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Pharma Sector Makes a Strong Recovery in 2017

As we head toward the end of 2017, the pharma and biotech sectors have bounced back nicely with the NYSE ARCA Pharmaceutical Index gaining 14.8%, while the Nasdaq Biotechnology Index is up 26.9%. 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 drug pricing was a key reason for the sector’s underperformance last year, it was not the only challenge for the sector. 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 like mixed results, slower-than-expected new product launches and increasing competition also weighed on the sector.

However, the sector has rebounded nicely this year. New product sales ramping up, R&D success and innovation, strong results, a higher number of FDA approvals and continued strong performance from key products are some of the factors that could contribute to a sustained recovery in the sector. Tax reforms and cash repatriation should also work in its favor.

Moreover, investors now seem more comfortable with the drug pricing scenario and are focusing more on the fundamentals of the sector. Although the drug pricing issue will remain a headwind, 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 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 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 15.6x forward 12-month consensus EPS estimate, below the S&P 500 P/E multiple of 18.2, leaving room for upside. Moreover, when compared to the industry’s own performance over the last five years, it can be seen that the current multiple is below the industry high of 18.1. 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.

A faster drug approval process and the proposed removal of outdated regulations that drive up costs and slow down innovation should also provide benefits.

But as we said earlier, drug pricing will remain a headline risk. Other challenges for the sector include the growing presence of biosimilars, generic competition, a slowdown in the growth of legacy products and high profile pipeline setbacks.

What About Mergers and Acquisitions (M&As)?

The year started off with expectations that M&A activity would pick up, but this did not happen. Although several small deals were announced, big-ticket M&A activity was more or less limited. Johnson & Johnson’s $30 billion acquisition of Actelion and Gilead’s (GILD - Free Report) $11.9 billion acquisition of Kite were the major M&A news this year, while a few bolt-on deals were announced by other companies.

The sector will receive an additional boost if more M&A deals are announced, though companies are likely to adopt a “wait and see” stance as they await more clarity on the drug pricing situation and tax reforms. Another major deterrent could be high valuations with companies remaining wary of bidding wars leading to over-priced deals.

Meanwhile, in-licensing deals continue to be popular with several big companies tying up with smaller and mid-sized players with promising mid-to-late stage pipeline candidates or interesting technology. These deals make sense for both sides -- the larger companies are able to boost their pipelines with promising candidates while the smaller ones gain access to a non-dilutive source of funds that allows them to continue investing in those pipelines.

Some companies that often find themselves on the acquisition radar include names like Exelixis, Incyte and TESARO, among others.

Divesting Non-Core Business Segments and Restructuring

Another trend being witnessed is the divestment of non-core business segments. Companies like UCB, Novartis, Teva (TEVA - Free Report) ), Sanofi, Valeant, Glaxo and AstraZeneca have all been a part of this trend. Pfizer (PFE - Free Report) , which has already divested several of its business segments, is currently looking at strategic options for its Consumer Healthcare business. The monetization of non-core assets allows these companies to focus on their key areas of expertise and to utilize the sale proceeds for returning value to shareholders in the form of share buybacks and dividends. Smaller companies have also been monetizing assets to raise money for pipeline development.

Restructuring activities are also gaining momentum as large 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 Up Pace

Highly-awaited new products launched 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.

Competitive Threat from Biosimilars on the Rise

With the FDA approving the first biosimilar in the United States (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 United States. The second biosimilar to gain approval in the United States 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 (AMGN - Free Report) 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 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 and Remicade biosimilars alone represent potential savings of more than $22 billion.

Apart from Amgen, Novartis and Pfizer, companies like Biogen 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 (Strong Buy) Rank stocks here.

What to Expect from the Sector in Q3 Earnings Season?

A look at consensus earnings expectations for the Medical sector from the Zacks Earnings Trends report for the third quarter earnings season shows that earnings will grow 0.8% from the year-ago period on revenue growth of 4.7%. This compares to Q2 earnings growth of 7% and revenue growth of 4.4%. The Medical sector is one of the few Zacks sectors that have consistently recorded growth over the last few quarters.

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, pricing pressure, 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 Pharmaceuticals, Biomedical and Genetics, Drugs and Generic Drugs.

We put our 265 industries into two groups: the top half (i.e. industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank).

Over the last 10 years, using a one-week rebalance, the top half beat the bottom half by a factor of more than 2 to 1.

Currently, the Zacks Large-Cap Pharmaceuticals sector is at the bottom 38% while the Zacks Biomedical and Genetics as well as the Zacks Drug sectors are at the bottom 40%. The Zacks Generic Drugs sector, which is facing intense pricing competition, is at the bottom 27%. Overall, factors like pricing pressure and slowdown in sales of legacy products are weighing on these stocks.

Click here to know more: About Zacks Industry Rank

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