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Industry Outlook

Challenges like sluggish prescription trends, EU pricing pressure, intensifying generic competition, pipeline failures and limited late-stage catalysts continue to impact the pharmaceutical industry. The next five years are expected to reflect a significant imbalance between new product introductions and patent losses.

All these factors will lead to a slowdown in global pharmaceutical market growth in the next five years. Products like Lipitor, Plavix, Lexapro and Zyprexa are expected to face generic competition over the next five years.

In fact, 2011 itself will see drugs worth more than $30 billion losing patent protection. This includes drugs like Lipitor, Zyprexa and Levaquin. The effect of the genericization of these products will be felt mostly in 2012, which will be a challenging year for several companies.

At the same time, new products are not expected to generate the same level of sales as products losing patent protection. With revenue growth stalling or slowing down, companies have been resorting to cost-cutting and share buybacks to drive bottom-line growth.

M&A Activity

The pharma sector continued to witness major merger and acquisition (M&A) deals in 2010. With most of the big pharma companies already facing or likely to face patent challenges for their blockbuster products, the companies have been looking toward M&As and in-licensing activities to make up for the loss of revenues that will arise with key products losing patent exclusivity.

The trend continues in 2011 with several major acquisitions being announced so far. We saw huge M&A activity over the last few months. Major deals include Johnson & Johnson's (JNJ - Analyst Report) acquisition of Dutch biopharmaceutical company Crucell NV. This acquisition should not only help strengthen Johnson & Johnson's portfolio, it should also allow the company to build its presence in the vaccines market, given Crucell's expertise in the manufacture, discovery and commercialization of vaccines.

Meanwhile, Japanese company Takeda is looking to expand its global presence through its upcoming acquisition of Nycomed. Pharma giant Pfizer (PFE - Analyst Report) acquired King Pharmaceuticals to strengthen its presence in the pain management market. Merck (MRK - Analyst Report) is looking to expand its ophthalmology product portfolio through its acquisition of Inspire Pharmaceuticals, Inc.

Oncology also remains a much sought-after therapeutic area with companies like Sanofi-Aventis (SNY - Analyst Report) and Celgene (CELG - Analyst Report) strengthening their presence in this market through acquisitions. Meanwhile, generic players are not far behind in the acquisition game. While Teva (TEVA - Analyst Report) announced its intention to acquire Cephalon, Inc. (CEPH), Watson Pharmaceuticals (WPI) acquired generic company Specifar Pharmaceuticals to expand and strengthen its presence in Europe.

The Cephalon deal is in-line with Teva's long-term strategy of expanding and strengthening its branded and specialty pharma business.

Elsewhere, companies have been looking toward biotech firms to build their product portfolios. A prime example is French pharma giant Sanofi-Aventis' acquisition of biotech company Genzyme Corp. With this acquisition, Sanofi is looking to create a new source of growth. The Genzyme acquisition will boost Sanofi's revenues as well as its pipeline.

In April 2011, Gilead Sciences, Inc. (GILD) acquired biotechnology firm Calistoga Pharmaceuticals, which focuses on developing therapies to combat cancer and inflammatory diseases.

Going forward, we expect the M&A trend to continue. We also expect a significant pickup in in-licensing activities and collaborations for the development of pipeline candidates. Instead of developing a product from scratch, which involves a lot of funds, pharma companies are shopping for mid-to-late stage pipeline candidates that look promising.

Small biotech companies are also game for 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 would recommend investors to put their money in 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.

Emerging Markets

Another recent trend seen in the pharmaceutical sector is a focus on emerging markets. Companies like Mylan (MYL - Analyst Report), Pfizer, Merck, Eli Lilly (LLY - Analyst Report), GlaxoSmithKline (GSK - Analyst Report) and Sanofi-Aventis 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 US market -- the largest pharmaceutical market -- along with Europe and Japan.

