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The biotech sector got a shot in the arm last week thanks to two major developments that led to a rally in the sector. The first catalyst was Gilead Sciences’ (GILD - Free Report) decision to acquire immunotherapy focused company, Kite Pharma and the second was the FDA approval of the first gene therapy in the United States – Novartis AG’s (NVS - Free Report) Kymriah.

Gilead has been under a lot of pressure to utilize its huge pile of cash for a major acquisition deal given the dwindling sales of its erstwhile top-selling hepatitis C virus ("HCV") franchise. The $11.9 billion Kite acquisition, slated to close in the fourth quarter, will place Gilead among the top players in the emerging field of cell therapy. Kite’s expertise lies in developing engineered cell therapies that express either a chimeric antigen receptor ("CAR") or an engineered T cell receptor ("TCR"), depending on the type of cancer.

With the Kite-Gilead deal being announced, other companies involved in CAR-T treatment saw their shares shooting up on hopes that more merger and acquisition (M&A) deals will be announced in this segment of the market. These include companies like Juno Therapeutics (JUNO - Free Report) and bluebird bio (BLUE - Free Report) .

Meanwhile, the FDA approval of Novartis’ CAR-T therapy also gave the sector a boost indicating the beginning of a new era in the treatment of cancer. The path-breaking immunocellular therapy is a one-time treatment that uses a patient's own T cells to fight cancer.

The NYSE ARCA Biotech Index was up almost 9% last week with most biotech stocks recording solid gains.

Will the Rally Continue?  

Biotech stocks were once a strong favorite chalking up impressive gains until 2015 when the drug pricing issue started weighing on the sector. But the sector rebounded in 2017 and is on a roll since the beginning of the year with the industry gaining 15.9% year to date, outperforming the broader market which is up 10.7%.


A key question now facing investors is will the rally continue and is this the right time to invest in this corner of the market?

The biotech sector is currently trading at a forward 12-month price-to-earnings ratio of 40.5, well above the S&P 500 price-to-earnings ratio of 18.3, which makes it rather expensive.

However, a look at the sector’s performance over the last five years shows that there is significant room for upside given the five-year high of 111.3%.

So, what are the factors that could drive the rally? 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 work in favor of the sector. The FDA has approved far more drugs so far in 2017 than it did in the whole of 2016.

With the Gilead-Kite deal, expectations are that M&A activity will pick pace. Finally, although drug pricing remains a headline risk this year as well, investors now seem to be more comfortable with the drug pricing scenario and are willing to look at the fundamentals of the sector.
 
On the flip side, the estimate revision trend for the sector is not very encouraging. The growing presence of biosimilars, a slowdown in growth of legacy products and high profile pipeline setbacks are also challenges for the sector. And, as we mentioned earlier, drug pricing will remain a headline risk.

As far as M&As are concerned, activity in this area could be muted given the “wait and watch” stance adopted by most companies regarding the drug pricing situation and tax reforms. Another major deterrent is high valuations with companies remaining wary of bidding wars leading to over-priced deals.

However, licensing deals should continue especially in orphan and rare disease areas as well as highly sought after therapeutic areas like immune-oncology.

The bottom-line is that although biotech stocks are definitely not cheap at current levels, there is still some room for upside in this “high risk - high returns” industry. 2017 is expected to be a catalyst-rich year for the sector with several major pipeline events lined up. Some buy-ranked biotech stocks include Gilead, Regeneron Pharmaceuticals (REGN - Free Report) and Alexion Pharmaceuticals (ALXN - Free Report) . While Gilead is a Zacks Rank #2 (Buy) stock, Regeneron and Alexion are Zacks Rank #1 (Strong Buy) stocks. You can see the complete list of today’s Zacks #1 Rank stocks here.

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