CEPH Cephalon (MM)

With 2011 coming to an end, the pharmaceutical industry continues to face challenges like sluggish prescription trends, EU pricing pressure, intensifying generic competition, pipeline failures and limited late-stage catalysts. The next five years are expected to reflect a significant imbalance between new product introductions and patent losses. All these factors will lead to a slowdown in global pharmaceutical market growth in the next five years, with major revenue-generating drugs like Lipitor, Plavix, Lexapro and Zyprexa losing exclusivity.

In fact, by the end of 2011, drugs worth more than a total of $30 billion will lose patent protection. This includes drugs like Lipitor, Zyprexa and Levaquin. The effect of the genericization of these products will be felt mostly in 2012, which will be a challenging year for several companies. At the same time, new products are not expected to generate the same level of sales as products losing patent protection.

Moreover, the government is exploring options which will help increase the availability of generics. Recently, 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 looking to bring this proposal into effect from 2012.

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.

With revenue growth stalling or slowing down, pharma companies have been resorting to cost-cutting and share buybacks to drive bottom-line growth.

M&A Activity

The merger & acquisition (M&A) activity that was witnessed in the pharma sector in 2010 continued in 2011. With most of the big pharma companies already facing or likely to face patent challenges for their blockbuster products, the companies have been looking towards M&As and in-licensing activities to make up for the loss of revenues that will arise with key products losing patent exclusivity.

We saw huge M&A activity over the last few months. Major deals included Johnson & Johnson's (JNJ) upcoming acquisition of Synthes, which should help strengthen its medical device portfolio.

Pfizer (PFE) acquired King Pharmaceuticals to strengthen its presence in the pain management market. Pfizer has been adding to its portfolio with other acquisitions as well including that of Icagen and Excaliard.  Merck (MRK) is looking to expand its ophthalmology product portfolio through its acquisition of Inspire Pharmaceuticals, Inc.

Another pharma major, Bristol-Myers Squibb (BMY), is also not far behind where acquisitions and deals are concerned. The company has been looking to expand via acquisitions and partnerships to counter the loss of revenues that will arise following the genericization of its key drugs, including the blockbuster blood thinner Plavix.

Oncology also remains a much sought-after therapeutic area with companies like Sanofi (SNY) and Celgene (CELG) strengthening their presence in this market through acquisitions. Meanwhile, generic players are not far behind in the acquisition game. While Teva (TEVA) acquired Cephalon, Inc., Watson Pharmaceuticals (WPI) acquired generic company Specifar Pharmaceuticals to expand and strengthen its presence in Europe.

Elsewhere, companies have been looking towards biotech firms to build their product portfolios. A prime example is French pharma giant Sanofi's acquisition of biotech company Genzyme Corp. With this acquisition, Sanofi is looking to create a new source of growth. The Genzyme acquisition will boost Sanofi's revenues as well as its pipeline.

In April 2011, Gilead Sciences (GILD) acquired biotechnology firm Calistoga Pharmaceuticals, which focuses on developing therapies to combat cancer and inflammatory diseases.

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, pharma companies are shopping for mid-to-late stage pipeline candidates that look promising.

Small biotech companies are also game for 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 to 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 in August 2011 and is currently exploring strategic alternatives for its Animal Health and Nutrition businesses. Meanwhile, GlaxoSmithKline (GSK) 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. 2012 will see Abbott Labs (ABT) splitting into two separate publicly traded companies. While one company will deal in diversified medical products, the other will focus on research-based pharmaceuticals.

Emerging Markets

Another recent trend seen in the pharmaceutical sector is a focus on emerging markets. Companies like Mylan (MYL), Pfizer, Merck, Eli Lilly (LLY), 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.

However, emerging markets are slowly and steadily gaining more importance and several companies are now shifting their focus to these areas. Emerging markets should see strong sales thanks to higher demand for medicines. Several factors like government initiatives for healthcare, new patient population, and increasing use of generics should help drive demand. Growth in emerging markets could help stabilize the base business during the industry's 2010-15 patent cliff.

