WXIBF - WuXi Biologics: Room For Valuation De-Rating (Rating Downgrade)

2023-05-08 14:56:19 ET

Summary

• WuXi Biologics (Cayman) Inc.'s short-term and mid-term financial guidance suggests that the company's revenue and earnings growth rates will be slower than what they were in recent years.
• Potential financing difficulties for the company's customers and the possibility of new policies targeting Chinese biologics outsourcing companies are the key risk factors to watch.
• I am of the view that WuXi Biologics (Cayman) Inc. shares have meaningful downside, taking into account the stock's current PEG multiple of 1.2 times, its outlook, and risk factors.

Elevator Pitch

My rating for WuXi Biologics (Cayman) Inc. (WXXWY) [2269:HK] stock is a Sell.

My prior update for WXXWY published in mid-December last year focused on a potential re-rating catalyst for the company and the market's worries relating to the Chinese biologics outsourcing industry.

In the current article, I touch on the outlook, risk factors, and valuations for WuXi Biologics. The company's financial outlook is unfavorable, and it faces significant risks relating to the difficult financing environment and worsening U.S.-China ties. Moreover, the company's shares are expensive at 1.2 times PEG ratio. These factors discussed above lead me to downgrade my rating for WuXi Biologics from a Hold to a Sell.

Readers should pay attention to the fact that WuXi Biologics' stock is traded on both the Hong Kong Stock Exchange and the OTC market. The mean daily trading value for the company's OTC- and Hong Kong-listed shares in the past 3 months are reasonably decent at approximately $0.7 million and $140 million, respectively as per S&P Capital IQ data. Investors can turn to stock brokerages which offer foreign markets trading like Interactive Brokers to buy or sell WuXi Biologics' shares listed in Hong Kong.

Financial Guidance Points To A More Modest Pace Of Growth

At the company's earlier fiscal 2022 earnings briefing in late March, WuXi Biologics shared its short-term and intermediate-term growth guidance. Specifically, the company sees its top line and normalized net income expanding by +30% and +26%, respectively for full-year FY 2023. WXXWY also think that it can deliver a three-year revenue CAGR of +30% and a bottom line CAGR of +26% for the FY 2023-2025 period.

On the surface, WuXi Biologics' near-term and medium-term top line and bottom line growth expectations appear to be pretty decent. In actual fact, WXXWY's management guidance points to a significant growth deceleration for the company. As per historical financial data obtained from S&P Capital IQ , WuXi Biologics' revenue CAGR for the FY 2019-2022 period was +56.7%, while its normalized earnings CAGR in the same time frame was +60.0%.

With regards to the top line, WuXi Biologics' revenue in the last couple of years was boosted by higher demand driven by the COVID-19 pandemic, which isn't sustainable. WXXWY noted at its FY 2022 results call that the company was "capturing all the COVID-19 opportunities" which drove "the past 3 years (2020-2022) of super growth," and highlighted that it was inevitable that the "transition from a high COVID-19 revenue to a low COVID-19 revenue" will eventually happen.

Separately, there are multiple factors that will affect WuXi Biologics' future profit margins and earnings growth in a negative way.

Firstly, WXXWY has chosen to prioritize market share gains over profitability improvement. WuXi Biologics has largely maintained the company's prices at the same level as compared with 10%-15% price hikes for its peers, as per the company's management commentary at the recent fiscal year earnings call. This implies that the company has decided to absorb the rise in costs, so as to remain price competitive and try to gain market share at the expense of rivals. It remains to be seen if WXXWY's pricing strategy will be successful, but the company's margins and bottom line will take a hit first.

Secondly, WuXi Biologics will most probably suffer from higher start-up expenses and negative operating leverage effects (associated with low utilization rates) with new facilities in Germany, the U.S., and Ireland coming onstream this year. As an example, WXXWY indicated at its FY 2022 results briefing that the new facility in Ireland is targeted to achieve a utilization rate of 65% by 2025 at the earliest.

Thirdly, the company needs to allocate a greater proportion of its cash flow to maintenance capital expenditures in the coming years. As discussed above, WuXi Biologics was doing very good business in the past few years as a result of pandemic-driven demand, which meant that most of the company's facilities were running at close to full utilization with limited time for maintenance. In other words, WXXWY has to endure some extended periods of shutdown going forward, as some of its existing facilities undergo maintenance in the future.

Tough Financing Environment And Geopolitical Tensions Are Key Risk Factors

There is a possibility that WuXi Biologics' top line and net profit growth for the years ahead could be even slower than what the company is currently guiding for, assuming certain risk factors materialize.

The first key risk factor is the adverse impact of the tough financing environment for WXXWY's customers. A rising rate environment coupled with recent bank failures have definitely made it more challenging for companies to secure financing, and if WuXi Biologics' customers get into financing issues, this could translate into below expectations sales. According to a March 24, 2023 OCBC Investment Research report (not publicly available) titled "Wuxi Biologics (2269 HK) - FY23 Guidance Maintained," "small to mid-sized biotech clients" accounted for "two thirds of (WuXi Biologics') its 2021 sales."

The second risk factor is related to the U.S.-China rivalry and relations. Bloomberg recently published a news commentary on April 20, 2023 citing its sources mentioning that "Biden aims to sign an executive order in the coming weeks that will limit investment in key parts of China's economy by American businesses." In terms of the impact of worsening U.S.-China ties, WuXi Biologics also acknowledged at its FY 2022 results call that "certainly, without the China-U.S. tensions, we could even do even better." In a nutshell, the geopolitical issues have already affected WXXWY's business and financial performance to some extent; things could get worse if the U.S. specifically targets the Chinese biologics sourcing sector that WuXi Biologics operates in with new measures or restrictions.

Valuations

The market values WuXi Biologics at a consensus forward next twelve months' normalized P/E of 31.2 times now as per S&P Capital IQ's valuation data. Using a price/earnings to growth or PEG ratio of 1 times as a benchmark for fair valuations, WuXi Biologics' shares have a downside potential of around -17% (its current PEG is 1.2 times) considering the company's guidance of a +26% earnings CAGR for the next three years.

Closing Thoughts

WuXi Biologics (Cayman) Inc. shares are trading at above 1 times PEG multiple, even though there are meaningful risk factors for the stock, and the company is expected to witness a more moderate pace of growth. In that respect, I think that a Sell rating for WuXi Biologics (Cayman) Inc. is fair.

For further details see: