While Navigating Risks, WuXi To Benefit from Global Outsourcing

BEIJING - WuXi PharmaTech is positioning itself to ride the rising tides of global pharmaceutical outsourcing to strengthen its role as China's largest contract research organization, according to a WuXi executive and an independent analyst.

And while WuXi recently set out an array of risks that might one day cloud its future in an annual earnings report filed with the U.S. Securities and Exchange Commission, most of these factors are too remote to affect the company's continued growth this year, according to Hai Mi, WuXi PharmaTech's vice president of corporate communications.

Some risks outlined in WuXi's SEC report likewise present obstacles or uncertainties to all foreign-invested pharmaceutical firms operating in China, said Jinsong Du, equity research analyst at Credit Suisse in Hong Kong.

WuXi reported that its net revenues for 2007 increased 93 percent to $135.2 million from $69.9 million in 2006, while its net income for last year rose by 283 percent to $33.9 million from $8.9 million in 2006.

When reporting its double-digit earnings growth for 2007, WuXi also outlined a list of factors that could negatively affect its performance ahead, in line with SEC requirements for all U.S.-listed companies.

These risks are unlikely to have any significant impact on Wuxi's earnings over the short- to medium-term future, said Du, who closely tracks the company.

WuXi's three largest customers in 2007 were Pfizer, Merck and Vertex Pharmaceuticals, which accounted for 15 percent, 12.2 percent, and 11.2 percent of the company's net revenues in 2007, respectively, the filing noted.

The company added that it generated substantially all of its net revenues over the last three years from sales to customers located in the U.S.

WuXi therefore could be vulnerable to cost-control measures included in any health care reform package passed in the U.S. In recent years, the U.S. Congress and state legislatures have considered various types of health care reform to control growing health care costs.

WuXi executives said this could adversely affect R&D expenditures by pharmaceutical, biotechnology and medical device companies, which could in turn decrease the business opportunities available to WuXi in the U.S.

International pharma firms and China-based CROs have all been following American moves to enact a health care reform package, yet reforms are unlikely to be passed quickly enough to have an impact on WuXi's 2008 earnings.

WuXi's management also told the SEC that any reversal in the trend toward global outsourcing by the world's leading pharmaceutical, biotech and device companies could slow the company's growth.

But Jinsong Du said there is little probability of a turnaround in outsourcing. He said that outsourcing in the global pharmaceutical sector is likely to follow the upward curves of an earlier and similar trend in the information technology sector.

The management at some pharmaceutical R&D groups based in China, along with select industry analysts, have voiced concerns that a continued economic downturn in the U.S. could spark a decline in American pharmaceutical companies' outsourcing research to China.

"There is a slight possibility that this could cut into WuXi's earnings," said Du. "But it is more likely that a continued economic slowdown in the U.S. could trigger more outsourcing to lower-cost pharmaceutical R&D organizations like WuXi in China," he said.

WuXi's SEC report states that some major pharmaceutical, biotech and device companies have made in-house research investments in China, and that this trend is expected to continue.

The Credit Suisse analyst said that while some multinationals are stepping up research investment in China, "most of this is focused on clinical trials, which is not in direct competition with WuXi's services."

WuXi's Mi agreed: "The only possible way these research operations might compete with WuXi PharmaTech is in terms of attracting talent."

Also on WuXi's charter of potential risks is the enactment of China's new business tax law. The tax law took effect Jan. 1, but still contains a range of unclear provisions.

China's new Enterprise Income Tax Law curtails tax incentives that had been granted to foreign-invested enterprises in the 1980's and 1990's.

The new law permits certain "high-technology enterprises" to enjoy a reduced 15 percent enterprise income tax rate, but the regulations do not clearly spell out which companies will qualify for the preferential rate (Also see "Insider Analysis From Jones Day: New Patent Approach Is Needed For Pharmaceutical Research In China" - Scrip, 26 Mar, 2008.).

WuXi's management therefore still does not know whether the company will be classified as a "high-technology enterprise" entitled to a preferential tax rate of 15 percent, as compared with the new tax rate of 25 percent applicable to all other domestic and foreign-invested enterprises in China.

"This is the same dilemma faced by pharmaceutical companies across China, which have all applied to be classified as a high-tech enterprise," said Du. "It is still uncertain when the Chinese government will clarify this law," he added.

AppTec, which WuXi recently acquired, is subject to a 40 percent U.S. corporate tax rate (Also see "PharmAsia News Notable Notes: WuXi Confronts Chinese Macro Challenges" - Scrip, 3 Apr, 2008.). WuXi acquired a 100 percent stake in AppTec for $151 million plus an assumption of $11.7 million in AppTec debt (Also see "China’s WuXi To Acquire U.S.-Based AppTec Laboratory Services" - Scrip, 15 Jan, 2008.).

Du added that WuXi's earning prospects remain strong in light of the company's past performance and likely future trends in outsourcing pharmaceutical research to China's leading CROs.

"The increasing number of blockbuster drugs going off patent, the mounting R&D costs per drug, and the exacerbating talent drain in developed countries should eventually open the floodgates for offshore outsourcing - just as what happened to IT outsourcing in the 1990's, and WuXi is well-positioned to be one of the biggest beneficiaries," he explained.

WuXi and Princeton, N.J.-based Covance recently announced a joint venture to provide preclinical drug testing services in China whereby each side will take a 50-percent stake in the venture, which will utilize a new testing facility that WuXi has already begun building in Suzhou, on the east coast of China (Also see "Patheon Looks To Establish Stronger Ties with Japanese Pharmas" - Scrip, 23 Jun, 2008.).

- Kevin Holden ([email protected])