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Tickers in this Article: BLRX, ZTS, MDVN, ABBV, AZN, AUXL, ELN, PFE, SNY, SNTS, BAYRY, NVS, BMY, SHPG, PCYC, CBST, ABT, BIIB, MYL, ACT, PRGO, SLXP, JNJ, FRX, XRAY, XOMA, RHHBY, MRK, GSK, VNDA, LLY, ALKS, VRTX, AMGN, VPHM
With 2013 coming to an end, the worst of the patent cliff faced by the pharmaceutical sector is over. Major blockbuster drugs like Merck’s (MRK) Singulair, Pfizer’s (PFE) Lipitor, Forest Laboratories’ (FRX) Lexapro, Sanofi/Bristol-Myers Squibbs’ (SNY/BMY) Plavix and Eli Lilly’s (LLY) Zyprexa representing combined branded sales worth more than $15 billion in lost patent protection over the last couple of years.

However, the effect of the genericization of these products was felt mostly in 2012. While the industry won’t be completely free from genericization, the major patent expiries are over and done with.

Several companies which had been struggling to post growth in the face of genericization over the past few years should see accelerated growth in 2014. New products should start contributing significantly to results and increased pipeline visibility and appropriate utilization of cash should increase confidence in the sector.

Some products that are slated to lose patent protection later this year and next year include:



AstraZeneca’s (AZN) Nexium could also start facing generics from 2014 in the U.S., where sales were $2.2 billion in 2012.

Collaborations, Acquisitions and Restructuring

The pharma sector witnessed major merger and acquisitions (M&A) activity over the last couple of years. The trend continued this year and going forward, we expect small bolt-on acquisitions to continue. In-licensing activities and collaborations for the development of pipeline candidates have also increased significantly. Several pharma companies are focusing on in-licensing mid-to-late stage pipeline candidates that look promising, instead of developing a product from scratch, which involves a lot of funds and time.

Small biotech companies are open to in-licensing activities and collaborations. Most of these companies find it challenging to raise cash, thereby making it difficult for them to survive and continue with the development of promising pipeline candidates. Therefore, it makes sense for them to seek deals with pharma companies that are sitting on huge piles of cash.

We recommend biotech stocks that have attractive pipeline candidates or technology that can be used for the development of novel therapeutics. Therapeutic areas which could see a lot of in-licensing activity include oncology, central nervous system disorders, diabetes and immunology/inflammation. The hepatitis C virus (HCV) market is also attracting a lot of attention.

Some recent acquisitions/deals include Shire’s (SHPG) upcoming acquisition of ViroPharma (VPHM), Salix’s (SLXP) upcoming acquisition of Santarus (SNTS) as well as the acquisition of Optimer Pharmaceuticals and Trius Therapeutics by Cubist Pharmaceuticals (CBST). Elan (ELN) is also on track to be acquired by Perrigo Company (PRGO) by year's end.

Another trend that we are seeing in recent months is the divestment of non-core business segments. Pfizer sold its Capsugel unit and its Nutrition business in Aug 2011 and Nov 2012, respectively. Pfizer then spun off its animal health business into a new company, Zoetis (ZTS). Meanwhile, GlaxoSmithKline (GSK) divested certain non-core brands from its Consumer Healthcare segment. In Aug 2011, AstraZeneca sold its Astra Tech business to DENTSPLY (XRAY).

The monetization of non-core assets will allow the pharma/biotech companies to focus on their areas of expertise. Abbott Labs (ABT) split into two separate publicly traded companies; while one company deals in diversified medical products, the other, AbbVie (ABBV), is focusing on research-based pharmaceuticals. Johnson & Johnson (JNJ) also announced its plans to explore strategic alternatives for its ortho-clinical diagnostics business, including a possible divestiture. Vertex (VRTX) monetized its Incivo-related royalties -- Vertex can use the cash generated from this deal for its cystic fibrosis program.

Restructuring activities are also gaining momentum as large pharma companies are looking to cut costs and streamline their operations. Most of these companies are re-evaluating their pipelines and discontinuing programs which do not have a favorable risk-benefit profile. Some of the companies that announced restructuring plans include Merck, Novartis (NVS), Eli Lilly, Shire and Sanofi.

