The domestic pharmaceutical and biological industry has moved beyond the traditional model of "drug manufacturing supremacy."
Twenty-nine years ago, the first pharmaceutical and biological company, Harbin Pharmaceutical Group, went public, marking the beginning of such companies entering the capital market. Since then, the number of listed pharmaceutical and biological enterprises has grown rapidly, their scale has continued to expand, and their segments have become increasingly diverse. As of the end of September 2022, more than half of the top 20 companies by market value in this sector were non-drug manufacturers, with research and development service providers—known as Contract Research Organizations (CROs)—taking three spots.
CRO companies, often referred to as the "water sellers" during a gold rush in innovative drug development, benefited immensely from the surge in domestic innovative drug development and the increasing outsourcing penetration rate of overseas clients. During the pharmaceutical bull market from early 2019 to mid-2021, the CRO sector was exceptionally prominent, becoming a sub-sector known for its high industry prosperity and highly concentrated holdings.
However, CROs were among the first to be affected during the recent year-long adjustment in the pharmaceutical sector. This article explores whether CRO valuations have bottomed out and offers some perspectives and outlooks.
Back to the Starting Point
After significant ups and downs, the valuation of the CRO sector in 2022 has returned to its initial starting point.
Following a structural "sector" bull market that lasted about two and a half years starting in January 2019, the pharmaceutical and biological sector has undergone its most substantial adjustment in the past five years over the last year, with the digestion of high valuations being the core issue—CROs have not been spared.
By the end of September 2022, the price-to-earnings ratio (TTM) of leading CRO companies had largely fallen to levels seen before the start of the 2019 structural bull market in the pharmaceutical and biological industry, or even lower. On one hand, this indicates that valuations have entered a bottom range relative to their own history; on the other hand, compared to the valuation levels of overseas leading companies, there is no longer excessive valuation premium.
We believe that valuation, to a considerable extent, reflects the market's expectations for a sector's growth under specific macroeconomic conditions. These expectations are not static over time but follow discernible patterns, largely dependent on judgments about the growth potential of the CRO sector itself and closely related to changes in market awareness. Considering the overall pharmaceutical market environment, we may better assess whether CRO sector valuations are currently in a bottom range.
Two Years of Sharp Increases, Over a Year of Digestion
After early 2019, CRO sector valuations significantly increased for over two years, driven by a three-dimensional resonance: a relaxed pharmaceutical market environment, rapid growth of the CRO sector, and sustained novelty in market recognition.
First, this period coincided with a structural bull market in the pharmaceutical and biological industry. The concentrated influx of incremental funds provided the driving force for the "configuration bull" that pushed CRO valuations higher. There was strong favor from foreign capital with prominent long-term allocation characteristics, growth in the scale of pharmaceutical-themed funds due to the equity transformation of residents' assets and wealth effects, and increased allocation by non-pharmaceutical funds due to sector comparative advantages and wealth effects.
Second, local CRO companies, which started in the 1990s, entered a period of rapid growth collectively around 2015. Full order books began to materialize, and performance under relatively low base conditions continued to be impressive (the CRO sector's revenue CAGR exceeded 30% from 2018 to 2021). The CRO sector continued to receive valuation premiums due to its exceptionally high industry prosperity.
Additionally, CROs only gradually became familiar to the capital market in recent years. Before 2018, there were very few listed CRO companies of scale. After WuXi AppTec returned to list on the A-share market in 2018, many domestic CRO companies completed their IPOs. By the end of September 2022, the number of listed CRO companies in China exceeded ten, systematically presenting this new pharmaceutical sector to investors and further enhancing the sector's capacity to absorb capital. Before mid-2021, the market viewed CRO as a novelty. Therefore, at that time, every quarterly report with outstanding performance, rapid order growth, or the introduction of equity incentive plans was likely to bring sector benefits, while the market had not yet shown excessive concern about marginal changes in industry prosperity.
From mid-2021 to the present, over a year of significant valuation digestion in the CRO sector has been influenced by a tightening pharmaceutical market environment. Meanwhile, market perception of CROs has shifted from novelty to concern, with uncertain expectations about their growth.
First, amid the strong performance of new energy and pro-cyclical sectors in the second half of 2021, the pharmaceutical and biological sector experienced significant capital outflows. In the first half of 2022, continued adjustments were driven by expectations of U.S. interest rate hikes suppressing growth stocks, coupled with chaotic policy expectations within the industry itself, leading to sustained and significant digestion of previous high valuations. As a typical sector with high valuations and high concentration of holdings, how could CROs not be affected?
As of now, the price-to-earnings ratio (TTM, excluding negative values) of leading companies has basically fallen to levels before the start of the 2019 structural bull market in the pharmaceutical and biological industry, or even lower.
