Mergers and acquisitions (M&As) continue to play a major role in the pharma sector and are not showing any signs of slowing down. The last few months have brought tax inversion deals into focus considering the number of agreements signed with ex-U.S. companies.
Tax inversion focused deals involve the creation of a more efficient tax structure. These deals, which were earlier popular among mid-sized companies, are picking up even among large-cap companies, prime examples being Pfizer's ( PFE ) unsuccessful attempt to acquire UK-based AstraZeneca ( AZN ) and AbbVie's ( ABBV ) agreement to acquire Shire ( SHPG ). Through the Shire acquisition, AbbVie will not only boost its product portfolio, it is will also be able to cut its tax rate to 13% by 2016.
While efforts are on to bring in more stringent anti-inversion rules, such deals will continue in the near term. In fact, expectations are high that Pfizer will resume talks to acquire AstraZeneca later this year.
Meanwhile, 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 immuno-oncology, oncology, central nervous system disorders, diabetes and immunology/inflammation. The hepatitis C virus (HCV) market is also attracting a lot of attention -- Merck's ( MRK ) $3.85 billion deal for acquiring Idenix ( IDIX ) will boost its HCV portfolio.
Another trend that we are seeing over the past few quarters is the divestment of non-core business segments. Companies like Pfizer, GlaxoSmithKline ( GSK ) and AstraZeneca have all been a part of this trend.
The monetization of non-core assets will allow the pharma/biotech companies to focus on their areas of expertise. Abbott Labs ( ABT ) recently signed a deal with Mylan for the sale of its non-U.S. developed markets specialty and branded generics business. Johnson & Johnson ( JNJ ) divested its ortho-clinical diagnostics business. Vertex ( VRTX ) monetized its Incivo-related royalties; the company can use the cash generated from this deal for its cystic fibrosis program. Theravance ( THRX ) also split into two companies.
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 Allergan, Merck, Novartis ( NVS ), Eli Lilly ( LLY ), Shire and Sanofi ( SNY ).
New Products Hold Promise
The worst of the patent cliff is over for the pharmaceutical sector which is slowly but steadily recovering from the impact of genericization. Many companies, which had been struggling to post growth in the face of genericization over the past few years, are now on the recovery path. New products should start contributing significantly to results, and increased pipeline visibility and appropriate utilization of cash should increase confidence in the sector.
2013 saw the FDA approving 27 novel medicines, about one-third (33%) of which were identified by the FDA as "First-in-Class," meaning they use a new and unique mechanism of action for treating a medical condition. These include drugs like Invokana (type II diabetes), Kadcyla (HER2-positive late-stage breast cancer), Sovaldi (an interferon-free oral treatment for some patients with chronic hepatitis C) and Mekinist (metastatic melanoma).
Yet another one-third of the approved drugs fall under the rare or "orphan" disease category that affects 200,000 or fewer people in the U.S. These include Imbruvica (mantle cell lymphoma), Gazyva (chronic lymphocytic leukemia), Kynamro (homozygous familial hypercholesterolemia) and Adempas and Opsumit (both for pulmonary arterial hypertension). Three of the approved drugs - Gazyva, Imbruvica and Sovaldi - had breakthrough therapy designation. Breakthrough status, a new designation that became effective after Jul 9, 2012, is designed to cut short the development time of promising new treatments.
Some important products approved in 2013 include:
Drugs like Tecfidera, Sovaldi, Olysio and Imbruvica are off to a strong start and represent significant commercial potential.
So far in 2014, drugs that have gained approval include AstraZeneca's Myalept (complications of leptin deficiency) and Farxiga (type II diabetes), Chelsea Therapeutics' ( CHTP ) Northera (to treat neurogenic orthostatic hypotension), BioMarin's ( BMRN ) Vimizim (Morquio A syndrome), Vanda's ( VNDA ) Hetlioz (non-24- hour sleep-wake disorder) and MannKind's ( MNKD ) Afrezza.
Immuno-oncology is another area that has been in the limelight especially after a good showing at the annual meeting of the American Society of Clinical Oncology (ASCO). Immuno-oncology therapies have the potential to change the treatment paradigm for cancer -- they basically use the natural capability of the patient's own immune system to fight the cancer.