Emerging Markets and Biosimilars

Another trend seen in the pharmaceutical sector is a focus on emerging markets. Companies like Mylan (MYL), Pfizer, Merck, Eli Lilly, Glaxo and Sanofi are all looking to expand their presence in India, China, Brazil and other emerging markets. Until recently, most of the commercialization efforts were focused on the U.S. market -- the largest pharmaceutical market -- along with Europe and Japan. Emerging markets are slowly and steadily gaining more importance, and several companies are now shifting their focus to these areas.

However, while higher demand for medicines, government initiatives for healthcare, new patient population and increasing use of generics should help drive demand, we point out that emerging markets are also not immune from genericization. Moreover, investigations into bribery charges in China could put a lid on near-term growth.

Meanwhile, growth in Europe will continue to be pressurized by austerity and cost-containment measures.

We are also seeing several companies entering into deals for the development of biosimilars, generic versions of biologics. Companies like Merck, Amgen, Biogen (BIIB), and Actavis (ACT) are all targeting the highly lucrative biosimilars market.

3Q Earnings

All companies falling under the Medical sector have reported third quarter 2013 results. While earnings-beat and revenue-beat ratios (percentage of companies coming out with positive surprises) were pretty impressive, growth ratios were modest. Third quarter results were characterized by currency headwinds especially in Japan as well as a slowdown in China where bribery investigations remained in the headlines.

Third quarter 2013 earnings "beat ratio" was 74.5% while the revenue "beat ratio" was 51.0%. Total earnings for this sector were up 0.2%, compared to the 1.5% decline recorded in the second quarter of 2013. Total revenues moved up 5.8% in the quarter versus 2.4% growth in the second quarter of 2013.

Looking at the consensus earnings expectations for the fourth quarter, earnings are expected to decline 3.5%. Tough challenges for some companies, negative currency movement and a few patent expiries will affect fourth quarter growth. With the year coming to an end, several companies maintained or narrowed their guidance ranges.

Overall, 2013 earnings are expected to grow 0.6%.

Focus on New Products

2012 saw the FDA approving 35 novel medicines including the following:



Most of these products have been performing well so far in 2013. Stivarga, Kalydeco, Xtandi and Kyprolis, especially, represent strong commercial potential.

So far in 2013, quite a few important products have gained approval including Biogen’s oral multiple sclerosis drug Tecfidera, Johnson & Johnson’s type II diabetes drug Invokana, Merck’s Liptruzet (cholesterol), Forest’s Fetzima (major depressive disorder), Pharmacyclics (PCYC)/Johnson & Johnson’s Imbruvica (mantle cell lymphoma) and Roche’s (RHHBY) Gazyva (chronic lymphocytic leukemia). Biogen’s Tecfidera is off to a strong start with sales surpassing expectations by a wide margin.

Upcoming events include FDA advisory panel reviews of the biologic licensing application (BLA) for Bristol-Myers Squibbs’ metreleptin (rare forms of lipodystrophy) and dapagliflozin (type II diabetes), and Merck’s Grastek (a Timothy grass pollen extract tablet for sublingual use). All these reviews are scheduled to take place in the Dec 11 - 12 timeframe.

A response on the approval status of Auxilium Pharma’s (AUXL) Xiaflex for Peyronie’s and Gilead’s sofosbuvir (chronic HCV infection) in the U.S. should also be out in December.

Zacks Industry Rank

Within the Zacks Industry classification, pharma and biotech are broadly grouped into the Medical sector (one of 16 Zacks sectors) and further sub-divided into four industries at the expanded level: large-cap pharma, med-biomed/gene, med-drugs and med-generic drugs.

We rank all the 260-plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more, visit: About Zacks Industry Rank.

As a point of reference, the outlook for industries with Zacks Industry Rank #88 and lower is ‘Positive,’ between #89 and #176 is ‘Neutral’ and #177 and higher is ‘Negative.’

The Zacks Industry Rank for large-cap pharma is #95, med-biomed/gene is #77, med-drugs is #66, while the med-generic drugs is #40. Analyzing the Zacks Industry Rank for different medical segments, it is obvious that the outlook is Positive for med-drugs, med-biomed/gene and med-generic drugs and Neutral for large-cap pharma stocks.

OPPORTUNITIES

The outlook for the pharma sector has improved significantly with the Zacks Industry Rank moving up from #195 to #95 over the past few months. While several companies will continue to face challenges like EU austerity measures and genericization, the pharma industry is out of the worst of the genericization phase.


