Will the Chinese CXO production capacity represented by WuXi AppTec be easily replaced?

In recent years, as a representative model of global division of labor in innovative drug R&D, the CXO industry has maintained remarkable growth. The increasing R&D investment in innovative drugs and the growing penetration of outsourcing year by year have become the driving force behind the industry's development.

However, this year, a series of bills led by the United States' "Biosecurity Law" have cast a geopolitical shadow over this thriving global industry.

Undoubtedly, political factors are stirring up the operational rules of the CXO industry. According to reports from Endpoints, international pharmaceutical giants are closely monitoring policy requirements and changes in the situation, on one hand hoping to delay the cutting of CXO production capacity in China through lobbying, and on the other hand promoting a reevaluation of the global supply chain layout.

At present, the revised House version of the "Biosecurity Law" has received more information from industry associations or heard the industry's voice before the debate in Congress. It is believed that more voices will emerge in the future, making the boundaries of the proposed bill clearer.

Regardless of what the unified version of the Senate and House will look like in the future, or what the final content of the bill will be, fundamentally, it still needs to continue to approach the truth and facts. As BIO stated, "Decoupling suddenly from Chinese CDMOs and CMOs will destroy patients and biopharmaceutical companies, and suddenly closing access to Chinese biotech companies will have a devastating impact on patients and biopharmaceutical companies."

The results of BIO's survey show:

1. 134 U.S. biotech participants (two-thirds of respondents with fewer than 250 employees in biotech companies) stated that 74% have signed preclinical and clinical service contracts with Chinese CDMOs/CMOs, and switching such services to other companies would take up to 6 years.

2. 30% of respondents have signed production contracts with Chinese CDMOs/CMOs, and switching drug production to alternative companies would take up to 8 years.

However, the process of gradual replacement is ongoing, but is this process really so easily replaceable?

According to The Economist, some pharmaceutical companies are looking for alternative suppliers from India. Apart from China, India is a major source of similar services, with some competitiveness, but also concerns in the pharmaceutical industry about issues such as overly lenient quality standards.

So, what is the industrial logic of the CXO industry, and can India take over some of China's CXO production capacity? This article attempts to predict the future direction of the CXO industry from the perspective of industrial laws.

Will the CXO industry continue to grow rapidly in the future, and can the complete rebalancing of CXO production capacity break away from China?

Recently, Goldman Sachs pointed out in a CXO industry report that the future growth of the CXO industry is mainly composed of incremental R&D spending and a higher proportion of outsourcing.

The industry's growth in the past 5 years has been mainly driven by relatively high levels of R&D spending (from 2017 to 2022, R&D spending has grown at a compound annual growth rate of about 7%)

At the same time, it is expected that there will be a higher level of outsourcing penetration in the next 5 years (approximately 34% in 2022, reaching around 39% by 2027, according to Frost & Sullivan), with R&D spending maintaining a growth rate of around 6-7%.

In terms of the absolute number of drug discoveries, the proportion undertaken by Biotech has far exceeded that of traditional large pharmaceutical companies. According to an article in "Drug Discovery Today," between 2010 and 2020, the proportion of First-in-Class drugs approved for Biotech was more than three times that of Biopharma (46% vs. 14%).

In addition to known benefits such as increased efficiency/productivity (clinical trials completed by CROs are about 30% faster than those conducted internally by pharmaceutical companies) and cost savings, small to medium-sized pharmaceutical companies (including biotechnology companies and virtual pharmaceutical companies) relying on CXOs can focus resources on core business and diversified supply chains, thus achieving rapid growth.

In the next 5 years, a significant portion of the global incremental R&D spending is predicted to be driven by relatively financially constrained small to medium-sized companies, which rely more on outsourcing partners, thereby further increasing the penetration rate of outsourcing on a broader scale.

For American and European companies, outsourcing to India/China can save 60-75% and 33-60% of costs, respectively (Frost & Sullivan).

Setting aside political factors, from the perspective of the division of labor in the CXO industry, East Asia and India are undoubtedly core regions, with India being the region with the lowest outsourcing costs outside of China Its advantages include:

• Increase in production capacity: The CRO/CDMO sector in India has been rapidly growing in recent years, partly due to the increasing demand for diversification in the global pharmaceutical supply chain. The rising trend in capital expenditure indicates that India will continue to increase its production capacity in the coming years.
• Cost efficiency: Compared to China, India has lower labor costs, providing better cost competitiveness.

However, India's problems are obvious.

1. Scarce high-end production capacity, compliance capability is crucial.
2. There is still a gap in research and development capabilities, especially in innovative frontier areas.
3. Weak ability for large-scale product response and delivery.

Issue 1: Compliance costs should not be underestimated, high-end production capacity is still a scarce resource

It is worth noting that for CXOs, there are still significant differences in manufacturing efficiency and quality between different manufacturers, just like semiconductor wafer foundries, where there are insurmountable process (technology) gaps; even with similar technologies, shortcomings in quality control compliance and production efficiency represent significant risk costs for customers.

