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Updated from 12:49 p.m. EDT

Eli Lilly

(LLY) - Get Eli Lilly and Company Report

shares fell 2.3% on Friday as Raymond James downgraded the company to underperform from market perform while raising questions about the quality of the drugmaker's earnings.

On Thursday, Lilly issued an earnings warning along with

second-quarter results, prompting Michael Krensavage, analyst at Raymond James, to downgrade the company. Krensavage believes the company's core business is faltering, noting that a 17% decline in new U.S. prescriptions for Zyprexa has forced the company to get creative with its accounting to offset the difference.


Lilly reported second-quarter earnings that depict a company increasingly desperate to overcome declining U.S. demand for its largest-selling medicine, the schizophrenia treatment Zyprexa," said the analyst in his downgrade. "Zyprexa's estimated 2004 sales of $4.4 billion would represent about 31% of estimated revenue of $14 billion. It probably accounts for half the company's profits." (Raymond James does and seeks to do business with the companies covered in its research reports.)

Yesterday, Lilly warned that gross margins on Zyprexa would come in near 77.2% in 2004, down from earlier guidance of 78.7%. With so much at stake, Krensavage questioned whether Lilly is turning to rebates and discounts to boost use of the expensive drug, which faces stiff competition from

Bristol-Meyers Squibb's

(BMY) - Get Bristol-Myers Squibb Company Report

Abilify and


(PFE) - Get Pfizer Inc. Report


Ultimately, the analyst said Lilly is turning to a combination of accounting and cost-cutting to offset weakness in its best-selling product.

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"Lilly hopes non-operating items will help it overcome the shortfall, allowing it to maintain its per-share earnings target, a range of $1.80 to $2.85," said Krensavage, noting the company raised guidance for "other income," adding between 5 cents and 8 cents a share to earnings. "Some of that benefit would stem from Lilly's plans to capitalize, rather than expense, interest charges."

With Lilly shares trading at a 35% premium to peers because of its strong pipeline, the company could be priced to perfection at a time when it faces risks. Earlier in the year, generic drugmakers launched a challenge on Lilly's patent for Zyprexa, hoping to introduce cheaper versions before the company's exclusive rights expire in 2011. A ruling is expected this summer.

But with Thursday's warning, Krensavage believes that even a favorable ruling on Zyprexa has limited upside. If Lilly wins, the company's earnings will remain unchanged, but if the company loses, estimates will have to come down again.

"Based on earnings including charges, Lilly shares are trading at about 23 times estimated 2004 earnings, compared to a group average of 17," he said. "While a Zyprexa court ruling likely would expand Lilly's premium, decreasing quality of earnings suggests such a gain would prove short-lived."

In reaction to the downgrade, shares of Lilly fell $1.49 to $63.25, after also declining Thursday on its earnings report.

Second-quarter earnings results from the major drugmakers have been mixed. Industry No. 1 Pfizer beat analysts forecasts by a penny Wednesday, as its stable of drugs posted broad-based gains.


(MRK) - Get Merck & Co., Inc. Report

met expectations, while profit and revenue slipped a bit.



fell short of expectations in posting a tiny loss.



surpassed forecasts as revenue rose 13%. Switzerland-based


(NVS) - Get Novartis AG Report

easily beat consensus estimates as net income rose 19%. Bristol-Myers Squibb reports July 29.

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