WPI Actavis, Inc.

The pharmaceutical industry is slowly showing signs of recovery from one of the biggest patent cliffs in recent times. The last few quarters saw major blockbusters like Merck’s (MRK) Singulair, Pfizer’s (PFE) Lipitor, Forest Laboratories’ (FRX) Lexapro, Sanofi/Bristol-Myers’ (SNY/BMY) Plavix and Eli Lilly’s (LLY) Zyprexa losing patent protection. These products alone represented branded sales worth more than $15 billion.

However, the effect of the genericization of these products will be felt mostly in 2012. While the industry won’t be completely free from genericization, the major patent expiries are over and done with. New products should start contributing significantly to results and increased pipeline visibility and appropriate utilization of cash should increase confidence in the sector.

M&A Activity

The M&A activity witnessed in the pharma sector in the last couple of years continued in 2012, in-line with expectations. Major deals so far in 2012 include Johnson & Johnson's (JNJ) acquisition of Synthes, Bristol-Myers Squibbs’ acquisition of Amylin Pharmaceuticals, Inc., GlaxoSmithKline’s (GSK) acquisition of Human Genome Sciences and Valeant Pharma’s (VRX) upcoming acquisition of Medicis (MRX).

Meanwhile, generic players are not far behind in the acquisition game. While Teva (TEVA) acquired Cephalon, Inc., Watson Pharmaceuticals (WPI) acquired generic player, Actavis.

Elsewhere, companies have been looking toward biotech firms to build their product portfolios. A prime example is French pharma giant Sanofi’s acquisition of biotech company Genzyme Corp. The Genzyme acquisition has boosted Sanofi’s revenues as well as its pipeline. Meanwhile, AstraZeneca (AZN) acquired biotech company Ardea Biosciences.

Going forward, we expect the M&A trend to continue. We also expect a significant pickup in in-licensing activities and collaborations for the development of pipeline candidates. Instead of developing a product from scratch, which involves a lot of funds and time, pharma companies are shopping for mid-to-late stage pipeline candidates that look promising.

Small biotech companies are open to in-licensing activities and collaborations. 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 that are sitting on huge piles of cash.

We would recommend investors put their money in biotech stocks that have attractive pipeline candidates or technology that can be used for the development of novel therapeutics. Therapeutic areas which could see a lot of in-licensing activity include oncology, central nervous system disorders, diabetes and immunology/inflammation. The hepatitis C virus (HCV) market is also attracting a lot of attention.

Another trend that we are seeing in recent months is the divestment of non-core business segments. Pfizer sold its Capsugel unit and its Nutrition business in August 2011 and November 2012, respectively. The company intends to spin-off its Animal Health business as well.

Meanwhile, GlaxoSmithKline is divesting non-core brands from its Consumer Healthcare segment. In August 2011, AstraZeneca sold its Astra Tech business to DENTSPLY (XRAY). The monetization of non-core assets will allow the pharma/biotech companies to focus on their areas of expertise. Abbott Labs (ABT) will be splitting into two separate publicly traded companies by year end. While one company will deal in diversified medical products, the other (AbbVie) will focus on research-based pharmaceuticals.

Obamacare Rules

A major event that will have a significant impact on pharma and biotech stocks is the upholding of the Patient Protection and Affordable Care Act (ACA) by the Supreme Court in late June 2012. The Act, popularly referred to as “Obamacare,” passed through Congress in 2010, represents major changes in the nation’s healthcare sector.

The Act will provide coverage to 32 million uninsured Americans, make healthcare facilities more affordable, expand coverage for customers with pre-existing health conditions and keep a check on health insurers. The healthcare reform aims to end the discrimination policy of insurance companies, create competition amongst insurers through the establishment of health insurance exchanges, add value to the overall healthcare system and reduce premiums.

The upholding of the Act is a big win for pharma companies as the coverage base will increase.

Meanwhile, the signing of the Gaining Antiobiotic Incentives Now (GAIN) Act should benefit companies pursuing the development of novel antibiotics. Once approved, these products will enjoy an additional five years of marketing exclusivity. Companies that should benefit from this Act include The Medicines Company (MDCO), Optimer Pharma (OPTR) and Cubist Pharma (CBST) among others.

The US government is also exploring options which will help increase the availability of generics. The Obama administration announced that it is looking to implement a proposal under which the exclusivity period for biologics will be cut down by 5 years, thereby allowing generics to enter the market sooner.

