China Medical System (867.HK) Armed against Short Selling! The Biggest CSO Took Control of Full Industrial Chain


The short-selling company Blue Orca Capital would not have expected that its confrontation with China Medical System Holdings Limited (“China Medical System”) actually helped the company. The confrontation allowed investors and the whole pharmaceutical industry in China to see the biggest CSO has quietly reached the end of its transformation into a new empire that has established full control over an industrial chain, from sales and marketing to production and quality, and has jumped from the domestic market to a company driven by global R&D innovative resources.

By reviewing the seemingly detailed report from Blue Orca Capital (“Orca”) and a brief but solid response from China Medical System issued on 7th February, as well as an interview with Mr. Lam Kong, Chairman of the board of China Medical System, Healthcare Executive tried to review the path of China Medical System’s most essential product upgrading experience, especially the globalized market and operation capacity of R&D resources from its large overseas companies groups, which was disclosed to the public for the first time. Throughout its development in the recent decade, China Medical System, as a leading CSO, has been revolutionizing itself since it was listed on the stock exchange. The journey of detaching itself from CSO and marching into the full industrial chain was full of tensions and challenges.

01. Malicious digging exposed a brand-new China Medical System
On the morning of 6th February, Orca released a 41-page short selling report against China Medical System. The report indicated that the profitability of China Medical System was fictitious and the actual net profit was 49% lower than the reported number. It also raised doubts that China Medical System was involved in private deals and corruption.

At 11:17 a.m. on that same day, China Medical System called for an immediate suspension in the stock market, which did not prevent a slump in its stock price of 12.7% in just 9 minutes. However, the price soon bounced back by 9% in the next 14 minutes. The closing price before the suspension was only 1.9% lower than that of the previous day. Despite the rollercoaster, the overall price still remained stable compared to that of companies involved in other short selling cases.

Companies listed in the Hong Kong Stock Exchange are regularly targeted by short sellers and these incidents have been growing more frequently since 2019. Orca has already attacked Pinduoduo, ANTA Sports and Kasen in the past year but these companies’ stock prices all surged after they resumed trading. ANTA, in particular, short sellers were frustrated when Anta’s share price hit a record high after rounds of short selling. Generally, companies pinned by the short sellers usually have much higher profit margin or much lower costs than that of their peer companies, or they have high continuous growth rate or burn rate. In the pharmaceutical industry, the short sellers once targeted Genscript, the parent company of Nanjing Legend, and BeiGene, which were both investing high in R&D and bearing high risks.

China Medical System was also in a key stage of transformation and the company has thus far proceeded with a stable operation and good profit margin. On the night of 7th February, China Medical System made a clarification announcement, providing responses to all Orca allegations, concluding that these allegations were “groundless and seriously misleading”.

Healthcare Executive quickly reached out to Mr. Lam Kong, the Chairman of the Board of China Medical System and set up an interview. Surprisingly, this company with relatively low profile decided to disclose an unprecedented amount of details, many of which were revealed for the first time. The abundant evidence provided by China Medical System not only crushed any allegation made by the short sellers, but also indicated that after many years of strategic transformation, a new China Medical System was appearing and that this new China Medical System had new ambitions and aspirations.

Throughout the company’s history, China Medical System was referred to as “the leading CSO”. But what is a CSO? It allows pharmaceutical promotion and sales activities based on powerful pharmaceutical promotion capacity and network coverage. Lam Kong barely explained the title, but it was clear that the association of CSO with China Medical System has obscured the development logic of the company over the past few years. This was the first time Mr. Lam Kong shared the innovative development of China Medical System with the public and unveiled the global competitiveness of China Medical System hidden under the “iceberg” of pharmaceutical marketing services.

02. The strongest fightback: up to 40% dividend for 10 consecutive years
Orca asserted that China Medical System overwhelmingly exaggerated its financial performance with an inflated profit of 49%. China Medical System replied in the “Clarification Announcement” that the company has maintained a constant 40% dividend payout ratio with its continued investment and low debt status since it was listed. It would be impossible for the company to realize such a high payout rate if the reported 49% profit were false.

China Medical System landed on Hong Kong’s capital market in 2010. According to the financial reports, from 2010 to 2018, the company’s annual profit rose from RMB 206 million to RMB 1,844 million, a compound annual growth rate of 32.9%. Throughout the decade, the company maintained a payout ratio of 40% of the net profit, with the accumulated dividend of RMB 3.08 billion.

