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This article is written based on public information and is for information exchange only and does not constitute any investment advice.

The cold winter reveals the pine and cypress, and the fierce fire refines the real gold.

At this time, market confidence is at its most fragile, and China's pharmaceutical industry is experiencing unprecedented challenges. CXO, generic drugs, innovative drugs, medical devices, and chain pharmacies, the bitter cold wind blows through almost every corner of the industry.

In such a difficult industry environment, WuXi AppTec, the leading domestic CXO company, released an "expected" semi-annual report:

WuXi AppTec achieved revenue of 17.241 billion yuan, which is almost the same as last year if the COVID-19 commercialization project is excluded. In the second quarter, revenue was 9.259 billion yuan, a month-on-month increase of 16%; adjusted non-IFRS net profit attributable to shareholders was 2.46 billion yuan, a month-on-month increase of 28.5%.

If this trend continues, we will be one step closer to achieving the revenue target of 38.3 billion to 40.5 billion yuan set at the beginning of the year.

However, for such performance, many investors who lack knowledge of the CXO industry think that this is a matter of course, because WuXi AppTec has only achieved the same level of revenue as in 2023. Judging from the pure numerical perspective, this view is not wrong, but China's industrial development does not need to solve "arithmetic problems", but must really think about the problem from the industrial level.

Looking at the overall development environment of the global CXO industry, investors will find completely different answers. Although WuXi AppTec's expected total revenue has not changed, its revenue structure has been continuously optimized. One-time revenues related to the new crown have gradually withdrawn from the stage of history, replaced by new molecules such as peptides. According to information disclosed by Bachem (a CDMO focusing on the development and production of peptides and oligonucleotides), WuXi AppTec currently ranks second in the global peptide market, with a scale of nearly 20%.

Figure: Global peptide market structure, Source: Bachem

According to the TIDES business disclosed by WuXi AppTec, revenue in the first half of the year reached 2.08 billion yuan, a strong year-on-year growth of 57.2%. As of the end of June, TIDES's orders on hand increased by 147% year-on-year. At a time when the global demand for peptide drugs is booming, it is intriguing that WuXi AppTec announced in its 24-year interim report that next year's D&M capital expenditure will exceed 50% year-on-year.

The most pessimistic moment in an industry is often the best window to observe the value of a company: those companies that can demonstrate resilience in adversity are often able to turn the tables and shine when spring comes.

01

China's CXOs are fully differentiated

When the performance of several leading companies in an industry begins to decline, it is no longer an individual problem but a common problem in the industry.

Although WuXi AppTec has just released a decent financial report, it is difficult to hide the harsh situation faced by the entire Chinese CXO. Throughout the first half of 2024, the revenue of several major CXO companies almost all experienced a year-on-year decline, and Alethe, Boten and Medicilon are expected to see a year-on-year revenue decline of more than 40%.

Figure: Overview of revenue data of Chinese CXO companies, source: Jinduan Research Institute

If the fluctuations in revenues cannot move investors, then the performance of the net profit after deducting non-recurring items of various CXO companies is even more despairing. Looking at all the leading CXO companies, except for a slight decline in the net profit after deducting non-recurring items of WuXi AppTec, the net profits of other companies have all fallen sharply, and even Boten Pharmaceuticals, Zhaoyan Pharmaceuticals, and Medicilon have already suffered losses after deducting non-recurring items.

Figure: Overview of China's CXO companies' non-GAAP net profit data, source: Jinduan Research Institute

Once upon a time, the three words "CXO" were a dazzling "golden signboard", and all those who entered the market were regarded as "water sellers" who could make a profit regardless of drought or flood, and were thus sought after by investors. However, as the domestic pharmaceutical industry has encountered internal and external troubles one after another, the halo of the CXO concept is disappearing.

In fact, as early as in the 2023 annual report, Medicilon disclosed a financial report that was difficult to satisfy investors. Although Medicilon's revenue in 2023 only fell by 17.68%, the company's net profit suddenly changed, with a loss of 33.21 million yuan, while in 2022, Medicilon's net profit was as high as 338 million yuan.

Unlike WuXi AppTec, which has a strong ability to resist risks, MediSci, as a representative of small and medium-sized CXO companies, has seen a sudden change in its performance, which fully demonstrates that the good days of China's CXO pro-cyclical industry are over, and differentiation may become the main theme of China's CXO industry in the future.

02

Global CXOs turn to high-quality development

The weak performance of Chinese CXO companies is actually just a microcosm of the intensified global CXO competition. On the surface, the poor performance of domestic CXO companies is due to the price war caused by internal competition, but at a deeper level, full competition is actually transmitted from the outside to the inside.

In the past week, IQVIA and Medpace, two leading US CXO companies, have successively disclosed their performance in the first half of 2024. Although their performance continued the growth trend, the fierce competition in the global CXO industry can still be felt from the words of the management.

Medpace is the most popular CXO upstart in the United States in recent years, with its stock price rising more than 20 times in the past seven years. Although Medpace achieved revenue of US$1.039 billion in the first half of the year, a year-on-year increase of 16%, this figure did not meet the consensus expectations of analysts. After the release of this unexpected financial report, Medpace's stock price plummeted 18%, setting a new low in the past year.

