Essex Biotechnology (1061 HK) – Core products fund investment portfolio

+ Silly low valuation at P/E 8 (net cash) given the companies track record of profitable growth.

+ A number of own developed patented products in the market selling at good margins, with large market share in China.

+ Founder led for 20+ years, building this company from scratch.

+/- Using much of it’s cash flow for investments in products from other research teams instead of dividends or share buybacks, which to me is still a negative. On the other hand the products are related to the companies own core business so the investments makes sense.

– The founders are running a real estate company listed in Singapore as well. It does not seem to be doing very well lately (hotels in Japan).

– A fair chunk of revenue is dependent on a distribution contract with Pfizer, which is expiring in 2021. It has been rolled multiple times since 2014, but its still an unknown.

Background

In the early 1990s, most Chinese pharmaceutical companies were focused on manufacturing generics. Essex instead pioneered the use of recombinant DNA technology (a process that involves molecular cloning of DNA from any species) to develop their own unique series of biologics. The company has obtained seven patents for drugs developed using recombinant DNA technology in China. The company enjoys more almost 60 percent market share in its niche areas (eye products). The high market share is largely explained by their very competitive pricing. For example, its Beifuji spray for treating burns and skin ulcers sells for $5 per 15ml bottle. By comparison, a 2.5ml bottle of Regranex, a widely-used spray for treating wounds and ulcers, sells for $74. The company’s products are used in more than 4,500 hospitals across China. Although Essex never explains it as such, my interpretation is that these products are like an advanced form of generics, which enjoys higher margins than simple generic pills.

The company listed all way back in 2001 and for many years grew revenue slowly of a very low base. The company disposed of an agriculture related business in 2009 and has since then developed in it’s current form. I therefore focus on the history of the company since 2010.

Some of the background story is taken from this article: Essex Bio — Bringing Pharmaceutical Innovation to China

Core products

Essex core products Beifushu series of drops and gels to treat eye injuries, dry eyes, refractive and cataract surgery, and the Beifuji series of sprays and powders to treat surface wounds, including burns, ulcers, and cosmetic plastic surgery. They also make Beifuxin, a gel that repairs and regenerates cells damaged by bruises, burns, contusions, cuts, surgery incisions, skin grafts, skin resurfacing, laser therapy wounds, bedsores, fistulas, and cervical erosions. The products are patent protected until 2030 in China. Essex also undertakes exclusive distribution in China of third party products that complement its area of focuses. Major third party products distributed are Pfizer’s eye products Xalatan and Xalacom, Iodized Lecithin Capsules for treating various eye diseases and Yi Xue An Granules for treating bleeding or spotting of uterus after induced abortion. Below is a picture of the products:

Third party products

The company has built up a fairly large sales network throughout China, which helps the company in penetrating the Chinese market with its products. On back of this network the company has managed to tie some third party products to them, the big one being Pfizer’s eye drop related drugs. This has been rolling contracts that has been extended multiple times since 2014, the current contract expires in 2021. The other two larger distribution agreements are for Iodized Lecithin Capsules and Yi Xue An Granules. The two last agreements have been won by Essex by investing in the companies that owns the products. In total these products are some 15-20% of Essex’s revenue, but less of its profits. Obviously there is some downside risk if Pfizer would abandon this agreement in 2021. Other smaller distribution contracts have also been negotiated, for example with Elektron Technology UK Limited (“Elektron”), where Essex is its exclusive distributor of Henson 9000 until 2024. The Henson 9000 is a machine to detect eye diseases.

Enrichment Programme

In 2015 Essex initiated an “Enrichment Programme” for “enhancing its research and development pipeline and expanding its products portfolio for boosting its competitiveness and maintaining a sustainable growth”. In plain English this means taking some of the cash generated from the core products and investing it in other companies which Essex can co-operate with. When I started to look into this I feared the company is throwing away money in silly projects and perhaps even investing with friends in some type of related party transactions. After having looking into this as deeply I have been able to, this is not the case. It’s rather a portfolio of very interesting assets, many with linkage to Essex core product of eye diseases. Another way to look at this is that company has decided to build it’s research pipeline more on investing with research teams around the world, instead of pouring all cash into a stronger in-house research team. That said, Essex still maintains a decent in-house research team as well. As Essex makes more and more investment the value of the company shifts towards the portfolio of call option like investments in pharmaceutical products in development stage. Essex has by end of 2019 invested some HK$430 million into this programme and has announced further large investments in early 2020. Given that the Market Cap of Essex is HK$2430 million this is already a significant portfolio for the company.

