When will the Hong Kong stock CXO welcome the collective slowdown, and when will the downward cycle end?

On April 4th, Endpoints pointed out in an article that the list of companies covered by The Biosecure Act in the United States may expand to include more Chinese CRO/CDMO companies. Following this news, the Hong Kong stock CXO sector, which was already jittery, collectively declined.

According to a report by the Wise Finance APP on April 5th, Zhongyan Pharmaceuticals fell by 10.92%, Kanglong Chemical dropped by 7.52%, Taige Medicine and Kailaiying fell by 5.27% and 5.52% respectively. This decline is obviously greater than the stock price decline seen by these companies at the end of March when their annual reports were released.

In fact, the performance of the secondary market reflects not only market sentiment being disturbed by non-rational factors such as geopolitical issues, but also the transmission of the "financing winter" in the global biopharmaceutical industry over the past three years to the upstream sector, leading the CXO sector into a downward cycle. For investors, rather than speculating on the trend of sanctions from across the ocean, it is better to look at the past performance and downstream development direction to see which company can lead the way through the cycle.

Performance Differentiation in the Downward Cycle of CXO

Although the domestic CXO sector in 2023 is under pressure, the performance of the top four companies in the Hong Kong stock CXO sector, Kanglong Chemical, Zhongyan Pharmaceuticals, Kailaiying, and Taige Medicine, showed significant differentiation in 2023.

Wise Finance APP learned that among the four companies mentioned above, only Kanglong Chemical maintained double-digit growth in revenue and profit. In 2023, it achieved revenue of 11.538 billion yuan, a year-on-year increase of 12.39%; and a net profit attributable to shareholders of 1.601 billion yuan, a year-on-year increase of 16.48%.

Following Kanglong Chemical is Taige Medicine, which still achieved double-digit growth in revenue and profit, but with weak growth. In 2023, Taige Medicine achieved total revenue of 7.384 billion yuan, a year-on-year increase of 4.21%; and a net profit attributable to shareholders of 2.025 billion yuan, a year-on-year increase of 0.91%.

In contrast to the above two companies with revenue and profit growth, Zhongyan Pharmaceuticals and Kailaiying showed a significant decline in performance. Zhongyan Pharmaceuticals achieved revenue of 2.376 billion yuan in the current period, a year-on-year increase of 4.78%; and a net profit attributable to shareholders of 0.397 billion yuan, a year-on-year decrease of 63.04%. Kailaiying's revenue for the current period was 7.825 billion yuan, a year-on-year decrease of 23.70%; and a net profit attributable to shareholders of 2.269 billion yuan, a year-on-year decrease of 31.28%.

Although the revenue and profit performance of the four companies mentioned above varies, the factors leading to the changes in performance are not the same, mainly due to the differences in business layout among the CXO companies Using Kanglong Huacheng as an example, as the second largest domestic CXO company in the business line after Pharmaron, Kanglong Huacheng's business covers the full chain of preclinical CRO and early clinical CRO business lines. Like Pharmaron, it is one of the earliest CXOs in China to provide integrated full-process drug development services. The company's business segments are divided into four major areas: laboratory services, CMC (small molecule CDMO) services, clinical research services, and large molecule and cell and gene therapy services.

One key point that has enabled Kanglong Huacheng to maintain double-digit revenue and profit growth in 2023 is that its four major segments are able to share the pressure and significantly improve the company's risk resistance.

Looking at the 2023 financial report, Kanglong Huacheng's cornerstone business, laboratory services, saw a revenue growth of 9.38% to 6.66 billion RMB, accounting for 57.72% of the current revenue. Since 2018, the revenue contribution rate of this business has dropped below 60% for the first time, and the growth rate has also fallen below 10% for the first time. Following laboratory services, Kanglong Huacheng's CMC business and clinical research services saw growth rates in the current period decline to 12.64% and 24.66% respectively. This means that even with a significant decline in the growth rate of laboratory services, other businesses still support Kanglong Huacheng's overall revenue growth.