Wugen's CEO mentioned in an interview that more and more competing contractors promise to provide the same services, but not all promises are based on the same capabilities. Indeed, in the high-end outsourcing manufacturing sector, competitors are still at a significant disadvantage compared to China, with quality control capability being a key differentiator.

It is worth noting that quality control compliance is not just a production issue for CXOs in developing countries; even suppliers from long-established developed countries repeatedly find themselves in a quagmire.

According to a recent report by Yicai, a "life-saving drug" for treating amyotrophic lateral sclerosis, Riluzole tablets (brand name "Liruta"), produced by Sanofi, experienced "shortages" in several large tertiary hospitals in Shanghai. Sanofi stated that the reason for the shortage was a change in the overseas production address requiring re-registration.

This situation is highly likely to be influenced by quality issues with Sanofi's CXO supplier EuroAPI. In March 2024, EuroAPI's Italian subsidiary discovered quality control deficiencies in an internal audit, leading to the suspension of the production of all active pharmaceutical ingredients (APIs) at the Brindisi plant.

43% of EuroAPI's revenue comes from Sanofi, and the active substance of Riluzole is included in EuroAPI's disclosed supply catalog.

A more typical case comes from Novo Nordisk, the owner of the drug Semaglutide.

Novo Nordisk has frequently disclosed in recent earnings conference calls that the demand for Semaglutide will continue to exceed its own production capacity. The biggest problem on the supply side comes from the capacity of the filling plant, especially as a supplier, Catalent has continuously experienced quality control issues, receiving multiple Form 483s (representing GMP or other regulatory issues found by the FDA during inspections, requiring the manufacturer to submit rectification within 15 days). This quality control issue directly led to a significant discrepancy between the production capacity of Semaglutide filling at Simec and the expectations of Novo Nordisk, severely impacting the company's revenue.

As a result, Novo Nordisk reluctantly chose to directly acquire Catalent for $16.5 billion, "when the supplier cannot deliver, the big customer steps in personally." If not to ensure the delivery of the "Drug King" Semaglutide, the cost would be so high that Novo Nordisk might not be willing to bear it.

Novo Nordisk's acquisition of Catalent further demonstrates the "forced" nature of pharmaceutical companies in dealing with quality incidents involving CXOs. Prior to this, Catalent was exposed for quality issues in cleaning and procedural execution at its Indiana plant, directly leading to the FDA's refusal to approve Regeneron's high-dose Eylea for market in 2023.

Catalent is already the third largest CDMO company in Europe, and facing the highly stringent quality requirements of innovative drugs, the frequent occurrence of problems has forced customers to take acquisition actions. In comparison, the quality record of the Indian pharmaceutical industry has reached another level of problems.

As a well-known work in the pharmaceutical industry observation, "The Truth About Generic Drugs" provides some relevant records. Through interviews with whistleblowers, investigators, and medical personnel, and sorting through a wealth of information in thousands of confidential documents from the FDA, author Catherine Eban exposed a rampant fraud and data falsification in the Indian generic drug industry. Corporate managers can ignore every safety production principle in order to reduce costs and maximize profits. As the industry saying goes: "We don't establish systems, we find ways to bypass them."

Therefore, when drugs with unpredictable ingredients pass through quality control measures that are virtually non-existent on production lines, and flow into a deceived medical system, catastrophic consequences can occur, even depriving patients of their lives.

Clearly, the chronic illness on the manufacturing side is a microcosm of the industry structure and decision-making model, and its impact will not be limited to generic drugs and manufacturing processes, but will definitely affect the quality of innovative drug products, a lifeline for CXOs. Just in the FDA inspections in December last year, three large well-known pharmaceutical companies in India, including Dr. Reddy's Labs, Laurus Synthesis, and Torrent Pharmaceuticals, received Form 483s from the FDA.

In stark contrast, WuXi AppTec disclosed in its first quarter report for 2024 that in 2023, the company underwent 748 quality audits from global customers, regulatory agencies, and independent third parties, all of which were 100% compliant.

This means that WuXi AppTec's production system faces and passes strict audits an average of twice a day, while meeting quality control requirements from various dimensions. In addition, information security audits were conducted up to 83 times throughout the year, with no major network security incidents or leakage of business secrets occurring. **

Issue 2: China maintains a leading position in R&D capabilities in innovative fields

Setting aside the differences in services and quality, in the R&D field involving cutting-edge technologies, the CXO industry chain's shift to India remains challenging.

As drug molecules become increasingly complex, the consumption of resources in process R&D is growing. Only industry-leading CXO companies can continuously introduce new technologies and equipment to enhance R&D production capabilities and quality control levels. They can meet the expanding market demands of innovative pharmaceutical companies in an extremely marginal cost and controllable input-output mode.

The pharmaceutical industry in India has not yet reached the level of R&D capabilities in China, which also hinders India's development in the CXO frontier areas.