Management & Ownership

Essex is a founder led company, which I tend to see as a big benefit, as long as there is no history of abusing the position or running the company not in the best interest of all shareholders. Patrick Ngiam and his brother Benjamin founded the company some 23 years ago and to this day holds just above 25% each of the shares in the company. The brothers have also founded a Singapore listed real estate company which mainly runs hotels in Japan (IPC Corporation). This company has not done very well over the some 27 years it has been listed, although lately all hotel related companies are getting hammered. This is a bit worrying also from the perspective that Patrick’s time seems to be split between Essex and IPC. Although from what I can see, his brother Benjamin is listed as Managing Director, so I think the brother is more involved in IPC (but nothing that I can confirm).

Business Outlook & Segments

The company has an impressive track record of revenue growth and cash flow generation from it’s core products and third party distribution.

Breaking this down into the three segments available, eye care, wound care and third party product sales we can see that the growth driver over the past few years has been the wound segment. The eye care segment has also been growing, but in the past 5 years at a much slower trajectory. Given how long the eye care products been in the Chinese market, without new product launches and looking at a slowing growth trend I would draw the conclusion that the product is fairly mature in the market and would rather grow by underlying factors as a large population needing the product, rather than growth from market penetration. But listening to sell side research First Shanghai, they claim that penetration in the market is still only 11.5%. This is nothing I have been able to verify elsewhere, but I’m a bit surprised that they estimate the penetration as so low.

Some volatility lately in sales, probably due to the two invoice policy implemented in China. Still trend is increasing sales, especially for the wound care products:

One should also mention that the company seem to see further growth in it’s own developed products. The company is currently expanding its factory in Zhuhai China. The plan is to construct the Group’s second factory with a gross floor area (GFA) of about 58,000 square metres to house the Group’s R&D centre, additional manufacturing facility, administrative office and staff hostel. Construction work has started on 1 January 2020 and is expected to be completed by mid 2023.

Pipeline of products

The main pipeline of products are from the so called enrichment programme, although some new releases of own products has also been made lately. Late last year it was for example announced that: “the company has obtained approval from National Medical Products Administration
(NMPA) for the registration and commercialisation of the preservative-free single-dose rb-bFGF Eye Drops (Single-Dose Beifushu Eye Drops) in the People’s Republic of China (“PRC”).”

It’s important to point out that the company has done all of these investments by the cash flow generated from it’s own products (one convertible loan has also been issues). The main investments which could bring future income to Essex are the following:

Company Amount Invested Timeframe
Abpro Corporation 3.5m USD 2016-2026
AC Immune SA (“ACI”) 5m USD + 0.75m CHF per year Listed company ACI
MeiraGTx Limited 5m USD (1.76% of listed entity) – half sold in 2019. Listed company
Mitotech S.A. (“Mitotech”) 16.5m USD + 20m USD Phase 3 trial. The product if succesful, is expected to be listed in the United States in 2023, the company will enjoy 60-65% of global equity. Ongoing trials
DB Therapeutics, Inc. (“DBT”), 4.5m USD +0.6m Subscription fee (45% of company if converted) Ongoing
Chengdu Shanggong Medical Technology 20m CNY (8% equity) rolled to 15m CNY Ongoing