Second, after mid-2021, as the market gained relative familiarity with CRO companies, concerns began to arise about marginal changes in this sector's prosperity.叠加行业整体的长期持续调整形成的负反馈，导致市场在消化估值的惯性下过分交易悲观预期。 Monthly order growth fluctuations, changes in domestic innovative drug policies, potential回流 of overseas orders, cooling primary market investment and financing, and macro international relations have all become reasons加速 the decline in CRO sector valuations.
Change and Constancy, Where to Go From Here
With CRO sector valuations returning to early 2019 levels, where will they go from here?
First, after more than a year of adjustment, the pharmaceutical market environment has entered a rare "three lows" state—low valuation, low holdings, and low trading volume proportion.
The current price-to-earnings ratio (TTM) of the Shenwan pharmaceutical and biological industry is significantly undervalued at 22 times. Meanwhile, in the second quarter of 2022, non-pharmaceutical active funds' pharmaceutical allocations were substantially underweight, hitting a 13-year low and underweight for seven consecutive quarters.
Looking at the past 15 years, the duration of undervaluation + underallocation does not last long. Undervaluation is generally followed by a subsequent round of increased allocations. Therefore, the currently overly pessimistic pharmaceutical market environment is unlikely to continue driving down CRO sector valuations. As the market gradually restores objective recognition of the pharmaceutical industry's growth attributes, the pharmaceutical sector, including the CRO sector, has significant room for valuation repair.
Second, we remain optimistic about the growth potential of the CRO sector. Innovation remains a major trend in global pharmaceutical development. Domestic CRO companies are far from reaching their growth "ceiling" compared to overseas CRO leaders and are expected to maintain high growth over three to five years or even longer.
On one hand, global demand for innovative drug research and development remains strong. Investment and financing in the innovative drug primary market account for a limited proportion of global R&D investment, and there were signs of recovery in the second half of 2022, allowing for a rational view of short-term volatility. Currently, domestic CROs, leveraging engineer dividends and efficient, high-quality service supply capabilities, are承接 the global industry chain's shift to China. The overseas outsourcing business orders for preclinical services of some leading companies continue to grow rapidly.
On the other hand, the great wave of domestic innovative drugs is rising. An aging population and complex changes in residents' disease spectra genuinely require innovative drugs and therapies, which will increase the market share of innovative drugs. Meanwhile, with the implementation of policies such as new regulations for anti-tumor drugs and medical insurance negotiations for innovative drugs, the acceptance and approval of new drugs are accelerating, highlighting the importance of clinical value and international standards. Therefore, the outsourcing penetration rate of new drug research and development is expected to continue to increase.
Admittedly, changes in indicators such as new orders, inventory, and even biological assets have become more focal points in measuring marginal changes in sector prosperity. At the current juncture compared to two or three years ago, some CRO companies may show a decline in order growth rates. However, objectively speaking, while domestic CRO companies have achieved rapid development in recent years, their scale base has also increased. Maintaining order growth at the same level as revenue and profit growth is equally precious.
Taking a step back, the current valuation level of the CRO sector has relatively fully digested the so-called expectations of marginal decline in industry prosperity, entering a bottom range. Returning to earnings growth, the CRO sector continues to have comparative advantages within the pharmaceutical industry, maintaining its growth sector attributes and highlighting medium- to long-term allocation value.
We believe innovation is an important driver for the long-term development of the pharmaceutical and biological industry and remain optimistic about the growth potential of the CRO sector.
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Frequently Asked Questions
What does CRO stand for in the pharmaceutical industry?
CRO stands for Contract Research Organization. These companies provide support to the pharmaceutical and biotechnology industries through research services outsourced on a contract basis, often during the drug development process.
Why did CRO valuations decrease significantly recently?
CRO valuations faced pressure due to a combination of factors including capital outflows to other sectors like新能源, tighter monetary policies affecting growth stocks, concerns over marginal changes in industry growth rates, and broader geopolitical and economic uncertainties impacting market sentiment.
Is now a good time to invest in CRO stocks?
Many analysts believe valuations have entered a bottom range after significant adjustment. With underlying industry growth drivers like global innovation demand and domestic drug development still intact, the sector may offer potential for long-term investors seeking exposure to pharmaceutical innovation. However, thorough due diligence is always recommended.
How do domestic CRO companies compete globally?
Domestic CROs often compete based on cost efficiency due to the "engineer红利" (skilled workforce at competitive costs) and demonstrated capabilities in delivering high-quality, efficient research services, making them attractive partners for global pharmaceutical companies looking to optimize R&D spending.
What are the main growth drivers for the CRO sector?
Key drivers include sustained global demand for new drug development, the ongoing shift of outsourcing work to countries like China, the rise of domestic innovative drug development, supportive regulatory policies, and increasing outsourcing penetration rates in the R&D process.
What risks should investors consider with CRO investments?
Risks include fluctuations in global R&D funding (especially from biotech startups), regulatory changes in key markets, potential geopolitical tensions affecting international collaboration, competition, and execution risks related to managing growth and capacity utilization.