn’t have any mortality side effects is a good thing, of course. Fro an investment perspective, however, inefficacy and increased mortality rates are interchangeable – they both translate to wasted capital. Again, exactly how much wasted capital remains unclear. We do know, however, that Pfizer spent circa $800 million bringing torcetrapib to its halted phase III, and that the Eli trial was conducted across a wider patient sample. We can reasonably conclude that Eli has spent this figure or more on development – the company has reported a Q4 charge of up to $90 million on its earnings as a result of the discontinuation, but this far from reflects the overarching cost of the drugs development when everything is accounted for. There is also a missed opportunity cost. Across the drug’s development, markets have slowly been pricing in the potential for a billion-dollar minimum boost to Eli’s annual revenues. The whole situation also places a negative spotlight on Eli’s macro strategy. The company has been very public about its intentions to focus on potential blockbusters, regardless if development cost. It has justified this approach through the claim that it focuses on only drugs with a high chance of trial success. With the latest failure, markets will question Eli’s judgment when it comes to future candidates.

So is there any opportunity to profit from this development? Well, maybe. Eli still has a strong pipeline, and while it wont be generating revenues from the CETP space going forward, a 10% decline in its market capitalization looks like an oversell. Additionally, it opens up an opportunity for a couple of shorts. Merck & Co. Inc. (NYSE:MRK) has a CETP candidate in ongoing trials, and with both Pfizer and Eli already having discontinued their respective candidates, the likelihood of Merck doing the same has increased. Amgen (NASDAQ:AMGN) is also set to suffer, with the company having picked up the rights to the then Dezima owned CETP candidate TA-8995 last month.

What can we take away from all this?  Well, this is a high profile flop for Eli, and could well be the nail in the coffin for the CETP class, but it may offer an opportunity to pick up an exposure to the biotech incumbent at a discount. The company still has some strong candidates in its self styled to-the-moon pipeline, and even against the backdrop of this miss, all it will take is one hit to catalyze an upside revaluation. This said, expect further selling pressure in Eli stock near term, likely to compound when the company gets around to releasing the specifics of the evacetrapib trial.

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