“It was like I earned 100 yuan, to which you said 49% of what I earned never existed, and that in actuality I only ever earned 51 yuan. Then, from that 51 yuan, I paid 40 yuan to the stakeholders as dividend. My question to you would then be, do you really think China Medical System is that foolish? How would it be possible to run the company and complete investments with the remaining 11 yuan? Why would I do this?”, said Lam Kong.

In fact, the cash flow and the gearing ratio of China Medical System have both been maintained at a good level. According to the previous financial reports, only the gearing ratio in 2016 and 2017 reached 16.5% and 20.7% while those in other years stayed below 15%. Through these periods, China Medical System was buying products. In particular, in 2016, it spent $310 million on the commercialization right of AstraZeneca’s exclusive product Plendil in China, which has become a classic case in the industry. As Lam Kong put it, “High payout ratio, low gearing ratio, and abundant cash cooperation cases overseas, these are enough to prove the profitability of China Medical System”.

From the short selling report, one of the major reasons behind the allegation of inflated profit was, “China launched the Centralized Procurement of Drugs with targeted volume in 2018. The policy directly forces down the price and weakens the value of marketing network. The profits of other agents all decreased while China Medical System’s profitability was still reported to be promising with continuous growth, which was very confusing.”

This type of “presumed-guilty argument” is absurd. Based on Healthcare Executive’s observation of the industry, the pharmaceutical industry in China is undergoing a drastic change. Although price-reducing policies like centralized procurement of drugs squeezed the profit of mature original drugs and generic drugs, the innovation encouraging and medical insurance policies are stimulating industrial growth. In the past year, multinational pharmaceutical companies with innovative drugs like Merck, Roche and AstraZeneca have undergone unprecedented growth. The sales of drugs that have not been listed in the centralized procurement are still increasing. By the advantages of its products, China Medical System is clearly more similar to multinational pharmaceutical companies.

So far, the products that contribute the major profits of China Medical System have not been affected by the centralized procurement. According to the upgraded procurement policy, it only applies to the products with at least one original and no less than two generics. Among the major products that China Medical System promotes and sells, Deanxit is the only product for which there is one generic competitor that has passed consistency evaluation. No other product has so far been affected. This also shows how unique and forward-looking the company is in its choice-making regarding products selection. It is expected that in the following 1 to 2 years, the products of China Medical System will not be listed in the centralized procurement.

Orca also reported that China started the two-invoice system in 2017, which directly affected China Medical System which lies between the manufacturers and agents and that the company’s position in this value chain was significantly challenged. But in fact, the two-invoice policy indicates that the national exclusive agents of imported drugs are deemed as manufacturers. The imported drugs, self-produced products and the products produced by the subsidiaries of the China Medical System would not be affected. For some non-self-produced products, the only difference is changing from low ex-price to high, which only affects the way of financial recording but not the profit. The allegation made by Orca not only seems too general, but also reflects its lack of knowledge about the pharmaceutical industry.

03. Products upgrade reflects an “alternative” path of R&D
After the release of Orca’s report, the three cases of overseas innovative drug investment, though little attention was paid to them previously, also came into public notice. This allowed the public to understand how China Medical System introduces products and the logic it employs regarding product upgrade and iteration.

Lam Kong explained that China Medical System is taking an “alternative” path of innovative drug R&D. It is defined as “alternative” because the common R&D path for pharmaceutical companies is simply R&D (research and development) but China Medical System is taking the path of S&D (search and development). China Medical System is enriching the product lines of innovative drugs by seeking high-quality innovative drug projects worldwide and participating in the early-stage research and development. In fact, in the recent two years, this pattern has been adopted by more and more companies for innovative drugs. China Medical System, on the other hand, has been pursuing this method of development for a considerable period of time.

The three “corruptive deals” raised by Orca were the products deals with three startup R&D companies, Helius, Faron and Neurelis, which Orca revealed all ended in failure.

China Medical System replied that the company’s requirement for its products is in global perspectives, to meet the clinical needs. It is well-known that this kind of products possess relatively high R&D risks in the early stages. The listed company is usually very cautious about this kind of investments due to concerns of stability. Therefore, as the major stakeholder of China Medical System, Lam Kong spent his own money to pay upfront for purchasing these products. And he also undertook the risks of investment failure. Lam Kong would not transfer the product (including the intellectual property and sales rights) to China Medical System until the product had achieved substantial progress. Lam Kong even joked that it was really rare to see such a good stakeholder being so loyal to the company, personally taking responsibility for all of the risks while giving all of the benefits to the listed company.