Many companies which had faced generic headwinds in the last couple of years should continue to see a sustained improvement in results as we move into 2014. Cost-cutting, downsizing, streamlining of the pipeline, growth in emerging markets and new product launches should support growth.

Among large-cap pharma stocks, Bayer (BAYRY), a Zacks Rank #2 (Buy) stock, looks well-positioned with several new products -- Eylea, Stivarga and Xarelto -- in its portfolio. These products represent significant commercial potential.

Forest Labs (FRX), another Zacks Rank #2 stock, is doing well with first half fiscal 2014 results beating expectations. The company has launched several new products over the past few quarters and continues to work on expanding its pipeline. This company also raised its earning guidance for fiscal 2014.

Shire (SHPG), a Zacks Rank #1 (Strong Buy) stock, looks well-positioned for growth with the company expanding its product portfolio and pipeline through the upcoming acquisition of ViroPharma.

We are positive on Johnson & Johnson (JNJ) even though the company currently holds a Zacks Rank #3 (Hold). The company has performed well so far this year and the momentum should continue. Johnson & Johnson upped its 2013 earnings guidance again after announcing third quarter results.


The company has been trying to offset the declining sales of some of its important products by bringing in new products through in-licensing deals and acquisitions. We believe the diversity and strength of the company’s underlying businesses will continue to provide strong growth in future.

In the biotech space, we are positive on Biogen (BIIB). Tecfidera, the company’s recently launched oral multiple sclerosis drug, is off to a strong start with the product delivering sales of $478 million since its launch in early April. While Tecfidera has gained the top spot in the oral multiple sclerosis market in the U.S., Avonex and Tysabri should continue contributing significantly to sales. Tecfidera should gain EU approval shortly. Biogen is also progressing with its hemophilia pipeline. Biogen is another company that raised its 2013 guidance again this year.

We are also positive on Amgen (AMGN). Amgen should be able to deliver on its long-term strategy based on expansion in key markets, launch of new manufacturing technologies, and pipeline development. Enbrel should continue performing well. Amgen’s late-stage pipeline is also moving along. While Amgen is a Zacks Rank #2 stock, Biogen is a Zacks Rank #3 (Hold) stock. Gilead, a Zacks Rank #3 stock, continues to do well in the HIV segment and is also progressing with its HCV pipeline.

Medivation (MDVN), a Zacks Rank #2 company, should continue delivering with its prostate cancer therapy, Xtandi, performing well. Based on the data we have seen so far, we believe Xtandi has blockbuster potential. It is currently in several studies including for the pre-chemo setting. Expansion into the pre-chemo setting would be a major positive for Medivation.

Vanda Pharmaceuticals, Inc. (VNDA) also looks well-positioned with the company receiving a positive feedback from the FDA regarding insomnia candidate, tasimelteon. The FDA’s advisory panel voted resoundingly in favor of approving the candidate for the treatment of Non-24-Hour Disorder in the totally blind. While the FDA is not required to follow the advice of its advisory panel, it usually does so. A response from the agency should be out by Jan 31, 2014. Vanda is a Zacks Rank #1 stock.

Among generic companies, Actavis (ACT) looks well-positioned. We view the acquisition of Actavis Group as a smart strategic move and we believe the company will be able to achieve its guidance easily. We are also positive on the recent acquisition of Warner Chilcott, which makes strategic and financial sense. With fewer major patent expiries slated to occur in the next few years, we are encouraged by Actavis’ focus on building its branded and biosimilars pipeline. The company carries a Zacks Rank #2.

WEAKNESSES

We recommend avoiding names that offer little growth or opportunity for a take-out. These include companies which are developing drugs that are likely to face regulatory hurdles. The FDA has been exercising more caution in granting approval to new products and several candidates are facing delays in receiving final approval.

Among large-cap pharma companies, Eli Lilly (LLY) is gearing up for another round of patent expiries: Cymbalta in Dec 2013 and Evista next year. We prefer waiting on the sidelines until the company is able to emerge from the impact of genericization.

Companies that currently carry a Zacks Rank #4 (Sell) include Alkermes (ALKS), BioLineRx, Ltd. (BLRX) and XOMA Corporation (XOMA) among others.

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