【VSP Insights】Healthcare Sector in China and US: 2021 Review & 2022 Outlook

Review: record IPOs, waning demand and anemic performance paired with macro overhang

The healthcare sector in both China and the US, with healthcare groups consisting mainly of biotech and pharma companies, went through a rather tough year in 2021, after a retail frenzy that fueled the space in 2019 and 2020.

The Supply and demand imbalance was one culprit behind last year’s pull-down. Supply spiked with too many IPOs in the industry. Meanwhile, demand shrank with retail investors and generalists exiting the space.

The IPO rush was palpable in the US where the market began to see a record level of biotech firms going public starting Q2 2020, both in the number of deals and in the value raised (as shown in Chart 1 & 2).

Chart 1: US Biotech IPO: deal count (green line) and dollar value (blue bar)

Source: Bloomberg. Data as of Dec. 31, 2021.

Chart 2: China and HK Biotech IPOs: deal count (green line) and dollar value (blue bar)

Source: Bloomberg. Data as of Dec. 31, 2021.

The number of constituents of the SPDR US biotech index (XBI), an equal-weighted index of all biotech companies listed on the NYSE, Nasdaq and Nasdaq Small Cap markets, went from around 120 pre-pandemic to some 180 as of November 2021.

A direct result from that IPO rush, and from the sector bull run in the two years prior, was unduly high valuation. And then, there was the ensuing drawdown (as shown in Table 1). The XBI logged -33.9% in performance since January 2021 till February 2022.

There was divergence between the XBI and the Nasdaq Biotech Index (NBI) despite their similar market breadths, with the NBI posting a milder loss of -15.5% over the same period. That divergence was due mainly to the vaccine-makers’ contribution. Moderna, BioNTech and Gilead have been the top three contributors in NBI and their weight in XBI is much smaller as per XBI’s equal-weighted property.

Table 1: Major healthcare indices performances (as of Feb 2022)

Cooled M&A activities in 2021, and hence less M&A premium in biotech valuation, also led to the sector drawdown after three years of high M&A volumes in the US biotech space (as shown in Chart 3).

Chart 3: US Biotech M&A activities: deal count (green line) and dollar value (blue bar)

Source: Bloomberg. Data as of Dec. 31, 2021.

Additionally, interest rate hike, inflation and supply chain pressures acted as macro pressure on the sector’s growth assets valuation.

Outlook: signs of betterment, but challenges loom large

Strong fundamental side

With many ETFs and generalists having sold and exited biotech assets in 2021, retail investors have looked, or are looking, to Covid names in the market.

The sell-off has also created price dislocations for quality companies who suffered even larger drawdown recently as they are more exposed to those flows.

In the US, the fundamental side remain solid. Innovation is still strong, and the industry continues to report promising progress of drug research and development, which has been and will be a big draw to investors.

Off the back of that positive momentum, the suppressed M&A activities are expected to return which will likely to provide a valuation floor for biotech companies with innovative pipeline, as cheap valuation of targets and healthy book of big pharms present themselves to be profitable and desirable (as shown in Chart 4). It takes the 3.6 years’ free cash flow generated by top 23 US big pharms to acquire the entire US biotech company space below 10B market cap. The number of years is at historical low and comparable to 2016 when the market rebounded strongly with three years’ bull run.

Chart 4: Big Biopharma’s buying power from 2016 to 2024

Source: RA Capital. Data as of Dec. 31, 2021.

Technical side remains challenging

On the IPO front, the US market can expect the supply and demand balance to be improved, now that biotech IPO activities have more or less returned to the pre-pandemic level, with the number of IPOs decreasing and the big pharm demand growing. With some stability, the market may even see mean reversion back to the 2019 level in IPO crossover activities. However, challenges facing the market are conspicuous from the fund flow perspective. The market may see redemption from, even closure of, some underperforming biotech hedge funds, and this may further pressure the sector.

As for the regulation aspect, the FDA approval continues to be supportive.?In addition, the US price control measure has come much better than most investors expected, which clears the regulatory uncertainty that clouded the market in 2021.

China biotech

China’s fundamental side is a mixed bag. Innovations in the country’s healthcare industry continue to be accounted for, but geopolitical issues, such as the US putting China-backed pharmas on its Unverified List to restrict their access to key experimental components, have dimmed the prospects. This means limited access to overseas market for players in the China’s healthcare space, while the home market faces regulatory pressure.

Against that backdrop, how Chinese companies can ensure foundational capabilities of innovation and monetize the innovation, and hence incentives for their growth, is in question. If the return upside from the reduced access to overseas markets and diminished innovation capabilities continue, the risk-return landscape of biotech investment in China will need to brace for challenge.?

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