Can Lilly afford to maintain its dividend?

As shareholders gather April 19 for Eli Lilly and Co.’s annual meeting, more of them than ever will come with an unusual
question.

Will Lilly be able to keep paying its dividend?

The company’s dividend has hardly ever been a concern. Lilly has paid a dividend for 125 straight years and has raised
it in each of the past 42. Lilly pays 49 cents each quarter—or $1.96 per year—for each share of its stock.

But the future at Lilly won’t look like the past. Along with the rest of its peers in the pharmaceutical
industry, Lilly will watch a raft of lucrative drugs lose their patents at the same time their pipeline has stopped producing
new blockbusters.

At this point, Lilly’s profits are predicted to decline beginning in 2012. And it’s not clear the company will
be able to keep spending half the cash it generates each year—or more than $2.1 billion—on shareholder dividends.

A big chunk of that money remains in the Indianapolis area, where Lilly stock is held by its 12,000 local employees and thousands
more retirees. In addition, many not-for-profits, such as Lilly Endowment Inc., rely on the company’s dividend to fund
millions of dollars in annual philanthropy.

“They will cut the dividend. The dividend rate is too high right now,” said Pat Latz, who worked at Lilly for
eight years and still holds a small number of company shares. As a percentage of its current stock price, Lilly’s dividend
is abnormally high at 5.4 percent.

Latz, who is now an independent industrial consultant, predicts that by year’s end Lilly will slice a dime or a nickel
per share from its dividend in order to pour more money into launching biotech drugs.

Investor unease

Chris Baker, whose financial-planning firm represents 450 Lilly employees and retirees, said many more of them have
asked about Lilly’s dividend in the past year or so. Almost none of his clients rely on the dividend to live, but some
do use the money for special purchases, he said.

“I have discussed it with a number of clients here recently,” said Baker, co-owner of Oaktree Financial Advisors
Inc. “The anticipation is that the earnings will start to drop. They could be in jeopardy of reducing it.”

What began to stoke Baker’s concern—and that of Wall Street investors and analysts—was the decision by
New York-based Pfizer Inc., the world’s largest drug company, to slash its dividend in half last year.

The cut followed Pfizer’s mammoth acquisition of New Jersey-based Wyeth.

In October, Lilly began getting questions on its conference calls with analysts about its “dividend stability”
and whether it would cut its dividend in order to make an acquisition to stem its looming loss of revenue.

Adding to their concern was the restructuring Lilly announced in September, where it promised to cut 5,500 employees and
$1 billion in annual expenses by the end of 2011.

Rice

But really, there’s nothing to worry about, says Lilly Chief Financial Officer Derica Rice.

“Let me assure you that we have no intention of cutting our dividend,” he has told investors repeatedly.

In a December presentation, Rice laid out a conservative scenario that would still allow Lilly to keep paying its dividend
at its current level.

If at the end of 2014, Lilly is bringing in revenue of only $20 billion (down 8 percent from last year) and has profits of
only $3 billion (down 30 percent from last year), it would still be generating enough cash to pay its dividend.

“Our robust underlying operational performance combined with this financial strength provides us the ability to fund
our growing pipeline and pursue business development opportunities to enhance future growth as well as to return significant
funds to our shareholders through the dividend,” he said.

Rice has seemed to convince Wall Street, according to Les Funtleyder, a health care stock analyst for Miller Tabak &
Co., which advises many hedge funds.

“The shares are not trading like a dividend cut is coming,” he said, as Lilly shares crept up near $37 apiece.
“If it comes, it’ll come as a surprise to investors.”

Vivian Aichele, who, with her husband Robert, holds roughly 20,000 Lilly shares, also agrees that Lilly will keep funding
its dividend. Otherwise, it would be the company’s “death knell” as a blue-chip stock.

But she has far less confidence that the company will be able to make the moves necessary to turn its stock price around
anytime soon. The Aicheles acquired much of their Lilly stock by exercising Robert’s stock options, earned in his 30-year
career at Lilly, in the late 1990s.

Since then, the company’s stock price has plunged by roughly half. The Aicheles, like many retirees, automatically
reinvest their Lilly dividends into more Lilly stock.

“We should have dumped this stock a long time ago,” said Vivian Aichele, an attorney who worked for Lilly for
10 years. But she said her husband insists on holding the stock out of “pure loyalty and sentimental value.”

Endowment’s strategy

Lilly’s largest investor, Indianapolis-based Lilly Endowment, keeps clutching its Lilly stock, too. It still
holds 95 percent of its assets in Lilly stock, even four years after a plan to diversify its non-Lilly holdings to 20 percent.

The Lilly dividend is a big reason why. The endowment received $266 million in dividend payments last year. That was equal
to 85 percent of the grants it made in all of 2008, the most recent year available.

“For us, it’s a principal source for how we make our grants,” said endowment spokeswoman Gretchen Wolfram.
She declined to comment on whether the endowment is concerned about Lilly’s cutting its dividend.

The potential for a dividend cut has caused some concern among the board overseeing the endowment at St. Paul’s Episcopal
Church in Indianapolis. That endowment was created in 1977 when Eli Lilly died and left gifts in the form of Lilly stock for
three Episcopal churches—Christ Church Cathedral, Trinity and St. Paul’s.

Eli Lilly also donated stock to such institutions as Earlham College.

St. Paul’s has cut its Lilly holdings in half in the past four years. Lilly stock now makes up less than 20 percent
of the endowment’s holdings, said Lisa White, St. Paul’s controller.

“The dividends are great. That’s the one reason anybody holds on to Lilly,” she said. “There would
be a concern,” she added about a possible dividend cut, “because it is a very healthy dividend.”

White said St. Paul’s board is convinced Lilly’s performance will turn around. But Wall Street analysts aren’t.

According to Thomson/FirstCall, six analysts rate the company “underperform,” which is a recommendation to sell.
That’s far more than any of Lilly’s pharmaceutical peers.

Another 12 rate Lilly a “hold,” which many investors interpret as a signal to sell.

“They don’t have a lot of fans on Wall Street. It’s everybody’s favorite sell rating,” Funtleyder
said. “We would like to see more evidence that their current strategy is going to work.”•