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We are halfway through 2017 and the pharma and biotech sector has bounced back nicely with the NYSE ARCA Pharmaceutical Index gaining 12.9% while the NASDAQ Biotechnology Index is up 17.2%. This is in sharp contrast to 2016 which was a tough year for pharma and biotech stocks, with the sector facing a lot of criticism for rising drug prices. While shares rallied post-election in November on hopes that drug pricing would not be a key focus area under a Trump presidency, it turned out to be short-lived following the President’s views regarding drug pricing.

Drug pricing was not the only headwind last year. 2016 was also disappointing from an R&D perspective with a fewer number of drugs managing to gain FDA approval. There were some high-profile pipeline failures as well. Other factors that weighed on the sector include mixed results, slower-than-expected new product launches and increasing competition.

However, the sector has fared better this year. New product sales ramp up, R&D success and innovation, strong results, a higher number of FDA approvals and continued strong performance from legacy products are some of the factors that could contribute to a sustained recovery in the sector. Tax reforms and cash repatriation would support a recovery as well.

Importantly, investors now seem to be more comfortable with the drug pricing scenario and are willing to look at the fundamentals of the sector. Although the drug pricing issue will remain a headwind this year as well, expectations are that steps taken by the Trump administration to drive down drug prices will not be as draconian as previously expected.  

Deregulation and increased competition seem to be some of the ways that will be used to control drug prices. FDA Commissioner Scott Gottlieb recently said that the agency is working on a plan to lower healthcare costs by speeding up the development of next-generation treatments, especially for rare diseases or targeted cancer therapies.

Valuation Suggests Upside Potential

Going by the current price-to-earnings multiple, which is often used to value drug stocks, the pharmaceutical industry looks pretty attractive at this point. The industry is currently trading at a P/E multiple of 15.8, below the S&P 500 P/E multiple of 18.3, leaving room for upside. Moreover, when compared to the industry’s own performance over the last year, it can be seen that the current multiple is below the industry high of 17. Keeping these numbers in mind, the current level seems to represent an attractive entry point.

So what are the factors that could drive the sector? First and foremost, this is an industry that will continue to witness demand for its products given an aging population and the increasing prevalence of a wide variety of diseases. Strong pipelines, innovative treatments, impressive results, and increased health care spending should support growth. Trump's pro-business stand is also expected to benefit the sector. Major companies should gain from Trump's proposed tax plan and proposal to repatriate corporate profits held offshore at a one-time tax rate.

A faster drug approval process and the proposed removal of outdated regulations that drive up costs and slow down innovation should also work in favor of the sector.

On the other hand, drug pricing will remain a headline risk. The growing presence of biosimilars, a slowdown in growth of legacy products and high profile pipeline setbacks are also challenges for the sector.

M&As to Pick Pace in 2017?

While there were not too many acquisitions in 2016, expectations are that M&A activities will pick up this year. But this year too, there has been limited M&A activity with Johnson & Johnson’s (JNJ - Free Report) $30 billion acquisition of Actelion being the major M&A news this year while a few bolt-on deals were announced by other companies. However, expectations are high that M&As will increase as the year progresses -- potential tax reform and cash repatriation are expected to lead to a boost in this area.

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 such deals, with most of them finding it challenging to raise cash, thereby making it difficult to survive and continue with the development of promising pipeline candidates. Therefore, it makes sense to seek deals with pharma companies sitting on huge piles of cash. Companies like Exelixis, Incyte (INCY - Free Report) and TESARO have often been considered attractive acquisition targets by industry-watchers.

Streamlining Operations

Another trend being witnessed is the divestment of non-core business segments. Companies like Pfizer (PFE - Free Report) , UCB, Novartis (NVS - Free Report) , Sanofi, Valeant, Glaxo and AstraZeneca (AZN - Free Report) have all been a part of this trend. The monetization of non-core assets allows these companies to focus on their areas of expertise. Smaller companies have also been monetizing assets to utilize the money for pipeline development.

Restructuring activities are also gaining momentum as large pharma companies look to cut costs and streamline operations. Most of these companies are re-evaluating their pipelines and discontinuing programs with an unfavorable risk-benefit profile.

New Products Should Pick Pace

Highly-awaited new products that gained approval over the last couple of years should contribute significantly to revenues. Key new products include Ibrance (cancer), Cosentyx (psoriasis), PCSK9 inhibitors -- Repatha and Praluent, Cotellic (advanced melanoma), Lartruvo (soft tissue carcinoma), Exondys 51 (Duchenne muscular dystrophy), Tecentriq (urothelial cancer), and Taltz (moderate-to-severe plaque psoriasis), among others. The FDA also expanded the label of cancer drugs like Kyprolis, Imbruvica and Xalkori.

Biosimilars A Competitive Threat

With the FDA approving the first biosimilar in the U.S. (Zarxio, a biosimilar version of Amgen’s blockbuster drug, Neupogen), the floodgates have opened. While biosimilars have been available in the EU for quite a while, there was no regulatory pathway for biosimilars in the U.S. The second biosimilar to gain approval in the U.S. was Pfizer and Celltrion’s Inflectra (infliximab-dyyb) with the reference product being Remicade.

This was followed by the FDA approval of biotech giant Amgen’s Amjevita (adalimumab-atto). Amjevita is approved for use in all eligible indications of the reference product, AbbVie’s Humira (adalimumab), which is used for a wide range of inflammatory diseases.

And then there is Lilly (LLY - Free Report) and Boehringer Ingelheim’s Basaglar, which while technically not approved as a biosimilar, is a “follow-on” insulin glargine product approved through an abbreviated approval pathway -- Basaglar was found to be sufficiently similar to Sanofi’s Lantus to scientifically justify reliance, and to establish its safety and efficacy for the approved uses.

Biosimilars should cut healthcare costs and provide a large number of patients with access to much needed biologic treatments. According to information provided by Express Scripts, about $250 billion could be saved in the next decade (2014 – 2024) if biosimilars for 11 products including Neupogen, Avastin, Epogen, Humira, Neulasta, Remicade and Rituxan are approved. According to the company, Neupogen biosimilars alone represent potential savings of about $5.7 billion.

Apart from Amgen, Novartis and Pfizer, companies like Biogen (BIIB - Free Report) and Allergan are targeting the highly lucrative biosimilars market. While all these companies are Zacks Rank #3 (Hold) stocks, you can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

What to Expect from the Sector in Q2 Earnings Season?

A look at consensus earnings expectations for the Medical sector from the Zacks Earnings Trends report for the second quarter earnings season shows earnings will decline 1% from the year-ago period while revenues will grow 3.7%. This compares to Q1 earnings growth of 5.5% and revenue growth of 5.7%.

While new products should start contributing significantly and increased pipeline visibility and appropriate utilization of cash should increase confidence in the sector, challenges remain in the form of currency headwinds, additional competition, slowdown in growth of mature products and loss of exclusivity for certain key drugs.

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.

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 Pharmaceuticals is #43, #196 for Medical-Generic Drugs, #163 for Medical-Biomedical and Genetics and #171 for Medical-Drugs. Analyzing the Zacks Industry Rank for different medical segments, it is obvious that the outlook is Positive for Large-Cap Pharmaceuticals, Neutral for Medical-Drugs and Medical-Biomedical and Genetics and Negative for Medical-Generic Drugs.

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