This is clearly different from the performance of Zhaoyan New Drug, which focuses solely on preclinical and early clinical CRO. According to the Zhitong Finance APP, the main work of non-clinical drug research services is GLP toxicology and PK studies required for R&D companies' IND applications, which are the core business of Zhaoyan New Drug, accounting for as much as 97% of current revenue. Due to the lack of explosive growth in the number of IND projects submitted by downstream new drug R&D companies in 2023, Zhaoyan New Drug's revenue growth only slightly increased by 4.78%.

As for Zhaoyan New Drug's net profit, it fluctuated due to monkey prices. Previously, the Zhitong Finance APP analyzed that in 2020, Zhaoyan New Drug changed the measurement method of experimental monkey biological assets in the annual report from "cost method measurement" to "fair value method measurement." The result of this accounting policy change is that when the price of biological assets continues to rise, the price gains are released in the current financial statements. However, as a double-edged sword, once the period of sharp rise in monkey prices ends, the company's net profit will also be negatively affected.

The sharp drop in Zhaoyan New Drug's net profit this time is due to the sharp drop in monkey prices in the market. According to Zhaoyan New Drug's 2023 annual report, the net loss caused by the change in fair value of biological assets was 267 million RMB. However, this has no impact on the company's normal operations and safety evaluation business

Is Overseas Business a Hurdle that Cannot be Overcome?

Recently, when it comes to domestic CXO companies, one cannot avoid mentioning the geopolitical impact. From the secondary market perspective, investors have indeed changed their investment strategies for CXO companies, with companies with a high proportion of overseas business seeing a significant decline in stock prices.

According to data from the Zhitong Finance app, companies like Kanglong Huacheng and Kailaiying, with overseas business revenue accounting for over 80%, have inevitably been affected by the "Biosecurity Act" in the United States at the beginning of this year. The impact on them is greater compared to companies with a smaller proportion of overseas business, such as Taige Pharmaceutical.

However, from the perspective of the global biopharmaceutical development trend and the cycle of the CXO sector, geopolitical factors cannot become the so-called "decisive factor for decoupling".

Looking back at the development of the global pharmaceutical industry, investors will find that pharmaceutical technology and product innovation are the foundation of pharmaceutical companies' development. The research and production investment generated from this continuously drives the continuous development of the CXO industry.

According to Frost & Sullivan data, collaboration between an innovative drug company and a CXO company can shorten drug development time by 25%-35% and save 30%-70% of research and development costs. In the current market environment where the innovative drug race is ongoing and the demand for cost control is increasing, the motivation for innovative drug companies to outsource research and development is becoming stronger. Overseas consulting agencies predict that by 2025, the outsourcing rates of innovative drug companies in China and the United States will reach 52% and 60%, respectively.

In short, after experiencing the "winter of financing", both domestic and overseas innovative drug companies have a strong demand for cost control in research and development. Therefore, from a budget perspective, domestically cost-effective CXO service providers are irreplaceable in the global downstream innovative drug companies' supply chain.

On the other hand, according to recent information from the Federal Reserve, the window for the first interest rate cut this year may be in June. This also means that with the release of liquidity, global primary investment and financing data in the pharmaceutical industry are expected to gradually improve. Therefore, under the subsequent drive of the downstream market, the market fluctuations brought about by geopolitical factors are unlikely to shake the core logic of the long-term development of the CXO industry in China and the United States.

Although the long-term development trend of the global CXO sector will not change, for companies, while overseas business grows, business and revenue structures may inevitably undergo changes. For example, in 2023, Kanglong Huacheng's revenue from North America accounted for 64.14% of total revenue; revenue from Europe accounted for only 15.99%; and over 80% of Kailaiying's revenue in 2023 came from the United States. Therefore, for these two companies, the focus in 2024 may be on adjusting their business structures. As for Taige Pharmaceutical and Zhaoyan New Drug, waiting for a comprehensive downstream recovery may be more important than focusing on overseas business