Is There Still Investment Value in Chinese Healthcare Companies Amid US-China Decoupling?

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Under the cloud of tense US-China relations, the US has repeatedly introduced legislation targeting Chinese pharmaceutical companies. President Biden signed an executive order urging the reshoring of biotech manufacturing. Additionally, the “Biosafety Act” was introduced to protect American genetic and personal health data, prohibiting US pharmaceutical companies from outsourcing production to Chinese contract manufacturers.

The stock prices of relevant pharmaceutical companies have plummeted, spreading pessimism across the sector.

In such a political environment, do Chinese pharmaceutical stocks still hold investment value?

To answer this question, we can start by examining the potential impacts of the US legislation. First, the president’s executive order on reshoring biotech manufacturing is relatively mild, aiming to regain control over the pharmaceutical supply chain. Companies engaged in manufacturing for US clients might face some risks but could circumvent policy sanctions through supply chain relocations or building factories abroad. The “Biosafety Act,” however, specifically targets pharmaceutical outsourcing companies, including CROs (Contract Research Organizations), CMOs (Contract Manufacturing Organizations), CDMOs (Contract Development and Manufacturing Organizations), and CSOs (Contract Sales Organizations). The Act has named several pharmaceutical companies, with WuXi AppTec being notably impacted, having previously been a favorite among investors.

WuXi AppTec primarily undertakes drug development, testing, and mass production for global pharmaceutical companies. American biotech firms, especially smaller ones, rely on experienced and well-staffed companies like WuXi AppTec for drug development and manufacturing. While WuXi AppTec has generated significant profits for these companies and improved the health conditions of many Americans, its business inevitably involves accessing US public health data and drug patents. Currently, this seems to be an unsolvable issue. Although the Act provisionally allows existing contracts to be extended to 2032, giving WuXi eight years for soft landing, the challenges facing the CXO business amid US-China decoupling appear to lack clear short-term solutions.

As of the end of 2023, there are 26 CXO companies listed on A-shares and H-shares, comprising a small portion of the pharmaceutical sector. The sector also includes many other companies engaged in medical services, medical devices, traditional Chinese medicine, chemical pharmaceuticals, and biotech. These companies, if focused on domestic business, are naturally less affected by US-China conflicts. Even those involved in exports, such as leading medical device companies and innovative biotech companies, may not be as significantly impacted by geopolitical tensions as one might think.

The reason is that top-tier medical device and original biotech companies mainly rely on their own R&D capabilities and innovation to compete internationally, unlike outsourcing companies that depend on foreign orders. The US has little incentive to suppress Chinese innovative drug companies due to the significant gap between the two countries’ strengths in this field. US innovative drug development is highly advanced, with many treatments for cancer and critical illness originating from US patents. Currently, the number of innovative drugs exported by China is minimal. The US government barely has any reason to stifle such a small competitor, especially that China is its major export market for innovative drugs. Even if China’s technological advancement rapidly improves in the coming years, the healthcare industry is fundamentally based on patent protection, which means it’s improbable for the US to deny Chinese innovative drug patents without undermining its own. The pharmaceutical sector accounts for over 17% of US GDP, and dismissing Chinese patents would have unimaginable repercussions for US pharmaceutical companies and the economy.

Therefore, we remain optimistic about domestic innovative drug companies with strong original research capabilities. A recent phenomenon shows Chinese innovative drug companies selling their developmental drugs to small American pharmaceutical firms, acquiring equity in these companies. When large multinational pharmaceutical companies acquire these American firms for their drugs, Chinese innovators benefit from equity transactions. While preclinical drug trading among pharmaceutical companies is common, Chinese-developed drugs in the US market often cost less than similar drugs developed by Japanese and Korean companies. This method helps secure fairer prices for good drugs.

Of course, for pharmaceutical companies, the ideal model is to directly export patented innovative drugs. China’s R&D investment as a percentage of GDP has been soaring through the past years. Against this backdrop, it is promising for Chinese innovative drug companies to play an increasingly important role in the international market.

Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein. In respect of any discrepancy between the English and Chinese version, the English version shall prevail.

The Struggle of EV Development for Traditional Automakers

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Apple recently announced the abrupt termination of its electric vehicle (EV) development project. Despite a decade-long effort, no tangible results have emerged. Apart from Apple, many traditional automotive companies have adjusted their EV plans in recent months. For instance, Ford announced plans to delay or cut its $12 billion spending on EVs and will reassess the need for in-house production of batteries. Honda and General Motors also scrapped their joint plan to develop affordable electric SUVs over a year ago.

Stumbling Blocks for Traditional Automakers

The reasons behind the cancellation or postponement of EV investments by US and EU traditional automakers can be gleaned from Ford’s financial performance last year. Ford’s EV business incurred losses of $700 million, $1.1 billion, $1.3 billion, and $1.6 billion in each quarter from Q1 to Q4. EV sales remained at approximately 34,000 to 36,000 vehicles per quarter from Q2 to Q4, with no visible growth. The EBIT margin in Q4 was almost -100%. With an average EV selling at around $47,000, the -100% EBIT margin represented a cost of about $93,000 per car, significantly higher than the traditional gasoline cars’ cost of $33,000.

The difficulty in the EV business lies not only in development but, more importantly, in cost reduction. President Biden’s support for wage increases in the automotive industry at the end of last year has made cost control more challenging for US car companies.

Ford EVs’ tepid sales last year indicate that the initial high-growth phase of EV development appears to have passed. Many consumers with purchasing power and a willingness to embrace new things may have already purchased EVs. To stimulate another wave of consumers, prices need to be lowered to achieve economies of scale through expanded sales and subsequently achieve profitability. However, for European and American traditional automotive companies, the decision to lower prices brings many risks and requires substantial investment in new capacity. It is also difficult to determine the level to which prices should be lowered. If demand fails to materialize and additional production capacity is added, it will only worsen losses and could even lead to bankruptcy. However, if traditional automakers cease their investment in EVs, in just over a decade, when the government completely bans the sale of fossil fuel vehicles, they will also be out of the market. Therefore, they have no choice but to grit their teeth and continue their EV investments.

Strong Competition from Chinese Brands

In contrast, the situation for Chinese EV manufacturers appears relatively optimistic. China’s traditional internal combustion engine (ICE) technology lags behind that of Western countries and is unlikely to catch up in the short term. However, EV is a new thing, and the previous technological differences in ICE do not apply to the EV competition. Moreover, EVs rely more on electronic and electrical technology, with relatively simple mechanical design. Chinese companies generally have a strong foundation in areas such as electronic product assembly and design, which makes them more competitive in developing EVs compared to ICE.

In recent years, the Chinese government has also vigorously promoted the development of the EV industry through subsidies. As a result, not only did the EV companies see rapid growth, but its upstream and downstream industries such as battery manufacturing and battery raw materials also thrived. China currently has a dominant position in global lithium battery supply. Since batteries can easily account for more than 30% of EV costs, Chinese companies have more competitive advantages than foreign brands in pricing EVs.

Finally, China has the world’s largest automobile market with a complete industrial chain and a massive economic scale. Many companies supply parts to foreign brands and have spent the past 30 years continuously improving product quality to meet the standards of foreign customers. Moreover, with wages being lower than in developed countries, their component cost-effectiveness is very attractive, leading to much lower EV costs than those of European and American automotive companies.

Tesla’s CEO Elon Musk recently told industry analysts that Chinese EVs are so good that without trade barriers, “they will pretty much demolish most other car companies in the world.” Ford’s struggle in developing its EV may be a showcase.

Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.

In respect of any discrepancy between the English and Chinese version, the English version shall prevail.