Major players in this field include Bristol-Myers Squibb ( BMY ), AstraZeneca, Merck, and Roche -- these companies came out with data on their immuno-oncology candidates at ASCO. Deals targeting immuno-oncology are being inked by companies like Bristol-Myers, AstraZeneca and Incyte ( INCY ).
Emerging Markets and Biosimilars
Another trend seen in the pharmaceutical sector is a focus on emerging markets. Companies like Mylan, 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. -- 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 to 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 and Actavis are all targeting the highly lucrative biosimilars market.
Earnings Trends (as of Jul 16)
The Q2 earnings season has just started with only 6% of the medical companies releasing their financial results. So far, the earnings "beat ratio" (percentage of companies coming out with positive surprises) is 100%, while the revenue "beat ratio" is 33.3%. Total earnings were up 11.6%, while total revenue improved 7.2% in the quarter.
With a major part of the medical sector yet to report Q2 results, earnings and revenue forecasts for Q2 stand at 4.3% and 8.5%, respectively. This compares to 6.4% and 8.0% earnings and revenue growth, respectively, in Q1. Factors like negative currency movement and a few patent expiries will affect second quarter growth.
The picture becomes brighter in the second half of the year with Q3 and Q4 earnings growth expected to be 5.5% and 15.2%, respectively. Revenues are expected to grow 8.6% and 7.8% in the third and fourth quarters of 2014, respectively. New product sales should pick up significantly in the second half of the year.
Overall, 2014 earnings are expected to grow 10.6%. For a detailed look at the earnings outlook for the Medical and other sectors, please check our Zacks Earnings Trends report.
The NYSE ARCA Pharmaceutical Index (^DRG) is up 20.9% over the last year and 8.9% so far this year. The sector benefited from ongoing M&A activities and an encouraging show at ASCO.
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 #91, med-biomed/gene is #100, med-drugs is #100, while med-generic drugs is #57. Analyzing the Zacks Industry Rank for different medical segments, it is obvious that the outlook is Positive for med-generic drugs and Neutral for med-drugs, med-biomed/gene and large-cap pharma stocks.
While several companies will continue to face challenges like EU austerity measures and genericization, the pharma industry is out of the worst of its genericization phase. Many companies which had faced generic headwinds in the last couple of years should continue to see sustained improvement in results this year.
Cost-cutting, downsizing, streamlining of the pipeline, growth in emerging markets and new product launches should support growth.
Among pharma stocks, Allergan, a Zacks Rank #1 (Strong Buy) stock, looks well-positioned for growth. The company is currently in the news thanks to strong second quarter results, its restructuring initiatives and the ongoing efforts of Valeant to acquire the company.
Specialty pharma company Salix, which boosted its portfolio and strengthened its position in the gastrointestinal market through the Santarus acquisition earlier this year, looks well-poised for growth. The company's upcoming merger with Cosmo will allow it to enjoy a tax efficient corporate structure and further strengthen its position in the gastrointestinal diseases market. Salix is also a Zacks Rank #1 stock.
Other well-ranked pharma companies include AstraZeneca and Pfizer -- both are Zacks Rank #2 (Buy) stocks.
In the biotech space, we are positive on AbbVie -- the Zacks Rank #2 company recently announced its intention to acquire Shire. The upcoming acquisition will not only lead to a more efficient tax structure, AbbVie will also benefit from Shire's strong product portfolio and pipeline.
Biogen, another Zacks Rank #2 stock, also looks well-positioned. Tecfidera, the company's recently launched oral multiple sclerosis drug, is off to a strong start with the product delivering sales of $876 million (as of Dec 31, 2013) since its launch in early April 2013. 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 gained EU approval recently. Biogen is also progressing with its hemophilia drugs.
Other well-ranked biotech stocks include BioMarin, The Medicines Co. ( MDCO ), Celgene, Pharmacyclics, Aegerion ( AEGR ), Theravance and Incyte ( INCY ). While BioMarin and The Medicines Co. are Zacks Rank #1 stocks, the others carry a Zacks Rank #2.
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.
Large-cap pharma companies that currently carry a Zacks Rank #4 (Sell) include Novo Nordisk ( NVO ) and Sanofi. Among biotech stocks, Auxilium is going through a challenging time -- the Zacks Rank #5 (Strong Sell) stock cut its revenue guidance primarily due to lower-than-expected Testim revenues. Companies like Cubist, Nektar ( NKTR ) and NPS Pharma ( NPSP ) also carry a Zacks Rank #5.
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