The government is also seeking to increase the availability of generics by preventing companies from entering into anti-competitive or “pay for delay” agreements which push out the availability of generics. These initiatives, if implemented, would result in additional pricing competition and genericization in the pharma industry. Moreover, the establishment of a biosimilar pathway will lead to the availability of cheaper versions of biologics.

Emerging Markets

Another recent trend seen in the pharmaceutical sector is a focus on emerging markets. Companies like Mylan (MYL), Pfizer, Merck, Eli Lilly, Glaxo and Sanofi are all looking to expand their presence in India, China, Brazil and other emerging markets. Until recently, most of the commercialization efforts were focused on the US market -- the largest pharmaceutical market -- along with Europe and Japan.

Emerging markets are slowly and steadily gaining more importance and several companies are now shifting their focus to these areas. According to the IMS Institute, spending on medicines in "pharmerging" markets will almost double to $345 billion - $375 billion in five years from $194 billion in 2011.

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 from genericization.

Meanwhile, according to the IMS Institute, annual growth in the branded medicines market will remain flat or increase up to 3% to $615 billion - $645 billion through 2016 from $596 billion in 2011.

As far as developed nations are concerned, the IMS Institute expects US spending to go up by $35 billion - $45 billion (1-4%) in the next five years. The introduction of medicines targeting unmet needs and higher patient access resulting from Obamacare are expected to drive growth.

However, growth in Europe will continue to be pressurized by austerity and cost-containment measures. According to the IMS Institute, growth in Europe will range from a negative 1% to positive 2%. The Japanese market is expected to grow at a slower pace annually (1-4%) through 2016 compared to the last five years.

Mixed Performance in the Third Quarter

Despite facing challenges like EU austerity measures, genericization, lower-than-expected contributions from new products, companies like Sanofi, Merck and Pfizer delivered stronger-than-expected results. However, companies like Eli Lilly, Bristol-Myers and Glaxo missed the Zacks Consensus Estimate. Both Eli Lilly and Bristol-Myers are facing stiff generic competition for their key products.

A look at the Earnings ESP (Expected Surprise Prediction - Zacks' proprietary methodology for determining which stocks have the best chance to surprise with their next earnings announcement) in the table below shows that companies like Sanofi, Johnson & Johnson, and Amgen could beat the Zacks Consensus Estimate in the fourth quarter of 2012. Johnson & Johnson, Biogen and Amgen have raised their outlook for 2012.

 
OPPORTUNITIES

We continue to have a Neutral outlook on large-cap pharma stocks. While the companies will continue to face challenges like EU austerity measures and genericization, the pharma industry should be out of the worst of the genericization phase from 2013. Several companies which had faced generic headwinds in the last couple of years should see their results recover from 2013. Cost-cutting, downsizing, streamlining of the pipeline, growth in emerging markets and product approvals should support growth.

Zacks #2 Rank (Buy) stocks in the pharma sector include Johnson & Johnson (JNJ), Bayer (BAYRY), Roche (RHHBY), Onyx Pharma (ONXX) and Valeant Pharma (VRX), among others.

In the biotech space, we are positive on Biogen (BIIB). We are optimistic on BG-12, the company’s oral multiple sclerosis candidate. Key products, Avonex and Tysabri, should continue contributing significantly to sales.

We are also positive on Amgen (AMGN). We are encouraged by the company’s performance so far this year. Enbrel should continue performing well. Amgen’s late-stage pipeline is also moving along. Amgen is a Zacks #1 Rank (Strong Buy) stock.

Among generic companies, both Watson (WTI) and Mylan (MYL) carry a Zacks #2 Rank. While Watson should benefit from its acquisition of Actavis, we are encouraged by Mylan’s geographic reach and product depth along with a robust generic product pipeline.

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. The FDA has been exercising more caution in granting approval to new products and several candidates are facing delays in receiving final approval.

Although both Forest Labs (FRX) and Eli Lilly (LLY) carry a Zacks #3 Rank (Hold), we remain concerned about the headwinds being faced by these companies in the form of generic competition and slow ramp up of new products.

Companies that currently carry a Zacks #4 Rank (Sell) include BioSpecifics Therapeutics (BSTC), Jazz Pharma (JAZZ) and Catalyst Pharma (CPRX), among others.
 
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