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Pharma Industry Outlook: M&A, Licensing Abound

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The pharmaceutical sector, which had been witnessing several tax inversion deals over the last few months, is unlikely to go down this route given the Sep 2014 notice issued by the U.S. Department of the Treasury. New rules imposed by the Treasury Department make such cross-border deals unattractive -- in fact, AbbVie (ABBV) dropped its plans to acquire UK-based Shire (SHPG - Free Report) and Salix (SLXP) also backed off from its decision to merge with Cosmo. Other casualties include the merger agreement between Auxilium (AUXL) and QLT, Inc. (QLTI).
However, mergers and acquisitions (M&As) will continue to play a major role in the pharma sector and are not showing any signs of slowing down. Auxilium, which terminated its merger agreement with QLT, will be acquired by Endo (ENDP) in the first half of 2015.
Meanwhile, we expect small bolt-on acquisitions to continue. In-licensing activities and collaborations for the development of pipeline candidates have also increased significantly. 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 -- 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 sitting on huge piles of cash.
We recommend biotech stocks that have attractive pipeline candidates or technology that can be used for the development of novel therapeutics. Therapeutic areas attracting a lot of interest include immuno-oncology, central nervous system disorders, diabetes and immunology/inflammation. The hepatitis C virus (HCV) market is also attracting a lot of attention.
Immuno-oncology has been a key focus area this year as these therapies have the potential to change the treatment paradigm for cancer -- they basically use the natural capability of the patient's own immune system to fight the cancer. Major players in this field include Bristol-Myers Squibb (BMY), AstraZeneca (AZN), Merck (MRK - Free Report) and Roche (RHHBY - Free Report) -- these companies came out with promising data on their immuno-oncology candidates at ASCO. Deals targeting immuno-oncology are being inked by companies like Pfizer (PFE - Free Report) , Merck KGaA , Bristol-Myers, AstraZeneca and Incyte (INCY).
Another trend witnessed recently is the divestment of non-core business segments. Companies like Pfizer, Abbott (ABT), UCB (UCBJF - Free Report) , Novartis (NVS - Free Report) , GlaxoSmithKline (GSK) and AstraZeneca have all been a part of this trend. The monetization of non-core assets allows pharma/biotech companies to focus on their areas of expertise.
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 which do not have a favorable risk-benefit profile. Some of the companies that announced restructuring plans include Allergan, Merck, Novartis, Eli Lilly (LLY - Free Report) , Shire and Sanofi (SNY - Free Report) .
New Products Hold Promise

The worst of the patent cliff is over for the pharma sector, which is slowly but steadily recovering from the impact of genericization. Many companies that had been struggling to post growth in the face of genericization over the past few years are now on the recovery path. New products should start contributing significantly to results and increased pipeline visibility and appropriate utilization of cash should increase confidence in the sector.
So far in 2014, about 34 new molecular entities and Biologics License Applications were approved. Some important product approvals so far this year include:

Emerging Markets and Biosimilars

Another trend seen in the pharma sector is a focus on emerging markets. Companies like Mylan (MYL - Free Report) , Pfizer, Merck, Eli Lilly, Glaxo and Sanofi are all looking to expand their presence in India, China, Brazil and other emerging markets.
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 to genericization. Moreover, investigations into bribery charges in China could put a lid on near-term growth.
We are also seeing several companies like Merck, Amgen (AMGN), Biogen (BIIB) and Actavis (ACT) targeting the highly lucrative market for biosimilars (generic versions of biologics).
Earnings Trends

The Q3 earnings season is winding down with 94.2% of medical companies releasing their results. So far, the earnings "beat ratio" (percentage of companies coming out with positive surprises) is 75.5%, while the revenue "beat ratio" is 79.6%. Total earnings grew 15.4% compared to 15.8% in the second quarter, while total revenue improved 12.2% in the quarter compared to 12.4% in the second quarter. Earnings growth was driven not just by cost-cutting measures but also by healthy top-line gains.
Looking at consensus earnings expectations for the fourth quarter, earnings are expected to grow 16.3% and revenues 8.9%. New product sales should pick up significantly going forward.
Overall, 2014 earnings are expected to grow 14.7% and revenues 9.3%. For a detailed look at the earnings outlook for the Medical and other sectors, please check our Zacks Earnings Trends report.
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. To learn more, visit: About Zacks Industry Rank.

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 pharma is #112, med-biomed/gene is #62, med-drugs is #74, while med-generic drugs is #21. Analyzing the Zacks Industry Rank for different medical segments, it is obvious that the outlook is Positive for med-generic drugs, med-biomed/gene and med-drugs, and Neutral for large-cap pharma stocks.

While EU austerity measures and genericization remain headwinds for some companies, the pharma industry is out of the worst of its genericization phase. Many companies, which had faced generic headwinds in the last couple of years, should continue to see a sustained improvement in results this year. Cost-cutting, downsizing, emerging markets and new products should support growth.
Among pharma stocks, companies like Allergan (AGN), Bristol-Myers and Shire look attractive with all three carrying a Zacks Rank #2 (Buy). Allergan has long been viewed an attractive acquisition target. Valeant Pharmaceuticals (VRX) is also well-positioned with a Zacks Rank #1 (Strong Buy).

In the biotech space, we are positive on AbbVie, Biogen, Gilead, Celgene, and Achillion (ACHN) among others. All these are Zacks Rank #2 stocks. AbbVie has an important regulatory event coming up with the FDA expected to decide on its HCV combination treatment shortly. Meanwhile, Achillion’s HCV pipeline holds immense potential.
Among generic companies, Akorn (AKRX), Mylan, Actavis and Teva (TEVA - Free Report) look well-positioned. While Akorn and Mylan are Zacks Rank #1 stocks, Actavis and Teva carry a Zacks Rank #2.

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.
Large-cap pharma companies that currently carry a Zacks Rank #5 (Strong Sell) include Sanofi, whose diabetes segment is under pressure. Among biotech stocks, companies like Regeneron and Intercept (ICPT) are Zacks Rank #4 (Sell) stocks.

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