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Industry Outlook

The pharmaceutical industry has witnessed major changes over the past few quarters, with performance being affected by factors like sluggish prescription trends, intensifying generic competition and limited phase III catalysts. The next five years are expected to reflect a significant imbalance between new product introductions and patent losses.

According to IMS Health, this is the main reason global pharmaceutical market growth will be restricted to the mid-single digits (5-8%) through 2014. Over the next five years, products that currently generate more than $142 billion in sales are expected to face generic competition, including Lipitor, Plavix and Zyprexa.

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

With most of the big pharma companies already facing or likely to face patent challenges for their blockbuster products, they have been looking towards mergers and acquisitions (M&A) and in-licensing deals to make up for the loss of revenues that will arise with key products losing patent exclusivity.

We saw huge M&A activity over the last few quarters. Major deals include Abbott Laboratories’ (ABT - Analyst Report) acquisition of Advanced Medical Optics and the pharmaceuticals business of Solvay Group, Johnson & Johnson’s (JNJ - Analyst Report) acquisition of Mentor Corp., Pfizer’s (PFE - Analyst Report) acquisition of Wyeth, the merger between Merck (MRK - Analyst Report) and Schering-Plough, and Merck KGaA’s (MKGAF) upcoming acquisition of Millipore Corporation .

While these deals took place between large-cap pharma companies, elsewhere companies have been looking towards biotech firms to build their product portfolios. Prime examples include Johnson & Johnson’s acquisition of Cougar Biotechnology, Roche's (RHHBY - Analyst Report) acquisition of Genentech, Bristol-Myers Squibbs’ (BMY - Analyst Report) acquisition of Medarex, Sanofi-Aventis’ (SNY - Analyst Report) acquisition of Fovea Pharmaceuticals, SA, Astellas Pharma’s hostile bid for OSI Pharmaceuticals and Abbott’s acquisition of Facet.

We expect this M&A trend to continue, albeit at a slower pace. In fact, we 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 going 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. As such, it makes sense for them to seek deals with pharma companies that are sitting on huge piles of cash.

As such, 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 Inc (MYL - Analyst Report), Pfizer, Eli Lilly (LLY - Analyst Report), GlaxoSmithKline (GSK) 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 U.S. 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. IMS Health estimates that these markets will grow 14-17% through 2014, while major developed markets will grow only 3-6%.

Although the U.S. will retain its position as the single largest market (estimated growth: 3-6% annually in the next five years), China will soon become the third largest market in the world. According to IMS Health, China’s pharmaceutical market is expected to continue to grow more than 20% annually, and contribute 21% of overall global growth through 2013. Growth in emerging markets could help stabilize the base business during the industry’s 2010-15 patent cliff.

Impact of Health Care Reform

With first quarter earnings underway, several pharma and biotech companies have been cutting their guidance for 2010 in order to reflect the impact of U.S. health care reform. The implementation of the new reform will impact revenues as drug companies will have to provide the government with larger discounts on drugs for Medicaid patients. The companies will also have to extend rebates to insurers who dispense drugs to people covered by Medicaid.

So far, companies like Johnson & Johnson, Gilead, Abbott, Amgen (AMGN) and Eli Lilly have all trimmed their forecasts for 2010 to reflect the effects of the health care reform. We expect other major companies to follow suit.

OPPORTUNITIES

In the pharma space, we are positive on Alcon (ACL). We believe Alcon will continue witnessing revenue growth based on continued international penetration, new product launches and market share expansion. Pipeline expansion through in-licensing deals and acquisitions should also add to growth.

Although we have Neutral ratings on names like Johnson & Johnson and Abbott, we maintain a positive outlook on these stocks given their diversified revenue base, strong business segments, contributions from recent acquisitions and impressive late-stage pipeline. We also have a positive outlook on Bristol-Myers, which has a strong presence in attractive areas like biologics, cancer and cardiovascular drugs.

In the biotech space, we are positive on names like Gilead Sciences (GILD) and Biogen Idec (BIIB) even though we have Neutral recommendations on these stocks. Gilead’s HIV franchise has been helping the company post better-than-expected earnings over the past few quarters, and we expect this trend to continue.

Biotech companies that could be acquisition targets provide opportunities for significant returns. Here, we would like to mention two companies that could be potential take-out targets – Biogen Idec and Acorda Therapeutics (ACOR). In addition to holding a leading position in the multiple sclerosis market, we believe Biogen has the best pipeline in all of biotech and could be an attractive takeover candidate for pharma companies interested in biologics.

Meanwhile, Acorda is one of the more interesting biotechnology companies under our coverage. Earlier this year, Acorda received FDA approval for Ampyra, which could have blockbuster potential worldwide.

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 before granting approval to new products and several candidates have been facing delays in receiving final approval.

We would avoid companies like Eli Lilly & Co. and Forest Labs (FRX), which are facing patent expirations on key products and do not have a solid pipeline to make up for the loss of revenues that will take place once generics enter the market. Another name that comes to mind is The Medicines Company (MDCO) -- our biggest concern with the stock is that lead product, Angiomax, will most likely lose patent exclusivity in the U.S. later this year.

Meanwhile, we continue to believe Pfizer’s acquisition of Wyeth will create an even bigger struggling company. Both companies have significant patent expirations in the years to come, and both have been severely lacking in their R&D productivity over the past few years. We recommend avoiding these names.

In the biotech sector, we would avoid Genzyme Corporation (GENZ) which has been under a lot of pressure over the past few quarters following the temporary shutdown of its Allston manufacturing facility due to contamination problems. Although the company is now working on emerging from the impact of its manufacturing issues, it may have to face additional challenges before it is able to go back to a normal production and supply schedule. In fact, Genzyme is facing the implementation of a consent decree which will result in the company incurring additional costs.

We would also recommend avoiding biotech companies that are struggling to survive and are unable to strike partnership deals for their pipeline candidates. A name that comes to mind is MannKind Corp. (MNKD), which has been looking unsuccessfully for a partner for its key candidate, Afrezza. With the FDA recently issuing a complete response letter for Afrezza and asking for updated safety data on the candidate, the chances of Afrezza gaining approval in the near future look bleak.

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