Mitotech co-operation is the investment that stands out

The largest amount invested and the by far most interesting product is Mitotech’s drug for dry eyes based on it’s SKQ1 ingredient. The product is already approved for sales in Russia under the name Visomitin. Essex together with Mitotech now wants to bring the product to USA. Here is some info about the SKQ1 ingredient: Mitotech SKQ1. And this is the paper which explains the trial process for getting the drug approved in Russia: Results of a Multicenter, Randomized, Double-Masked, Placebo-Controlled Clinical Study of the Efficacy and Safety of Visomitin Eye Drops in Patients with Dry Eye Syndrome. As you can see the products Essex invests in, is very much in line with the companies strategy. Although Essex is a small company, in this niche it acts like a larger player, funding a small research team to get a product through the trial stages. Given that this product is already listed in Russia, I’m pretty bullish on the phase 3 trials being approved, but you never know. This would by my understanding be the first product where Essex would launch something which is a world class product with the margins that comes with it. It’s current products sell well in China, because they are competing on price with equal or better products sold by the big Pharma companies. The Visomitin product would be different story.

The second most near term interesting investments in my view is the Chengdu Shanggong Medical Technology.  The company uses medical data analytics (AI Algorithm) in the medical service industry in China. Using 700,000 retinal images of diabetic patents in China. The AI Algorithm can screen retinal images of patients and detect diabetic retinopathy, which affects almost a third of diabetes patients that would otherwise be examined by highly trained ophthalmologists.

Valuation

As has been prestend above the revenue and profit growth of the company has been very strong. The share price had done nothing the past 5 years though. This can be explained by again, like many Hong Kong companies a serious multiple contraction. This used to trade like a US/Europe medical company at P/E between 15-30, but is now instead down at P/E 8. Partly this can be explain by the changes in China’s invoicing system for purchases of drugs. This has in general contracted the multiple for these type of listed companies. But the fact is that Essex has had very limited damage done to it’s revenue and profit margins due to this. In fact the operating income margin has increased over the past years, from stable around 20% upwards to 26% for 2019. One would think that would warrant a higher multiple but so far no.

The company has as presented two parts:

  1. The cash flow generating core business, which can easily be valued by a DCF
  2. The enrichment programme which is much harder to value, but where we know that the company has invested some 430 million HKD. Parts of those investments are done to drive revenue to the core business.

Assumptions – Essex Core

IFC has a 150 million HKD convertible loan with conversion price 5.9 HKD per share (maturity July 2021). Given that the share price is so far away from 5.9 I will give less weight to the share dilution of such a conversion and just count it as debt.

Discount rate = 10%

Revenue growth rate = 0% growth this year due to Corona and 5% for 9 years, 2% in perpetuity (last years growth was 8% and year before that was 30% growth).

Operating Margin: Decreasing from 25% back to long term average of 20% over 5 years.

Investments = 40 million yearly, for factory increase etc.

Net Cash = 300 million HKD

Valuation = 7.4 HKD per share an 80% upside from the current level.

Conclusions

This above valuation is with very conservative assumptions on growth and even decreasing margins. This is also not accounting for the investment portfolio and the value add the Mitotech co-operation could have in a few years time. It’s pretty easy painting a bull scenario with an extremely high valuation. Say growth continues at a historically more average pace of some 15% per year, with 2019 margins. The valuation is such a bull scenario comes out at some 12-13 HKD per share. A more simple way to phrase it would be that if the company trades at a 24x P/E multiple, the share is trading in that range.

I think this company is a really hidden gem on the Hong Kong exchange, a bit more risky than some of my other holdings. It’s not easy to judge the competitive landscape in China for it’s drugs, so there lies the major risk. To be honest I have not been able to figure out if there is any other product being developed by a competitor that could threaten Essex sales. This would obviously be a huge risk, at the same time such a product would need to either be better and/or much cheaper. Given how long time it taken Essex to reach the penetration it has in the market, I think that says something about the moat of this niche product segment. In my view it’s well worth taking that risk which such a strong track record of profitable growth over such a very long time period. I deploy my 5% cash to this holding as of latest available close (Friday). I hope you enjoyed yet another HK “growth at a reasonable price” case! There are a lot of those on the HK exchange and I think this is among the very strongest ones I have been able to find.

