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Industry Outlook

It’s been a rough start to the year for pharma and biotech with several factors weighing on the sector including media and political focus on the high price of drugs, mixed first quarter results, slower-than-expected new product launches, and increasing competition. Macroeconomic factors have also been playing a role in the sector’s performance.

The impact of these issues is more prominent in biotech stocks with the NASDAQ Biotechnology Index declining 14.5% year-to-date (YTD).

However, the sector’s fundamentals remain strong and mergers and acquisitions (M&As), product approvals and positive data flow should act as catalysts.

M&As to Pick Pace?

With the major price correction that has resulted in reasonable valuations, we could see several M&A agreements being announced as the year progresses. So far in 2016, some of the announced/completed acquisitions include Shire-Baxalta, Bristol-Myers (BMY - Free Report) -Padlock, and Pfizer (PFE - Free Report) -Anacor among others. Currently, Sanofi (SNY - Free Report) is looking to acquire cancer-focused Medivation – we expect a bidding war as Medivation has signed confidentiality agreements with many firms including Sanofi.

Meanwhile, small bolt-on acquisitions will 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 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.

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 central nervous system disorders, hepatitis C virus (HCV) and immunology/inflammation.

Another highly lucrative area is immuno-oncology 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, AstraZeneca, Merck and Roche.

Deals targeting immuno-oncology are being inked by companies like Pfizer, Merck KGaA, Bristol-Myers, AstraZeneca and Incyte. Companies like Kite are also advancing in this area.

Another trend being witnessed is the divestment of non-core business segments. Companies like Pfizer, UCB, Novartis, Glaxo and AstraZeneca have all been a part of this trend. The monetization of non-core assets allows these 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 with an unfavorable risk-benefit profile. 

New Products Should Gain Traction in 2H16

Highly-awaited new products that gained approval last year should contribute significantly to revenues. Some of the important new product approvals include Vertex’s cystic fibrosis treatment, Orkambi, Amgen’s (AMGN - Free Report) heart failure treatment, Corlanor, Pfizer’s cancer treatment, Ibrance, Novartis’ psoriasis treatment, Cosentyx, PCSK9 inhibitors – Amgen’s Repatha and Sanofi/Regeneron’s Praluent, Roche’s advanced melanoma treatment, Cotellic and Gilead’s Genvoya (HIV).

Meanwhile, so far in 2016, the FDA has approved 15 new drugs including Epclusa (HCV) Ocaliva (rare, chronic liver disease), Zinbryta (multiple sclerosis), Tecentriq (urothelial cancer), Venclexta (chronic lymphocytic leukemia in patients with a specific chromosomal abnormality), Taltz (moderate-to-severe plaque psoriasis), Cinqair (severe asthma) and Zepatier (HCV) among others. The FDA also expanded the label of cancer drugs like Kyprolis, Imbruvica and Xalkori.

Biosimilars Gaining Importance

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.

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 Novartis, companies like Merck, Amgen, Pfizer, Biogen (BIIB - Free Report) and Allergan are targeting the highly lucrative biosimilars market.

Drug Pricing to Remain in Focus

With Presidential candidates, policymakers, the media and the general public focusing on the high price tags for drugs, the drug pricing issue is not likely to die down easily at least not until elections are over.

According to the Oct 2015 Kaiser Health Tracking poll, affordability of prescription drugs remains at the top of the public’s priority list for the President and Congress – focus should be on ensuring the affordability of high-cost drugs to people who need them and taking steps to lower prescription drug prices.

So, drug companies may find it a bit difficult to justify their high prices by citing the years and funds that go into bringing new treatments to market and the need to invest in R&D to bring additional treatments to market.

Earnings Trends

Looking at consensus earnings expectations, the Medical sector, which had performed well in 1Q16, is expected to see earnings growth of 1.7% and revenue growth of 7.7% in Q2. While results will continue to be affected by currency movement, new products should start contributing significantly and increased pipeline visibility and appropriate utilization of cash should increase confidence in the sector. Performance should improve as the year progresses.

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 pharma is #74, #32 for med-generic drugs, #85 for med-biomed/gene and #89 for med-drugs. Analyzing the Zacks Industry Rank for different medical segments, it is obvious that the outlook is Positive for large-cap pharma, med-generic drugs and med-biomed/gene while Neutral for med-drugs.

OPPORTUNITIES

While negative currency impact and pricing pressure remain headwinds, many companies which are out of the worst of the genericization phase, should continue to see a sustained improvement in results this year. Cost-cutting, share buybacks, and new products should support growth.

Among pharma stocks, companies like Bristol-Myers is a Zacks Rank #1 (Strong Buy) stock while Johnson & Johnson (JNJ - Free Report) is a Zacks Rank #2 (Buy) stock.

In the biotech space, we are positive on Gilead, Incyte and AVEO – all are Zacks Rank #2 stocks. Within the generic segment, Mylan, Allergan, Mallinckrodt and Supernus are Zacks Rank #2 stocks.

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.

Pharma companies that currently carry a Zacks Rank #4 (Sell) or Zacks Rank #5 (Strong Sell) include Sanofi and Glaxo. Among biotech stocks, companies like Medivation and Lexicon are Zacks Rank #5 stocks, and others like Juno (JUNO - Free Report) and Epizyme are Zacks Rank #4 stocks.