Domestic CXO companies in China, although partially deriving revenue from abroad and thus being susceptible to geopolitical risks, are also witnessing robust growth in their domestic business, with some generic drug CXO companies even growing against the trend. In recent years, the development of innovative drugs by Chinese pharmaceutical companies has been rapid, with significant breakthroughs, and the CXO industry chain can also benefit from the growth of domestic innovative drugs.

Over the past year or so, the fate of China's CXO industry has been fraught with challenges. On one hand, companies that are partly dependent on overseas markets have been greatly affected by geopolitical risks; on the other hand, the high base numbers from large COVID-19 orders during the pandemic have led to negative growth in the performance of many listed companies, with valuations and performance being impacted. However, it can also be observed that the domestic business of Chinese CXO companies is showing strong growth, and some generic drug CXO companies are growing against the trend, which may mark a new starting point.

Engineer Dividend

Although some of the business revenue of domestic CXO companies comes from abroad and is susceptible to geopolitical risks, the reason why China's CXO industry has been able to flourish over the past decade is closely related to the unique cost advantages that Chinese CXOs possess, and it is expected that this advantage will continue for a relatively long period.

Innovative drug companies have always faced two major contradictions. First, the patent protection period for innovative drugs is only 20 years. After the patent expires, generic drugs emerge, and drug prices will be significantly reduced, which is known as the "patent cliff" of innovative drugs. This forces pharmaceutical companies to continuously develop new products with better efficacy to smooth their revenue curves. Second, the increasing difficulty of drug research and development, with rising R&D expenditures, extended development cycles, and increased failure rates.

Advertisement

Faced with these two contradictions, large and medium-sized pharmaceutical companies, as well as small and start-up pharmaceutical companies, are more willing to outsource some of their R&D and production business to CXO companies as a means of shortening time to market, saving costs, ensuring compliance, and reallocating internal resources, allowing them to focus more on new drug development and sales. China, India, and Latin America are the main regions for the transfer of CXO production capacity from Europe and the United States, with China's CXO pharmaceutical market size, human resources, and intellectual property protection being more advantageous.

Comparing the average compensation per employee of domestic and foreign leading CDMO companies, the average labor cost of Chinese CDMO companies from 2018 to 2020 was between 110,000 and 200,000 yuan per person per year, which is still a significant gap compared to foreign CDMO companies such as Lonza and Samsung Biologics. In addition, comparing the average cost per employee of global pharmaceutical companies and CRO companies, domestic CRO companies have a lower average cost per employee and a greater cost advantage: the multinational pharmaceutical company AbbVie has an average R&D cost of $710,000 per person per year, Merck at $530,000 per year, Eli Lilly at $500,000 per year, while the average cost per person for leading international companies in 2020 was between $140,000 and $170,000, with an average of $154,000 per person, and domestic companies had an average cost of $48,000 to $100,000 per person in 2020, with an average of $71,000 per person.

According to statistics from the Ministry of Commerce, the execution amount of China's pharmaceutical biotechnology offshore outsourcing contracts has been growing continuously, with a growth rate of 25% in 2020 and 24.7% in 2021, significantly exceeding the growth rate of the past five years. Xinda Securities believes that the continuous growth in the amount of offshore outsourcing contracts further confirms the trend of global order transfer. Although European and American CXOs occupy the main global market, due to labor costs, environmental protection pressures, production capacity configuration, and other reasons, global production capacity continues to transfer to countries such as China and India; it is expected that the cost advantage brought by the engineer dividend will continue for a relatively long period.

Finding a New Path

Faced with the risks of relying on overseas business, CXO companies have also turned their attention to the domestic market. In recent years, the progress of domestic innovative drugs has been very significant. In 2023, three domestic new drugs were approved by the FDA. Although most still choose popular targets, they can still achieve non-inferiority or even superiority head-to-head. Comparing the scale of drug R&D pipelines between China and the United States, it can be seen that in recent years, the overall growth rate of China's drug R&D pipeline has been at a high level, all exceeding 30%, reaching 56% in 2019, far exceeding the global level. Looking at the main business areas of global pharmaceutical transaction companies, China's pharmaceutical transaction heat is currently ranked second globally, with the United States being the first: in 2022, the global number of pharmaceutical transactions was 1728, with a total transaction amount of $172.8 billion, involving an upfront payment of $19.2 billion, among which China's pharmaceutical transaction number was 233, accounting for 29.53% of the global total, with a total transaction amount of $34.7 billion, accounting for 20.08% of the global total, the highest in recent years, with an upfront payment of $1.9 billion, accounting for 9.9% of the global total. With the rapid development of innovation in Chinese pharmaceutical companies, Chinese CXOs can also share a piece of the pie in the development of domestic innovative drugs.Additionally, several CXO companies rooted in the local market have seen good growth in their domestic business. In 2023, Tigermed's main domestic business revenue was 4.163 billion yuan, compared to 3.542 billion yuan in the same period last year, a year-on-year increase of 17.51%. This growth is mainly due to the company's leading position in China's clinical outsourcing services market, with a continuous increase in revenue from the operation of clinical trials for drugs and medical devices, as well as rapid business growth in on-site management and patient recruitment in 2023; revenue from data management and statistical analysis, scientific affairs, medical imaging, real-world research, and pharmacovigilance services has steadily increased. Baicheng Pharmaceutical achieved a business revenue of 1.017 billion yuan in 2023, with a net profit of 272 million yuan, representing a year-on-year increase of 67.51% and 40.07%, respectively. In the first quarter of 2024, it achieved a business revenue of 216 million yuan and a net profit of 49.82 million yuan, with a year-on-year increase of 34.04% and 42.06%, respectively. Sunshine Noah achieved a business revenue of 932 million yuan and a net profit of 185 million yuan in 2023, with a year-on-year increase of 37.76% and 18.47%, respectively.

