Large pharmaceutical companies are facing challenges as the rate of new discoveries has declined and margin pressures are forcing them to reduce costs. As these pressures create headaches for the large producers, they also open opportunities for the young thriving CRO (Contract Research Organization) sector. While many CRO firms operate in the traditional US and European markets, large companies have increasingly been turning to India and China to outsource their research projects. While China is playing catch up to its Indian counterparts, the large supply of labor and lower costs are driving more business to China.
Among the handfull of CRO firms operating in China, WuXI PharmaTech (WX) is becoming known for its strict compliance to research standards and its high quality work. While the company does not participate directly in official clinical trials, WX completes Research and Development projects and pre-clinical evaluations of drugs and compounds for the major pharma firms. While the company is not the cheapest of the Chinese CRO providers, outsourcing firms still typically save up to 50% of the traditional costs if they had done the same research in western facilities. WX has been successful in landing quality clients, boasting that its client roster includes 19 of the top pharmaceutical and 8 of the top 10 biopharmaceutical companies in the world.
WuXi breaks its business down into two divisions. Laboratory services include the research and development on new and developing compounds, and pre-clinical trials on discovered drugs. The second division is manufacturing which makes up a small but rapidly growing portion of revenues. In this division, the company produces drugs that have already been designed and tested. Adherence to strict manufacturing processes make this a delicate and tedious process which requires significant skill and oversight. The manufacturing division carries higher margins than the Laboratory Services and is growing at a more rapid rate. At the same time, analysts caution that manufacturing revenue may experience lumpy growth as major orders are filled and delivered and those contracts may not be spread evenly throughout the next several quarters.
The company recently priced its IPO and offered 20% of the company to the public. At this time management owns 22% which leaves roughly 58% owned by investors who became involved before the IPO. This means there could be significant overhang if the prior shareholders begin to sell, but the setup is not atypical for a new issue and especially for one operating on foreign soil. WuXi is actually incorporated in the Caymans which allows it to enjoy an attractive tax rate, but does all of its operational work in China. There are still challenges to attract and retain qualified personnel but the constrictions appear to be less difficult to work with than the labor situation in India.
I currently have a position in WX and continue to expect higher prices. While the stock is not without risk, and the multiple is high, strong growth in a favorable sector often has a way of pushing stock prices much higher than normal earnings models would predict.
FD: Author has a long position in WX
WuXi PharmaTech Inc (WX)
October 27th, 2007 at 9:43 am
Hey Zach-
What is your general feeling about holding through earnings releases? I tend to sell on the eve of announcements to avoid the gap down risk. Not to mention that I buy solely based on charts so I don’t generally know enough about the companies to make that kind of bet. I’d be interested in your thoughts on this.
Jim
October 27th, 2007 at 9:54 am
Thanks for the comment Jim,
I think for the fundamental investor it is key to hold through earnings announcements. These announcements often represent the most important fundamental news events. If you are investing based on a long term view of the company or the industry prospects, these earnings announcements will be the catalyst to tell the world about the fundamental progress the company is making. If your analysis is right, you want to be there at this time to make the money for your research.
That said, if you are purely a technical trader it may make sense to not be involved during announcements because at this time, the stock will react more due to the new information than due to natural ebbs and flows of the stock pattern.
Hope this helps,
ZDS
October 27th, 2007 at 10:41 am
That’s helpful, Zach. Thanks.
As it pertains to small company stocks, this question has been echoing in my brain for the last couple of days after watching VDSI get absolutely gutted when their earnings report was released. I’ve been in and out of VDSI several times- as I often do with IBD 100 stocks- but I thankfully lacked the courage to hold it through earnings. This was a stock with a 99 fundamental rating from IBD. That being the case how can an investor be confident enough in their fundamental assessment of a smallish company to risk losing their shirt on something like VDSI? This is probably more a rhetorical question than anything.
October 27th, 2007 at 10:52 am
I understand, its a tough connundrum. That’s why diversification is so important because there are events that will move a stock through and below your stop point without giving you an out. At the same time, investing involves risk. Academically, that is what we are getting paid for. Theoretically you should be paid more for the amount of risk you are taking. Our job is to find ways to make higher returns with lower quantities of risk.
Good luck with your trading!
October 29th, 2007 at 8:10 pm
Hi, Zach and Jim,
Thanks for the great discussion. I have been a big fan of WX so far and has made quite a lot of money from it. I have hold the stock since $35 and plan to hold through the earnings. My understanding is that this company truly has something to look forward to and if good news (almost for sure) come out in the earning announcement, it will make investors more confident that it will continue to grow in the future, so this will almost gurantee a increase in the earning announcement day.
Anyway, stock always involves risk so nothing is impossible to some extent.
November 9th, 2007 at 11:35 am
Jim, I am looking for a catalyst for the recent plummet of WX. Have I missed something? Is it the overhang?
Thanks, Doug
May 19th, 2008 at 2:23 am
What are your overall feelings about WX as of today. I know their stock slipped quite a bit along with the rest of the market throughout the last few months.
Does you think WX is at a bargain price now or is their something more fundamentally wrong?