However, emerging markets are slowly and steadily gaining more importance, and several companies are now shifting their focus to these areas. Emerging markets should see strong sales thanks to higher demand for medicines. Several factors like government initiatives for healthcare, new patient population, and increasing use of generics should help drive demand. Growth in emerging markets could help stabilize the base business during the industry's 2010-15 patent cliff.

According to the IMS Institute, spending on medicines in pharmerging markets will double to $285-$315 billion in the next five years from $151 billion in 2010. This will catapult "pharmerging" markets to the second position where spending on medicines is concerned.

Branded Drugs Market Share to Decline

According to the IMS Institute, market share for branded drugs will continue declining in the next five years. Branded drugs market share, which declined from 70% in 2005 to 64% in 2010, is expected to decline to 53% by 2015. The decline will be driven by patent expiries, with generics accounting for a significant part of pharma spending. Spending on branded medicines in 2015 is expected to remain at the same level as in 2010.

While the US will witness a major increase in generic spending, generic spending in Japan will continue to be the lowest even though significant efforts are being made to increase the use of generics in Japan. Overall spending in generics is expected to increase from 20% in 2005 to 39% in 2015.

Global spending for medicines is expected to reach almost $1.1 trillion by 2015, according to the IMS Institute. However, the five-year compound annual growth rate of 3-6% represents a significant slowdown from the 6.2% annual growth seen in the last five years.

Moreover, the US's share of global spending is expected to decline from 41% in 2005 to 31% in 2015. The share of spending from the top 5 European countries is also expected to decline (from 20% in 2005 to 13% in 2015) with spending by pharmerging markets expected to increase from 12% in 2005 to 28% by 2015.

(Source of growth forecasts: IMS)

OPPORTUNITIES

We currently have a neutral outlook on large-cap pharma stocks (Zacks #3 Rank). While the companies will continue to face challenges like pricing pressure and genericization, growth in emerging markets and product approvals could help reduce the impact.

According to the IMS Institute, 44 new branded products were launched in 2010. However, the new product approval mix was more towards orphan drugs and medicines with the same mechanism of action as existing treatments. While 10 products represented new mechanisms of action, five orphan drugs and six new chemical entities using existing mechanisms were approved.

Important product approvals in 2011 so far include the approval of Johnson & Johnson's prostate cancer therapy, Zytiga, Merck's hepatitis C virus (HCV) treatment, Victrelis, Bristol-Myers Squibb's (BMY - Analyst Report) melanoma treatment, Yervoy, and Vertex Pharma's (VRTX - Analyst Report) HCV treatment, Incivek, among others.

We currently have Neutral recommendations on companies like Abbott Labs (ABT), Allergan Inc. (AGN) and Pfizer. We believe that Allergan's presence across different segments and geographies will help maintain decent growth going forward. We believe the company will be back on its historical mid-to-high teens earnings growth trajectory from 2011.

In the biotech space, we are positive on Biogen Idec (BIIB - Analyst Report). Biogen started 2011 on a strong note with revenues being driven by Tysabri and Avonex. Earnings estimates for Biogen have been increasing based on continued strong performance of the multiple sclerosis franchise. Longer term, we are optimistic on BG-12, the company's oral multiple sclerosis candidate.

We currently have an Outperform recommendation on Perrigo Company (PRGO) -- we believe Perrigo's strong position in the brand OTC pharmaceutical market and growing generics and API businesses will help it deliver solid top- and bottom-line growth in the coming years. Perrigo also has a very strong and impressive pipeline which could drive growth in fiscal 2012 and beyond.

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 US Food and Drug Administration (FDA) has been exercising more caution in granting approval to new products and several candidates have been facing delays in receiving final approval.

We would also avoid companies like Eli Lilly (LLY - Analyst Report), which is facing patent expirations on key products and whose new products may not be enough to make up for the loss of revenues that will take place once generics enter the market.

2011 will be a challenging year for Eli Lilly with the company losing patent exclusivity on Zyprexa. Zyprexa sales should erode rapidly with the entry of generics. Moreover, we expect continued erosion of Gemzar sales due to genericization. Another company that is highly exposed to a patent cliff is Forest Labs (FRX).

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