Compared to innovative drug CXOs, generic drug CXOs have a shorter cycle and rely more on the company's own cash flow to drive growth. Against the backdrop of medical insurance payment reform, the acceleration of localization has shortened the investment return cycle for generic drugs. In terms of project revenue sharing, generic drug CXOs participate in the value distribution of generic drugs through self-driven cooperation and revenue sharing, evolving from one-time order benefits to continuously sharing the growth value of the product.

Minsheng Securities pointed out that, from a policy perspective, the consistency evaluation of generic drugs has raised the threshold for drug research and development access. In terms of quantity, the supplementary application for consistency evaluation has entered a stable stage, and the "three-year closure" system will gradually clear the old approvals; the new registration classification application for generic drugs has become the mainstream, with the number of newly approved generic drugs growing rapidly, and the consistency evaluation will expand from oral preparations and injections to all dosage forms, bringing a broad market space for CROs.

In addition, the self-developed pipelines of leading generic drug CXO companies have been deeply cultivated for many years and are about to reach a turning point in external transformation and revenue sharing. For example, Sunshine Noah has signed joint development project agreements with several companies, and six equity varieties have been approved, with the first revenue sharing expected in 2024; as of the first half of 2023, Baicheng Pharmaceutical had 73 products with sales revenue sharing rights, of which six have been approved, and the revenue sharing business has entered an upward cycle. In terms of innovative drugs, Baicheng Pharmaceutical will opportunistically transfer its new drug pipeline externally in the future.

The industry's prosperity is expected to rise.

In terms of performance, due to the high base of performance brought by the previous large orders for COVID-19, the performance of the main listed companies in the CXO industry has fluctuated significantly since 2023. In addition, the continuous low level of investment and financing prosperity since the end of 2021 has led to the current low position of pharmaceutical funds' holdings in CXO, with the holdings decreasing from the highest of 60.8% in the third quarter of 2021 to 14.4% in the first quarter of 2024, which is lower than the 15.0% in the first quarter of 2020. The proportion of the top ten CXO holdings in medical funds has also decreased from the highest of 35% in the third quarter of 2021 to 7% in the first quarter of 2024. However, with the basic digestion of the new coronavirus commercial orders by leading CXO companies and the temporary resolution of geopolitical competition, the sector valuation is expected to be reshaped.

From an industry perspective, R&D expenditure, drug sales, and penetration rate are the core factors determining the market size of the CXO industry. The number of drugs under research and development, IND (Investigational New Drug) applications, and NDA (New Drug Application) applications, as well as the number of approved drugs related to sales, are key indicators for observing the prosperity of the CXO industry.

In recent years, the R&D investment of global pharmaceutical and biotechnology companies has been steadily increasing. The 2008 financial crisis had a significant impact on global pharmaceutical R&D, with the growth rate of R&D investment dropping to 1%; since 2011, the growth rate has gradually stabilized and rebounded. According to Evaluate Pharma statistics, the global pharmaceutical R&D investment growth rate in 2021 was close to 14.6%. In absolute terms, global pharmaceutical R&D investment increased from $144 billion in 2014 to $238 billion in 2021, with a compound annual growth rate of 7.3%. Institutions predict that global pharmaceutical R&D will continue to grow steadily at a rate of 2.6% from 2021 to 2028.

The R&D expenditure of Chinese pharmaceutical and biotechnology companies has also been increasing rapidly in recent years. In 2021, the R&D investment of A-share pharmaceutical and biotechnology companies was 102.28 billion yuan, a year-on-year increase of 49%. Since then, affected by factors such as investment and financing, the growth rate has slowed down slightly. From the first quarter to the third quarter of 2023, the R&D investment reached 73.9 billion yuan, a year-on-year decrease of 3.7%, with a significant decline in the third quarter growth rate of 45.8%, compared to the 19.4% growth in the second quarter.In terms of investment and financing, since 2022, the global capital market has been cooling down, with the total investment and financing amount for the year being 611.405 billion yuan, a year-on-year decrease of 50.9%, and the total number of financing events being 2,988, a year-on-year decrease of 16.8%. However, since the beginning of 2023, the global healthcare industry's financing activities have continued to improve. The total investment and financing amounts for 2023 and the first two months of 2024 were 608.396 billion yuan and 136.836 billion yuan, respectively, with year-on-year changes of -0.5% and 96%, respectively. The total number of financing events was 3,035 and 506, with year-on-year growth of 1.6% and 8.4%, respectively.

The number of IND and NDA applications for innovative drugs is also continuously increasing. After 2019, the number of IND applications for innovative drugs in China has steadily increased, from 811 in 2020 to 1,245 in 2021. The number of NDA applications for innovative drugs has also grown rapidly since 2019, from 157 in 2020 to 182 in 2021, indicating that domestically produced bio-innovative drugs are entering a period of market harvest. In 2023, China saw an increase in the number of new IND applications for innovative drugs to 1,563, a year-on-year growth of 26.76%, and the number of new NDA applications to 256, a year-on-year growth of 61%, with both approved quantities showing rapid growth.