Addition to the U.S. Unverified List
• Quick tumble in share price this morning before trading was suspended, which looks overdone.
• Management has clarified the addition into the U.S. Unverified list differs from the Entity list and likely arose from delays in physical end-user onsite inspections by the U.S. DoC amid the extended period of pandemic related travel challenges.
• While “very minimal impact to business” is expected given its stockpile and access to other suppliers, near term overhang is likely as the firm explores interim measures and seeks on-site inspections by the U.S. DoC, with some supply chain disruptions expected.
• Fair value is trimmed to HKD136, as we adjust our DCF estimates to incorporate a higher cost of equity.
Share price tumble and trading suspension today following reports that two of its company units are amongst thirty-three Chinese entities added to the U.S. Unverified List by the US Department of Commerce. Wuxi Biologics’ share price fell ~23% to HKD62.25 this morning before intraday trading was suspended in the wake of uncertainties from reports that two of its company units were amongst 33 Chinese entities added to the U.S. Unverified list by the Bureau of Industry and Security (BIS) at the U.S. Department of Commerce (DoC) for receiving U.S. exports.
Implications for entities named on the Unverified list: As a background, we understand that the DoC
adds organisations to the Unverified list in cases where it is unable to establish – which can include an end-use check – if key export items are used in a legitimate and reliable manner by the entities added to the list. Entities added to the list are not eligible to receive items subject to export administration regulations (EAR) via license exception.
Management call highlights – In the investor call today, Wuxi’s senior management stressed the company is in compliance with U.S. export control rules and expects the addition to the U.S. Unverified
list to have “minimal impact” on its business. The inclusion is anticipated to affect its U.S. imports of certain parts of bioreactors and niche filters (which are used in ~5% of its total projects). In a worse-case scenario if the firm remains indefinitely on the unverified list, it plans to reach out to alternative suppliers based in Europe, Japan and China. Switching vendors is not likely to impact margins meaningfully although time may be required to make changes for affected projects.
Unverified list differs from the Entity list – During the call, the firm stressed that the U.S. Unverified list differs from the U.S. Entity list (which Wuxi is not listed on), where entities’ conduct on the entity list could be viewed as harmful to U.S. national interests). The firm reiterated its prior communication that it has no dealings with Chinese firms linked to the military.
Why was it added to the U.S. Unverified list? The firm believes the inclusion into the U.S. Unverified list
likely arose due to repeated delays over the past years in physical onsite inspections taking place in China by the U.S. BIS team as a result of the pandemic requirement for extensive quarantine for travelers into China, which led to the incompletion of routine process required to verify proper use of select items it imports from the U.S. (controllers for bioreactors and hollow fiber filters) that are subject to export controls.
Rectification steps with the U.S. authorities are being actively pursued at the moment, timeline looks indefinite while further share buybacks may be reviewed at a later stage – The firm stressed it does not re-export or re-sell items subject to U.S. export controls and is reaching out to authorities to initiate the process of being verified in order to be removed from the list. Its legal team is preparing to reach out to the U.S. commerce department. Management plans to pursue interim measures such as arranging physical inspections of its Chinese sites by the global BIS inspection team based in U.S. or as an temporary measure, explore the possibility of a potential onsite inspection by the U.S. DoC team which has an office based in China although its understanding is that the staff based in this location could have more general background.
Some supply chain disruption looks likely but overall business impact should be manageable – Our understanding is that U.S. suppliers will likely be required to have a license to sell items on the export control list (e.g. bioreactors and select filters) to firms on the Unverified list, which can result in disruptions in the purchasing process. Wuxi Biologics has shared that it expects very minimal business
impact from the latest inclusion to the U.S. unverified list given it already has a solid stockpile of production material in its inventory (~6 months for specific filters). With increased concerns on geopolitical risks over the past years, it has and will continue to work on diversifying its suppliers across geographies. The firm shared there are 4-5 suppliers based in Europe and Japan which it can approach in the event it needs to find alternative suppliers for the specific items impacted by its inclusion in the unverified list.
Trimming fair value to HKD136, incorporating a higher cost of equity within our discounted cashflow analysis. While rectification steps relating to the unverified list inclusion are being pursued at the moment and near-term earnings outlook remains positive, the longer-term impact remains to be assessed, given uncertainties on the timeline it may be removed from the unverified list, success in navigating the upcoming supply chain disruptions (firm plans to negotiate with other non-US firms based in Europe and Japan) and heightened investor worries over geo-political risks.
We maintain our view that the stock is more suited to more aggressive, growth-oriented investor profiles who can tolerate higher volatility and its previously flagged out geo-political risks. The company’s strong additions to its total backlog to date should continue to underpin growth, driven by successful execution of its follow-the-molecule and win-the-molecule strategies and continued resilience in outsourcing demand globally. The firm has recently issued a profit alert guidance for profit attributable to equity shareholders to increase more than 98% for FY21. We expect continued positive operational performance in FY22E but expect near term share price overhang due to uncertainties from the latest U.S. Unverified list inclusion, slowdown in domestic environment and more stringent regulations. Next reporting is expected late March 2022.
ESG updates
The company ESG rating pegs the firm in the top 41% of global peers being covered despite the downgrade in July 2020. While the firm scores well in governance and product safety & quality categories (performance appears to be stronger than peers), its positioning relative to global peers is rated negatively for human capital development and carbon emissions, with more room for improvement cited in areas such as limited policies observed to address issues such as business ethics and corruption. Wuxi Biologics is committed to ICH Q5Q (R1) standards in terms of raw material supplements and conducts regular employee training and quality related audits in its operations, with no major product recalls over the past three years although there was one Form483 (as of November 2020). It has also taken steps to work on its talent management practice and implemented an independent employee engagement program from a third party to track employee satisfaction and retain productivity and staff morale. Fair value of HKD160 is based on DCF valuation, which incorporates the latest guidance of higher growth expectations, long-term growth rate of 3.8%, increased CMO revenue contribution and the company’s higher than domestic peers’ ESG rating. BUY. (Research Team)