The core reason why Medpace's performance fell short of expectations is the decline in the popularity of innovative drugs. Affected by monetary policy, many orders were canceled by customers. Management admitted that if the cancellation rate this year was the same as in 2023, then Medpace's revenue would be able to meet expectations, but unfortunately too many customers canceled their orders in June, and the number of cancellations was almost twice the average level in 23 years.

There are many reasons why customers cancel orders, such as re-prioritization and tight liquidity of pharmaceutical companies. There was even one customer who was acquired by a large pharmaceutical company, which chose to terminate the order and let its preferred supplier serve instead. These cases show that overseas CXO companies are also facing fierce competition.

Forced by the objective fact of intensified competition in the entire industry, Medpace chose to lower the company's 2024 performance guidance in the interim report: the revenue growth rate was lowered from 14%-16.7% in the first quarter to 12.7%-15.3%.

Figure: Medpace's 2024 performance guidance, source: company announcement

Unlike Medpace, which did not meet expectations, IQVIA delivered a satisfactory report in this year's interim report. However, when answering questions from analysts, IQVIA management believed that the business environment was strong and was confident about the future, but also conveyed a cautious attitude: in response to the anti-inflation bill, almost all large pharmaceutical companies are carrying out cost-cutting plans, accompanied by reviews of various suppliers, and are particularly cautious in spending, facing greater challenges in negotiations.

The cautiousness of large pharmaceutical customers in terms of payment has weakened the bargaining power of CXO companies, and many CXO companies have begun to formulate more aggressive pricing strategies. This indirectly requires CXO companies to make more efforts to retain customers, but in the long run, companies will pay more attention to how to use funds effectively, and for CXO companies, how to improve production efficiency, speed and quality has become the main way to win customers.

Since entering 2024, the production capacity of global CXO companies has continued to change, and many companies have even begun to close bases and lay off employees. In March, German CXO company Evonik announced that it would lay off 2,000 employees worldwide, most of whom were management positions, and would eventually retain only about 60% of its employees; although Catalent's layoff ratio was not that large, it also laid off 130 employees; New Vision, Lonza, Thermo Fisher and other CXO companies are also strategically shrinking to varying degrees.

The reason why the CXO industry has grown rapidly in the past is essentially based on the rapid explosion of R&D demand for innovative drugs around the world. In big waters, there must be big fish. When pharmaceutical companies actively promote innovative pipelines, the dividends of R&D investment will naturally flow to the CXO track, which obviously amplifies the demand of pharmaceutical companies and is destined to not last long.

As pharmaceutical companies begin to turn cautious in their R&D attitude, the past overflow of R&D dividends have quietly disappeared, and CXO is returning to its normal state. This is inevitable.

03

CXO underlying competition logic

The global CXO industry is entering a counter-cyclical period. How will Chinese companies perform? Considering the underlying competitive logic of CXO, perhaps this is our opportunity to overtake others.

Liu Gesong of GF Fund once proposed the concept of "global comparative advantage manufacturing industry". The so-called "global comparative advantage manufacturing industry" refers to industries that have obvious advantages on both the supply and demand sides in global competition. On the demand side, it must be global and irreplaceable. In other words, the product competitiveness is strong, with obvious cost advantages, and it is difficult to find a rival even in the international market; on the supply side, the industrial chain must be autonomous and controllable, without the risk of being stuck, and the industrial agglomeration effect is obvious.

Although the domestic CXO industry is in a trough, from the perspective of both supply and demand, it is an industry that meets the requirements of "global comparative advantage manufacturing industry". From the demand side, China's innovative medicine is in the ascendant, and the core demand users of CXO are scattered all over the world, mainly in the United States and Europe, and Japan, Southeast Asia, South Africa, Australia and other regions are also important markets; from the supply side, my country has a complete supporting system for raw material supply, engineer bonus, R&D and manufacturing chain, and has obvious comparative advantages in the world.

This global comparative advantage is not innate, but it is formed through long-term development. In the long-term survival of the fittest, the manufacturing industry has built its own strong moat through its own manufacturing costs, engineer bonuses, R&D accumulation, entrepreneurship, industrial chain support, etc., which is not easily subverted by new entrants. The supply and demand pattern is stable and demand continues to expand, resulting in leading companies entering a stage of sustained high growth.

As for domestic CXOs, as the complexity of products continues to increase, the agglomeration effect of the industrial chain continues to emerge. In addition to labor costs, the number of engineers and the completeness of the industrial system are also competitive advantages of the domestic manufacturing industry, which means that it has comprehensive advantages in innovation ability, comprehensive cost, organizational ability, and responsiveness. Once this systemic advantage is established, it is difficult to be subverted. The resilient performance of WuXi AppTec in the past two years is the best proof.