 

7 thoughts on “Essex Biotechnology (1061 HK) – Core products fund investment portfolio

  1. thanks for this excellent summary. the valuation is quite good and I think the company might have some good fortune for its investment (as examined by you). I know nothing about these medicines though.

    have you looked into the company’s receivables (some overdue, overall quite large?)? also the dramatic
    “sales and marketing expenses” comparing to the revenue: this might contribute to the low valuation, which upon my impression is a similar trend (“valuation” depressions) in last year China A share markets too (regulation concerns, and then the market might over-react or what? I don’t know). Related is its surgical business, which I think sales fees intensive, I didn’t capture how did you evaluate that part of business – competitiveness?)

    all in all thanks for the idea for us, again. (I’m a recent regular reader of your valuable blog, no crucial insights but just some cents…)

    1. Thanks Gokkog, good points that you bring up!

      Receivables is always good to look at as a warning sign. It has gone up quite a lot indeed, 50% increase. But looking at the aging of it, almost to whole increase sits in 0-60 days, which makes me much less worried. But of course it’s still a negative and you are right, the more than 3 months past due has actually increased some 18m HKD.

      Regarding distribution and selling expenses, I think this how the Pharma market in China works, reaching out to all those hospitals around China costs a lot in terms of “distribution and selling” especially for a smaller player like Essex which is also selling fairly low cost products. Then these expenses eats up a large part of revenue. If we look at a bigger player like Fosun Pharma that I owned in the past. They have Revenue of 24bn CNY and have selling & distr expenses of 8bn, so about a third of revenue. Essex is at 50%, so higher, but it’s still not strange given Fosun’s larger size and bigger own network.

      I did not really evaluate the competitiveness, I just look at sales growth and draw the conclusion that they seem to be doing a lot of things right. My impression is that they have a good product where they compete on price versus the western developed products at much higher price. I have not found any Chinese local competitor which is listed or so which have the same type of product.

      1. thanks for the comprehensive response. In China I believe the regulations have something to do with the big distribution and selling expenses in recent years, e.g. “central bidding” and cost cutting for medical system as well as anti-bribery/inappropriate-marketing campaigns. I am really outsider individual investor, particularly know little on med, but I saw some very secular “strong” growth pharm companies (A shares listed) with big distribution and selling expenses got hammered (somehow for revenue, and big for market cap) in last year and on. Also there’s a difference valuation for generic medicines v.s. _I_don’t_know_the_name. In short, you might be aware the regulation arena.

        (this 8X P/E is still valued lowers than 15X or 12X PE for what I compared the A shares companies, they have much larger sales and the valuation between HK v.s. A shares have some diff) Anyway, I’m not having a clear “position” :))

        I’m based in Shanghai, we may grab a coffee if you happen to be here someday!

        1. If you read Chinese maybe you can help me check what the compeeting products are in the local market? If I understood things correctly its all medicine prices has suffered, generica and patended products, since China centralised purchasing and pricing with the aim to lower the cost for providing good healtcare to the population. Given the current lock downs it will be a while before I visit Shanghai again..

          1. yes i’m native Chinese. however i don’t really get any keywords concerning the company’s surgical product(s), did you? (I briefed the 2019 annual report Chinese version). your understood is aligned with me. esp. for some generic products the competition is very fierce from general news broadcasting. and there’s a sentiments (mid 2019 particularly I think) for the media and related market to question the huge distr/selling fees. that’s the point you already have been aware of.
            time slows down and hopefully it will get back to usual track. stay safe!
            you can add my wechat if you have one (I modified the email addr with my wechat name)

  2. Super Interesting ! That said, and considering Luckin’s recent lesson, I would preventively factor in a 20% ‘ad-hoc’ cut in the aforementioned valuation… hence 5.9 HKD (50% upside?).

    Seems as Chinese are very bad at accounting: both in Luckin and in Covid-19. 🙁 !

    1. I think all China companies have a discount due to this long before Luckin. This company has been listed for 20 years, so it would need to be a very long term scam in this specific case. Also the cash invested in other investments is proof that the cash generated is real.

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