CRO company Parexel claims that government crackdown on Chinese biotechnology partners may have the greatest impact on cell and gene therapy. The company stated in an article: "In the early stages of cell and gene therapy development, transitioning from academia to early-stage biotech companies, developers often heavily rely on external partners. With limited funds and resources, they often exclude establishing internal labs and manufacturing facilities, thus relying on CDMOs to complete experiments and manufacturing processes."

In the field of cell and gene therapy R&D and production, CXO utilization has exceeded 70%, with China's CXO holding a significant advantage in the cell and gene fields.

The U.S. biotech startup Iovance Biotherapeutics is currently collaborating with WuXi AppTec. Its subsidiary, WuXi Advanced Therapies, received FDA approval in February to start manufacturing Amtagvi, a T-cell immunotherapy for unresectable or metastatic melanoma. Amtagvi is the first and only personalized T-cell therapy approved by the FDA, and its rapid progress is inseparable from the support of Chinese CXOs.

Issue 3: Weak large-scale product response and delivery capabilities

Even if the quality control compliance and high-end R&D issues are successfully addressed, the Indian CXO industry still has a long way to go in terms of sustaining stable and expanding production capacity.

"Drug King" Sumitomo Dainippon Pharma and Novo Nordisk, major competitors in the diabetes drug/weight loss field, have also recently emphasized concerns regarding production capacity.

Due to strong demand, Novo Nordisk raised its full-year sales expectations by over $2 billion during the 24Q1 conference call, stating that due to the expansion of its own factories and the increase in capacity of CDMO partners, the production of its weight loss product Mounjaro in the second half of the year is expected to increase by 1.5 times.

Both Novo Nordisk and Sumitomo Dainippon Pharma benefit from the sufficient capacity of related peptide CDMOs in China. Taking WuXi AppTec as an example, the company's TIDES revenue in the first quarter reached 780 million RMB, showing a strong year-on-year growth of 43.1% At the end of the first quarter, TIDES' on-hand orders increased significantly by 110% year-on-year. In January 2024, the overall volume of peptide solid-phase synthesis reactors increased to 32,000L, and the new peptide production capacity utilization rate approached full capacity. The company stated in a conference call that it will continue to increase relevant peptide production capacity.

Recently, WSJ reported that many pharmaceutical companies, including Lilly, believe that suppliers like WuXi AppTec are facing increasing scrutiny from the U.S. government, which could seriously affect their supply capabilities. After all, supporting large-scale rapid delivery and providing expandable high-end capacity is almost an exclusive endowment of Chinese CXOs.

In contrast, Indian CXO companies are smaller in scale, making them vulnerable to the impact of product or customer concentration. Unstable delivery capabilities in India may lead to significant fluctuations in market share. According to industry insiders, related Indian CXO companies often delay deliveries for no reason, arbitrarily change delivery requirements, and the delivery quality is also uneven.

Boteng shares made a similar statement in the first quarter earnings conference call: "Although the cost in India is the lowest, due to issues with overall management system construction, intellectual property rights, most customers believe that the delivery of most Indian companies is unreliable, and the order delivery process is very painful."

During the spread of the COVID-19 pandemic, some European and American manufacturers had previously prioritized Indian supplies to avoid capacity congestion. However, the performance of the Indian pharmaceutical industry turned out to be disappointing. This shows that even in emergency situations, compliant capacity and rapid response remain key to delivery.

Furthermore, the Indian pharmaceutical industry is also highly dependent on the Chinese supply chain.

Global pharmaceutical companies are unlikely to want to shift from one country that is equally dependent on China to another. The objective fact is that even if the Indian pharmaceutical industry intends to reduce its dependence on the Chinese supply chain, the import of APIs from China has not weakened. A study shows that nearly 70% of India's raw materials for drugs still come from China in 2022.

In addition, for companies that rely on large CXOs like WuXi AppTec to commercialize complex drugs, the transfer of the supply chain has an extremely fatal impact.

Even excluding issues such as research and development technology, compliance, etc., the mass production transfer of mature large projects can take several years—because such transfers have a significant impact on the health and survival of global patients, they can only be carried out gradually and orderly after careful overall planning. Any adverse consequences will bring widespread medical ethical issues.

Conclusion

The pharmaceutical industry is a highly globalized industry, with different countries and regions having their own division of labor and complementary advantages in the industry chain. Artificially severing the connection and contribution of Chinese CXOs to the industry will undoubtedly weaken the innovation capability and resilience to meet demand of the entire industry When possessing both R&D capabilities and high-end production capacity for quality control compliance, it is almost impossible to find suitable alternatives in low-cost regions. Forcing a switch that goes against industry norms will only slow down the pace of medical development, make medical innovation bear meaningless costs, increase the suffering of diseases, and impose burdens on patients and frontline medical practitioners. Fighting diseases should be a common vision for all humanity.

Even if such operations are packaged with excuses such as geopolitical conflicts and industrial security, they will inevitably face enormous risks and trigger unstoppable backlash. The author believes that political manipulation cannot stop the medical industry from progressing in a direction that benefits patients and benefits humanity