The rise of the CXO model is not a lucky coincidence, but an inevitable result of the gradual segmentation of the biopharmaceutical industry. With the abnormally high R&D costs of an innovative drug easily exceeding US$2 billion, CXO companies that help pharmaceutical companies reduce costs and increase efficiency have long become the core lifeline of the company's development. Especially for those biotechs that focus on cutting-edge innovation, the strength of the CXO companies they cooperate with can determine their survival.

The narrative of competition between major powers is essentially a war of attrition. Returning to the industry and enterprise level, the essence of competition is also a war of attrition with a long-term perspective, and the final decisive factors are still cost, efficiency and quality. The US side suppresses China's CXO industry, which is nothing more than a consideration of its own interests, but such an approach obviously does not consider the life and death of Biotech companies, and it is contrary to the objective laws of industrial development.

Based on this, it is unrealistic for overseas pharmaceutical companies to drastically decouple from Chinese CXO, because it is difficult for pharmaceutical companies to find a stable, efficient, and high-quality pharmaceutical R&D outsourcing industry chain like Chinese CXO. Chinese CXO is a typical "global comparative advantage manufacturing industry" with outstanding global comparative advantages. Some countries use industrial policies and tariffs as weapons, which may achieve certain results in the short term, but in the long run it is destined to be unable to change the development pattern of the industry.

As global large pharmaceutical companies place higher demands on suppliers, the advantages of China's CXOs in "global comparative advantage manufacturing" will be further magnified. The crisis of global CXOs may be an opportunity for China's CXOs.

04

Not so much should

Most people live in a mindset that they have forged in their heads.

Based on WuXi AppTec's consistently excellent performance, investors naturally assume that it should maintain rapid growth and are unwilling to consider changes in the overall environment.

In response to the complex environment, global pharmaceutical companies have changed their strategies for R&D pipelines, and all CXO companies will face extremely severe challenges. This is why more overseas CXO companies or upstream companies that are deeply related to the innovative drug industry chain have chosen to lower their performance guidance for 2024. However, in the face of external pressure, WuXi AppTec was not swayed by external unstable factors, but still set a revenue guidance range of 38.3 billion to 40.5 billion yuan at the beginning of the year. If the new crown commercialization project is excluded, it will still maintain a low single-digit to high single-digit growth range.

In the second quarter, WuXi AppTec achieved a 16% month-on-month revenue growth. If this trend continues, it will not be a big problem to achieve the full-year operating target. However, for such performance, many investors who lack knowledge of the CXO industry think that this is a matter of course, because WuXi AppTec has only achieved the same revenue level as in 2023. But if you weigh the situation of CXOs around the world, you will find that WuXi AppTec's "40 billion" this year is completely different from last year's "40 billion".

Figure: WuXi AppTec's quarterly revenue and month-on-month growth rate, source: Jinduan Research Institute

On the basis of maintaining more than 6,000 active customers, WuXi AppTec added more than 500 new customers in the first half of this year; the small molecule D&M pipeline continued to expand, with 644 new molecules added in the first half of the year, and the current pipeline molecules total 3,319. At present, WuXi AppTec has 43.1 billion orders on hand, a year-on-year increase of 33.2% excluding COVID-19 commercialization projects, of which the top 20 global pharmaceutical companies have a revenue of 6.59 billion, a year-on-year increase of 11.9% excluding COVID-19 commercialization projects.

As large pharmaceutical companies become more cautious, they will also be more stringent in auditing suppliers, and the share of the entire CXO industry will become more concentrated. Under such circumstances, behind WuXi AppTec's seemingly unchanged total revenue, there is actually a continuous improvement in its industry competitiveness. As the global CXO industry slows down and shifts gears, investors should no longer overly consider revenue figures, but should pay more attention to the company's voice in the industry.

To be fair, it is not easy for WuXi to deliver such a financial report data that matches the performance guidance in the context of the global CXO entering a counter-cyclical period. The US "Biosafety Act" is on the verge of being enacted, and WuXi AppTec is the primary target of the US blockade. In such a difficult objective environment, WuXi AppTec did not look for a way out, but faced the challenge head-on and used a financial report that matched expectations to prove its efforts.

Almost all Chinese CXO giants in the same field as WuXi AppTec have begun to experience declining performance. In such a pessimistic environment, WuXi AppTec can still maintain its performance, which is actually beyond expectations.

WuXi AppTec, which once had a market value of nearly 500 billion yuan, now has a market value of just over 100 billion yuan. If investors only consider the stock price, they may think that WuXi AppTec has suffered losses. But what is the reality? WuXi AppTec has not only not suffered losses, but its performance has even remained at a historical high, and it is still generating tens of billions of profits every year.

The global biopharmaceutical industry is no longer booming in terms of R&D, and it is time for the market to readjust its future expectations for CXO companies. In the counter-cyclical situation, CXO companies will no longer compete on aggressive growth, but on who can provide more value to customers, who is more resilient, and who has more core competitiveness.

There are not so many things that are taken for granted in this world. Behind WuXi AppTec's seemingly ordinary goal of 40 billion, its own competitiveness is actually constantly improving, and its voice in the industry is continuously increasing, fully reflecting the company's overall tenacity.

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