The year 2017 was rewarding for pharma and biotech stocks, with the sector witnessing some positive developments that led to a much-awaited recovery.
The NYSE ARCA Pharmaceutical Index gained 11.8%, while the Nasdaq Biotechnology Index was up 18.7% in 2017. This is in sharp contrast to 2016, which was tough for pharma and biotech stocks following criticisms about rising drug prices.
A key reason for the sector’s improved performance was the willingness of investors to look beyond the drug pricing controversy and focus on fundamentals instead. Although the drug pricing controversy will remain a headline risk, investors seem more comfortable with the issue.
Moreover, a significantly higher number of FDA approvals in 2017 restored investor confidence in the sector. The approval of the first gene cell therapy last year was a major breakthrough.
Though the sector was off to a strong start in 2018, it has been struggling recently with the NYSE ARCA Pharmaceutical Index and Nasdaq Biotechnology Index down 1.8% and 2.8% year to date, respectively, probably on broader market correction. Also, the mention of high drug prices by President Trump in his State of the Union address dampened investor sentiment. However, the sector is largely expected to rebound as the year progresses.
New product sales ramp up with rising demand, successful innovation and product line expansion, strong clinical study results, more frequent FDA approvals, continued strong performance from key products, growing demand for drugs especially for rare-to-treat diseases, an aging population and increased health care spending are some of the factors that should keep the sector on track in 2018. A faster drug approval process and the proposed removal of outdated regulations that push up costs and slow down innovation should also provide benefits.
Hopes of more mergers and acquisitions (M&As) have also gone up with the tax reform in place and big players on the lookout for companies with innovative pipelines/technology. There has already been quite a bit of M&A buzz this year about potential deals. Sanofi (SNY - Free Report) and Celgene (CELG - Free Report) have already announced two deals each.
However, headwinds include drug pricing scrutiny, pricing pressure, increasing competition, the growing presence of biosimilars, generic competition, a slowdown in the growth of legacy products, concerns regarding Amazon’s interest in entering the healthcare arena and major pipeline setbacks.
We are discussing some factors in details here.
Mergers and Acquisitions (M&As) on the Rise
The year started off with expectations that M&A activity would pick up. The new tax law, which cuts corporate tax rate from 35% to 21% and encourages companies to bring back huge cash held overseas at a one-time tax rate of 10%, is expected to spur merger activity this year.
This was held true with biotech/pharma M&A activity already starting to gather steam. Sanofi, earlier this year, announced deals to buy Belgian biotech company, Ablynx and haemophilia focused biotech, Bioverativ BIVV. Celgene also announced deals to buy Juno Therapeutics, Inc. JUNO, which focuses on the development of CAR-T therapies and Impact Biomedicines, which will add a late-stage JAK2 kinase inhibitor, to Celgene’s pipeline.
Merck (MRK - Free Report) recently announced that it has proposed to buy Australian oncolytic immunotherapies maker Viralytics Ltd. to strengthen its presence in the fast-growing immuno-oncology market.
In fact, most big pharma CEOs believe the tax cuts will place American companies on a level playing field as they can compete better with their foreign counterparts, which operate in better tax environments.
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 Exelixis, Incyte, BioMarin 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 (NVS - Free Report) , Teva (TEVA - Free Report) , Sanofi, Valeant, Glaxo (GSK - Free Report) and AstraZeneca (AZN - Free Report) 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. Teva divested many non-core assets last year, mainly in the women’s health portfolio, to support repayment of debt.
The monetization of non-core assets allows these companies to focus on their key areas of expertise and 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), Repatha and Praluent (PCSK9 inhibitors), 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 Lynparza, Opdivo, Kyprolis, Imbruvica and Xalkori.
Competitive Threat from Biosimilars on the Rise
While biosimilars have been available in the EU for quite a while, there was no regulatory pathway for biosimilars in the United States for several years. 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.