According to the IMS Institute, spending on medicines in pharmerging markets will double to $285-$315 billion in the next five years from $151 billion in 2010. This will catapult pharmerging markets to the second position where spending on medicines is concerned.

Branded Drugs Market Share to Decline

According to the IMS Institute, market share for branded drugs will continue declining in the next five years. Branded drugs market share, which declined from 70% in 2005 to 64% in 2010, is expected to decline to 53% by 2015. The decline will be driven by patent expiries, with generics accounting for a significant part of pharma spending. Spending on branded medicines in 2015 is expected to remain at the same level as in 2010.

While the US will witness a major increase in generics, generic spending in Japan will continue to be the lowest even though significant efforts are being made to increase their use in the country. Overall spending in generics is expected to increase from 20% in 2005 to 39% in 2015.

Global spending for medicines is expected to reach almost $1.1 trillion by 2015, according to the IMS Institute. However, the five year compound annual growth rate of 3-6% represents a significant slowdown from the 6.2% annual growth seen in the last five years.

Moreover, the US' share of global spending is expected to decline from 41% in 2005 to 31% in 2015. The share of spending from the top 5 European countries is also expected to decline (from 20% in 2005 to 13% in 2015) with spending by pharmerging markets expected to increase from 12% in 2005 to 28% by 2015.

OPPORTUNITIES

We continue to have a Neutral outlook on large-cap pharma stocks (Zacks #3 Rank). While the companies will continue to face challenges like pricing pressure and genericization, growth in emerging markets and product approvals could help reduce the impact.

About 35 new molecular entities have been approved by the FDA up to mid-November 2011. Important product approvals include Johnson & Johnson's prostate cancer therapy, Zytiga, Merck's hepatitis C virus (HCV) treatment, Victrelis, Bristol-Myers' melanoma treatment, Yervoy, AstraZeneca's Brilinta, Vertex Pharma's (VRTX) HCV treatment, Incivek, Pfizer's lung cancer treatment, Xalkori, and Glaxo/Human Genome Sciences Inc.'s (HGSI) lupus drug Benlysta, among others.

In the biotech space, we are positive on Biogen Idec (BIIB). Biogen started 2011 on a strong note with revenues being driven by Tysabri and Avonex. Earnings estimates for Biogen have been increasing based on continued strong performance of the multiple sclerosis franchise. Longer term, we are optimistic on BG-12, the company's oral multiple sclerosis candidate.

We currently have an Outperform recommendation on Perrigo Company (PRGO) -- we believe Perrigo's strong position in the brand OTC pharmaceutical market and growing generics and API businesses will help it deliver solid top- and bottom-line growth in the coming years. Perrigo also has a very strong and impressive pipeline which could drive growth in fiscal 2012 and beyond.

In spite of a Neutral recommendation on Bristol-Myers, we are positive on the stock. 2011 has been a fruitful year for Bristol-Myers so far, with many key drugs getting approved. Growth in the coming quarters is expected to be driven by new product launches and acquisitions and deals.

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 US Food and Drug Administration (FDA) has been exercising more caution in granting approval to new products and several candidates are facing delays in receiving final approval.

We would also avoid companies like Eli Lilly, which are facing patent expirations on key products and whose new products may not be enough to make up for the loss of revenues that will take place once generics enter the market. 2012 will be a challenging year for Eli Lilly with the company losing patent exclusivity on Zyprexa in October 2011. Zyprexa sales should erode rapidly with the entry of generics. Moreover, we expect continued erosion of Gemzar sales due to genericization. Another company that is highly exposed to a patent cliff is Forest Labs (FRX).

We currently have a Zacks #4 Rank (short-term Sell rating) on Alkermes, Inc. (ALKS). The company, which merged with Elan Corp.'s (ELN) Elan Drug Technologies, delivered average results in the second quarter of fiscal 2012.

Moreover, while releasing the revenue guidance for fiscal 2012, the company did not alter the earlier projection of the standalone unit and merely added the expected sales of the purchased unit to it. We believe that it will take some time for the newly formed entity to start delivering and prefer to remain on the sidelines until then.
 
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