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Industry Outlook

The pharmaceutical industry has been showing signs of recovery from one of the biggest patent cliffs in recent times. The last few quarters saw major blockbusters like Merck’s (MRK - Analyst Report) Singulair, Pfizer’s (PFE - Analyst Report) Lipitor, Forest Laboratories’ (FRX) Lexapro, Sanofi/Bristol-Myers’ (SNY - Analyst Report)/BMY) Plavix and Eli Lilly’s (LLY - Analyst Report) Zyprexa losing patent protection. These products alone represented branded sales worth more than $15 billion.
 
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. 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 in 2013 include:
 

 
Collaborations and Acquisitions
 
The pharma sector witnessed major merger and acquisitions (M&A) activity over the last couple of years. Going forward, we expect small bolt-on acquisitions 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 and time, pharma companies are shopping for mid-to-late stage pipeline candidates that look promising.
 
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 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. The hepatitis C virus (HCV) market is also attracting a lot of attention.
 
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. Earlier this year, the company’s Animal Health business started trading separately.
 
Meanwhile, GlaxoSmithKline (GSK - Analyst Report) divested certain non-core brands from its Consumer Healthcare segment. In Aug 2011, AstraZeneca (AZN) sold its Astra Tech business to DENTSPLY (XRAY - Analyst Report). 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 is focusing on research-based pharmaceuticals. Johnson & Johnson (JNJ - Analyst Report) also announced its plans to explore strategic alternatives for its ortho-clinical diagnostics business, including a possible divestiture.
 
Emerging Markets and Biosimilars
 
Another trend seen in the pharmaceutical sector is a focus on emerging markets. Companies like Mylan (MYL - Analyst Report), 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 US -- 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. According to the IMS Institute, spending on medicines in "pharmerging" markets will almost double to $345 billion - $375 billion in five years from $194 billion in 2011.
 
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.
 
Meanwhile, according to the IMS Institute, annual growth in the branded medicines market will remain flat or increase up to 3% to $615 billion - $645 billion through 2016 from $596 billion in 2011.
 
As far as developed nations are concerned, the IMS Institute expects US spending to go up by $35 billion - $45 billion (1-4%) in the next five years (from 2011). The introduction of medicines targeting unmet needs and higher patient access resulting from Obamacare are expected to drive growth.
 
However, 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), Actavis (ACT) and Teva (TEVA - Analyst Report) are all targeting the highly lucrative biosimilars market.
 
A Look at Fourth Quarter Results
 
Despite facing challenges like EU austerity measures, genericization and lower-than-expected contributions from new products, companies like Eli Lilly, Bristol-Myers Squibbs, Merck, and Pfizer delivered stronger-than-expected results. However, companies like Amgen, Glaxo, and Forest Labs missed the Zacks Consensus Estimate.
 
While guidance provided by Johnson & Johnson and Merck lagged expectations, Amgen and Eli Lilly provided an encouraging outlook.
 
A look at the Earnings ESP (Expected Surprise Prediction - Zacks' proprietary methodology for determining which stocks have the best chance to surprise with their next earnings announcement) in the table below shows that companies like Pfizer, Biogen, Teva, Actavis, Celgene (CELG - Analyst Report) and Bristol-Myers Squibb could beat the Zacks Consensus Estimate in the first quarter of 2013. Meanwhile, Johnson & Johnson, Gilead, Amgen, Allergan and Mylan are likely to deliver below expectations.


 
Major Product Approvals in 2012

Most of these products should be major contributors to the top-line in 2013. Stivarga, Kalydeco, Xtandi and Kyprolis, especially, represent strong commercial potential.
 
Meanwhile, key regulatory decisions expected this year include a response regarding the approvability of Forest Labs’ levomilnacipran (depression) and cariprazine (schizophrenia and bipolar mania), Merck’s Atozet (primary or mixed hyperlipidemia) and Biogen’s rFIXFc (hemophilia B) among others. Biogen’s oral multiple sclerosis drug, Tecfidera, and Johnson & Johnson’s type II diabetes drug, Invokana, gained FDA approval last week.
 
OPPORTUNITIES
 
We continue to have a Neutral outlook on large-cap pharma stocks. While the companies will continue to face challenges like EU austerity measures and genericization, the pharma industry should be out of the worst of the genericization phase from 2013.

Several companies which had faced generic headwinds in the last couple of years should see their results recover from 2013. Cost-cutting, downsizing, streamlining of the pipeline, growth in emerging markets and product approvals should support growth.
 
Zacks Rank #2 (Buy) stocks in the pharma sector include Eli Lilly (LLY - Analyst Report) and Novo Nordisk (NVO), among others. Despite the presence of generic competition for key products, share buybacks and cost control should help Eli Lilly achieve its 2013 guidance.
 
In the biotech space, we are positive on Biogen (BIIB). We are optimistic on Tecfidera, the company’s oral multiple sclerosis drug which gained approval last week. Key products, Avonex and Tysabri, should continue contributing significantly to sales. The company is also progressing with its hemophilia pipeline.  
 
We are also positive on Amgen (AMGN). Amgen’s 2013 guidance was above expectations. The company also provided an update on its long-term strategy. 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.

Both Biogen and Amgen are Zacks Rank #2 stocks. Gilead, another Zacks Rank #2 stock, continues to do well in the HIV segment.
 
Osiris Therapeutics (OSIR), a stem cell company, currently carries a Zacks Rank #1 (Strong Buy). Prochymal’s approval in Canada and New Zealand were major milestones for the company. Meanwhile, the Biosurgery segment is also gaining traction. A partnership deal for Prochymal would be a major boost for the stock.
 
Among generic companies, Mylan carries a Zacks Rank #2. We are encouraged by Mylan’s geographic reach and product depth and robust generic product pipeline.
 
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.
 
Although Forest Labs (FRX) carries a Zacks Rank #3 (Hold), we remain concerned about the headwinds being faced by the company in the form of generic competition and slow ramp up of new products.  
 
Companies that currently carry a Zacks Rank #4 (Sell) include Affymax, Inc. (AFFY), Protalix BioTherapeutics (PLX), Elan Corp (ELN) and Jazz Pharmaceuticals (JAZZ) among others. Affymax is currently evaluating strategic options like a sale, merger, restructuring, wind-down of operations and filing for bankruptcy. The company took this decision after it recalled all lots of Omontys (peginesatide) voluntarily along with its partner Takeda Pharmaceutical Co. (TKPYY) in Feb 2013.

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