Seven biosimilar applications have been approved by the FDA to date in the United States. These include, other than Zarxio, Sandoz’s Erelzi (biosimilar version of Amgen (AMGN - Free Report) /Pfizer’s Enbrel), Amgen’s Amjevita (biosimilar to AbbVie’s Humira) and Mvasi (biosimilar of Roche’s Avastin), Pfizer and Celltrion’s Inflectra and Ixifi (both are biosimilars of Merck/J&J’s Remicade).
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. Also, last December, Sanofi gained FDA approval for Admelog (insulin lispro injection), technically a follow-on biologic version of Lilly’s (LLY - Free Report) Humalog.Admelog wasthe first follow-on Humalog product to be approved by the FDA.
Biosimilars should cut healthcare costs and provide a large number of patients with access to the 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, Merck and Allergan are targeting the highly lucrative biosimilars market. Pfizer (PFE - Free Report) is a Zacks Rank #2 (Buy) stock. You can see the complete list of today’s Zacks #1 (Strong Buy) Rank stocks here.
How did the Sector Perform in Q4?
AbbVie, Allergan, Novartis, Bristol-Myers, AstraZeneca, Glaxo, Lilly and Pfizer all beat estimates for both earnings and sales in the fourth quarter. While AbbVie and Lilly raised their previously issued earnings expectations for 2018, Pfizer provided an upbeat outlook for the year. Allergan expects lower revenues and earnings in this year than 2017 as it faces generic competition to Restasis.
J&J and Merck issued mixed results as they beat estimates for earnings while missed the same for sales.
Sanofi’s fourth-quarter 2017 results were below expectations as it missed expectations for both earnings and sales. However, Sanofi expects to return to growth in 2018.
Overall, the sector performed quite well in the fourth quarter and looks optimistic for further growth in 2018.
Importantly, at their conference calls, most companies discussed plans to invest in capital expenditures, products/pipeline and in-licensing or acquisition deals on expectation of an improved cash position following the tax reform.
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 top 41% while the Zacks Biomedical and Genetics as well as the Zacks Drug sectors are at the bottom 28% and 24%, respectively. The Zacks Generic Drugs sector, which is facing intense pricing competition, is at the bottom 17%. Overall, factors like pricing and competitive pressures and slowdown in sales of legacy products are weighing on these stocks.
Click here to know more: About Zacks Industry Rank
As of Feb 28, 2018, 470 S&P 500 members in the Medical industry, accounting for 94% of the index’s total market capitalization, reported results, according to the latest Earnings Trends.
If we look at the overall results of the Medical industry, earnings growth was 8.5% in the December quarter. Total revenues rose 6.1% in the quarter. The sector racked up an earnings beat ratio (the percentage of companies coming out with positive surprises) of 85.4% and a revenue beat ration of 87.5% in the December quarter.
Earnings and revenues for the March quarter are expected to rise 8.2% and 6.3%, respectively.
Valuation Suggests Upside Potential
Going by the price-to-earnings multiple, which is often used to value drug stocks, the pharmaceutical industry looks poised for growth at this point. The industry is currently trading at 17.33 x forward 12-month consensus EPS estimate, slightly below the S&P 500 P/E multiple of 18.85, 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 19.01. Keeping these numbers in mind, the current level seems to represent an attractive entry point.
While 2017 was strong, 2018 is expected to be another important year for the drug biotech sector as these companies continue to invest in the pipeline, build their global business and support new product growth. In preparation for 2018, many of these companies have accelerated their cost-saving initiatives to enable investment in new products and defend existing products to optimize long- and short-term growth.
The Hottest Tech Mega-Trend of All
Last year, it generated $8 billion in global revenues. By 2020, it's predicted to blast through the roof to $47 billion. Famed investor Mark Cuban says it will produce "the world's first trillionaires," but that should still leave plenty of money for regular investors who make the right trades early.
See Zacks' 3 Best Stocks to Play This Trend >>