Internet Mini Case #1

Eli Lilly & Company

Maryanne M. Rouse

A LEADING U.S. PHARMACEUTICAL COMPANY, ELI LILLY AND

COMPANY (LLY) PRODUCED a wide variety of ethical drugs (approximately 94.2%
of 2003 revenues) and animal health products (just over 5.8% of 2003 revenues). The
company history began with Colonel Eli Lilly, a Union officer in the Civil War, who
invented a process for coating pills with gelatin. Lilly’s principal activities were to
discover, develop, manufacture, and market pharmaceutical-based health care solutions.
The company’s two business segments are Pharmaceutical and Animal Health. The
company’s pharmaceutical product lines comprised neuroscience, endocrine, anti-
infective, cardiovascular agents, oncology, and animal health. Lilly manufactured and
distributed its products through owned or leased facilities in the United States, Puerto
Rico, and 26 other countries; the company’s products were sold in approximately 160
countries.
In the United States, Lilly’s pharmaceutical products were distributed through
approximately 35 independent wholesalers that served physicians, pharmacies, hospitals,
and other health care professionals. Three wholesalers in the United States, AmeriSource
Bergen Corporation, Cardinal Health, and McKesson, each accounted for between 19%
and 23% of 2001 consolidated net sales. Products were promoted through sales
representatives who called on physicians, wholesalers, hospitals, managed-care
organizations, retail pharmacists, and other health care professionals. The company
supported sales representatives’ efforts with advertising in medical and drug journals and
distributed literature and samples of products to physicians at medical meetings. Like its
competitors, Lilly also advertised certain products directly to consumers, a practice
coming under increased criticism from public health and cost-containment advocates.
Marketing methods and product emphasis were adapted to meet local needs and
regulations in markets outside the United States.

This case was prepared by Professor Maryanne M. Rouse, MBA, CPA, University of South Florida.
Copyright ©2005 by Professor Maryanne M. Rouse. This case cannot be reproduced in any form without
the written permission of the copyright holder, Maryanne M. Rouse. Reprint permission is solely granted to
the publisher, Prentice Hall, for the books, Strategic Management and Business Policy–10th and 11th
Editions (and the International version of this book) and Cases in Strategic Management and Business
Policy–10th Edition by the copyright holder, Maryanne M. Rouse. This case was edited for SMBP and
Cases in SMBP–10th Edition. The copyright holder, is solely responsible for case content. Any other
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Lilly’s patents were critical to maintaining its competitive position. Current patents for
major products included:

Drug Year Introduced Purpose

Alimta 2004 Malignant mesothelioma and advanced lung
cancer
Symbax 2004 Bipolar depression
Cialis 2003 Erectile dysfunction
Straterra 2003 ADHD
Forteo 2002 Osteoporosis
Xigris 2001 Severe sepsis
Actos 1999 Type 2 diabetes
Evista 1998 Osteoporosis
Zyprexa 1996 Schizophrenia, bipolar maintenance
Humalog 1996 Type 1 and type 2 diabetes
Gemzar 1995 Pancreatic, bladder, breast, and lung cancers
ReoPro 1995 Prevention of cardiac ischemia
Humatrope 1987 Human growth hormone
Humulin 1982 Type 1 and type 2 diabetes

For a number of these products, in addition to the compound patent, the company
held patents on the manufacturing process, formulation, or uses that may extend beyond
the expiration of the product patent. Although industry analysts had concerns about
Lilly’s performance as it moved beyond the “Prozac era” (the company lost patent
protection for its blockbuster antidepressant in August 2001, after a Federal Circuit Court
reversed a part of a Federal Court decision upholding Lilly’s patents), the introduction of
six major drugs between 2001 and 2004 plus a strong pipeline and solid performance had
secured the company’s ranking as one of the top 10 global pharmaceutical firms, with
most analysts rating the company’s stock as “outperform.”
As part of an inspection related to regulatory reviews of Lilly’s Zyprexa
intramuscular and Forteo products in 2001, the Food & Drug Administration (FDA)
found quality problems at several of the company’s manufacturing sites. Although Lilly
appeared to be moving in the right direction in resolving these quality issues, they were
still a concern several years later. The bottom-line implication from this manufacturing
mess was that several new product approvals, including Forteo and Straterra, were
delayed. Lilly’s margins were likely to remain under pressure from lower volumes and
costs associated with resolving its manufacturing problems. The company expected to
resolve most manufacturing problems to the satisfaction of the FDA by year-end 2004.

Legislative-Related Activity and Litigation

In early October 2002, Lilly and Bristol-Myers Squibb settled over 300 lawsuits accusing
them of failing to stop Kansas City pharmacist Robert Courtney from diluting cancer
drugs over a period of years. Plaintiffs had maintained that both companies were
complicit in the pharmacist’s actions, based on internal documents showing they knew as
early as 1998, three years before the arrest, that cancer drugs were being diluted but
failed to act. In 2004, Lilly still faced a number of consumer lawsuits related to Prozac
and was involved in patent litigation involving both Prozac and Zyprexa. Lilly was also
expected to face charges of deceptive marketing in connection with its osteoporosis
drug Evista. Critics noted that Lilly had attempted to position Evista as a means of
lowering the risk of cardiovascular events (heart attack, heart-related chest pain, and
other coronary events) based on data gathered in a study designed solely to assess
Evista’s effects on osteoporosis. Questions were also raised about financial support
provided by Lilly to the authors of the study.

Financial Position/Performance
The loss of patent protection for Prozac had a significant effect on Lilly’s sales and
profitability in both 2001 and 2002; however, worldwide sales for 2003 increased 14%,
due primarily to the strong performance of more recently introduced drugs, including
Zyprexa, Evista, and Gemzar, as well as growing sales of Cialis, Straterra, and Forteo.
Net income for 2003 declined approximately 5.5%, from $2.71 billion in 2002, due to
increased spending on research and development, revamping of manufacturing facilities,
and an increase in marketing costs from 30.9% of revenue in 2002 to 32.23% of revenue
in 2003. Impairments, restructurings, and other special charges (principally as a result of
the Isis joint venture) resulted in a $382.2 million write-down for 2003. Complete
financial information, including links to Eli Lilly’s annual and quarterly reports and SEC
filings, is available via the company’s web site or www.wsj.com.

The Industry
In the United States, the largest segment of the global pharmaceutical market,
demographic trends, including the baby boom population bulge and longer average life
spans, drove industry growth. At the turn of the 21st century, although approximately
12% of the U.S. population was over 65 years of age, over 33% of all U.S. prescriptions
were written for those over 65. Patients generally considered prescription medicines
necessary purchases which, together with a third-party payment system, tended to reduce
the price elasticity of demand.
Despite near-term uncertainties with respect to pricing and patent expirations, the
pharmaceutical industry was still one of the healthiest and widest-margin industries in the
United States. U.S. prospects for the longer term were enhanced by demographic growth
in the elderly segment of the population (accounting for about one-third of industry
sales), as well as by new therapeutic products resulting from discoveries in genomics and
biotechnology. However, drugs generating over $40 billion of industrywide sales in 2001
were going to lose patent protection over the next four years. The flood of patent
expirations offered major opportunities for the generic manufacturers, especially for
those obtaining 180 days of “first to file” marketing exclusivity.
On the regulatory front, the FDA had become much tougher on new drug
approvals. Regulatory compliance was costly both in out-of-pocket application,
establishment, and product fees and in time required to gain approval. Major new drug
therapies took an average of 14 years to develop, at an estimated cost of $500 million.
Only about 1 applicant in 20 makes it through Phase 3 trials to FDA approval. The FDA
was also cracking down on drug manufacturing, with some plants closed as a result of
quality problems.
Three key developments were expected to act as a ceiling on profits for
pharmaceutical firms: (1) Managed care plan buyers, who accounted for 70.4% of
prescription drug purchases, had made drug cost containment a priority, (2) the Medicare
Prescription Drug Improvement and Modernization Act was signed into law in December
2003, and (3) states had become very aggressive in pushing for new legislation aimed at
obtaining greater drug discounts for Medicaid and other state-run programs. Many HMOs
used a three-tiered copay system to discourage the use of expensive drugs and encourage
the use of generics.
Outside the United States, the competitive landscape was quite different.
Although the standardization of regulatory requirements among European Union
member countries was expected to create a simpler operating environment, the EU
imposed stringent price controls and banned most direct-to-consumer marketing;
similar price controls and advertising bans existed in Japan. The operating and
competitive environments in developing nations were characterized by a high degree
of uncertainty and, while they represented significant opportunities for revenue
growth, they lacked the strong intellectual property protection pharmaceutical
companies relied on to justify huge investments in R&D.

Recent Developments
A growing challenge to U.S. pharmaceutical firms came from increased out-of-country
purchases. On October 12, 2002, the largest U.S. health insurer informed members of the
senior citizens lobbying group AARP that it would reimburse them for prescriptions
filled in Canada and elsewhere abroad where governments cap drug prices. UnitedHealth
Group, Inc., sent a letter to 97,000 people who bought insurance with a drug benefit
through AARP about the coverage. Although buying prescription drugs outside the
United States for use in the country violated federal regulations, it was a growing practice
among older Americans seeking relief from high-priced name-brand drugs. UnitedHealth
and AARP appeared to want to keep the announcement low key; however, thousands of
AARP members, as well as other senior citizens, regularly purchased prescription
medicines in Canada and Mexico—in person or via the Internet—where the drugs are
significantly cheaper, even if not reimbursed. By October 2003, industry lobbyists, who
had mounted a campaign against reimportation of prescription drugs based on purported
safety concerns, were pressing Congress to set harsh penalties for those facilitating the
practice.
In early October 2002, the U.S. Office of the Inspector General warned drug
companies that offering incentives, such as concert tickets and vacations, to physicians
could lead to civil or criminal charges. The policy came after years of concern about drug
industry marketing practices that critics said influenced doctors to prescribe certain drugs
that led to higher costs for consumers. Although the policy did not bar nominal-cost gifts,
golf balls, or bags emblazoned with company logos, meals other than those in
conjunction with medical education, concert and other entertainment tickets, cash
payments, and a wide range of other incentives were not allowed. The policy also
prohibited drug companies from reporting average wholesale prices that differed
substantially from what was actually charged—and touting those prices in marketing. The
government’s concern stemmed from the use of average wholesale prices in determining
reimbursement for the drugs Medicare currently covered. There had been some concern
that if drugs were sold to doctors for less, doctors could bill for the higher amount and
keep the difference. Critics said this was a tactic drug makers used to lure doctors to their
products and further inflate consumer drug costs by more than $1 billion annually.
To continue generating the returns enjoyed by the industry over the past decade,
pharmaceutical companies would be forced to rethink how they identify and exploit
opportunities to gain a competitive edge in an increasingly complex market.