Besides, these investment cases are not exactly the “disastrous investment” described in the short selling report. In 2015, when Lam Kong was investing in Neurelis, the drug had not yet reached the clinical stage and was highly uncertain. As China Medical System announced on 13th January 2020, the U.S. FDA has approved Neurelis’ diazepam nasal spray for marketing in the U.S. market by epileptic patients of 6 years of age and older, who suffer from intermittent and stereotypic epileptic seizures. This product has recently received the clinical trial notice from NMPA. After five long years of tireless efforts, Lam Kong had achieved his first overseas investment success.

It is clear that Lam Kong had already made attempts in introducing R&D innovative products overseas while the company remained focused on the sale and promotion of drugs in 2015. His vision and strategic pace were a step ahead of the industrial development. According to him, the transformation of China Medical System started as early as 2013.

In February 2013, China Medical System had already acquired the exclusive sales rights for at least 9 products including Deanxit, Ursotalk, Ganfule, Stulln and Xinhuosu. By then, Lam Kong noticed that the market for Ganfule, a product treating liver cancer, was constrained by upstream manufacturers. To make a comprehensive market plan for Ganfule, China Medical System spent RMB 81.10 million acquiring the manufacturing plant of Ganfule, Lengshuijiao Pharmaceuticals, and thereby obtained full control of the product. Since then, the company has continued to pursue product rights, including those for Lamisil, Parlodel, MOVICOL, Combizym, Hirudoid, Stulln and DanShenTong. The company even started a war with Tibet Pharmaceuticals for the controlling rights of Xinhuosu, eventually bringing this product into its product line as well.

From then on, China Medical System has gradually introduced a pattern of introducing products covering exclusive sales rights, rights control, equity cooperation and self-production, enabling the company to gain more and more control over the product. This has become known as the “China Medical System pattern” within the industry. This pattern was best exemplified when the company bought Plendil from AstraZeneca in 2016, proving that China Medical System had established a deep cooperation with major multinational companies.

Since 2015, Lam Kong has noticed the innovative trend in the Chinese pharmaceutical market and got down to the business of introducing innovative drugs, which opened the second stage of the transformation. This process was conducted by the personal and stakeholder investment, like the Neurelis project mentioned above.

In 2017, as the overseas business development team was growing mature, considering the high risks of on-going R&D drugs, Lam Kong and China Medical System each handled half through equity investment. Once the investment succeeded, China Medical System could obtain 100% of the drug’s rights and take over the global R&D resource and talent resources. According to the annual report, in 2018, China Medical System strategically invested in several R&D companies from the U.K., France, Switzerland and America and acquired the rights of 5 major innovative drugs in China and part of Asia-Pacific markets. The company also purchased the exclusive rights of two products in China from an Israel biopharma company.

In 2019, the centralized procurement policy was released and quickly spread. Though China Medical System’ products were not yet affected, Lam Kong still expected to increase the pace of business innovation and introduce more good quality products to the Chinese market. China Medical System started to purchase some products approved by the FDA but not yet launched in China. For example, it bought the exclusive licensing rights of two innovative drugs and five generic drugs from Sun Pharma in India and signed another contract with Sun Pharma for the licensing rights of five innovative drugs including Paclitaxel injection concentrate in November.

This is the strategic map of the acquisition journey China Medical System has followed. It is also a history of how its products structure has evolved in response to changes in relevant policies. By investing in the overseas innovative R&D companies, China Medical System was also able to arrange its resources for global innovative research institutes and talents while also extending its business to cover the full medical industrial chain including R&D, production and marketing. Starting from a CSO company, China Medical System has been detaching itself from CSO and transforming to a “well-established, innovation-driven specialty pharma with a focus on sales & marketing in China.”

To Lam Kong, the logic is very simple, “The purpose of research is for the products, rather than the research itself. There are many ways to meet the unmet clinical needs and get the valuable drugs. Overseas business development is also a capability.” Driven by the innovation and the policy of centralized procurement, China Medical System has always been leading the way in the development of the pharmaceutical industry under tight regulations. Making preparations before everything becomes apparent makes a wise man.

04. Under the iceberg: establish a global industrial chain system
Over the past half month, China Medical System spent the busiest Spring Festival ever with its global partners. After the outbreak of the new coronavirus, China Medical System immediately called upon its global partners and purchased 200,000 N95 masks and 50,000 children masks from overseas. The supplies were transported and successfully passed through customs thanks to its global business supply chain. With its digital marketing platform, 20,000 N95 masks were delivered to 10,000 doctors in just one day.

China Medical System’s global supply chain system is currently demonstrating its power. In such an urgent time, there are surely not many companies that are able to personally distribute global supplies to the hands of doctors.

“Many only see our CSO businesses in China, but that is just a tip of the iceberg. Like an iceberg, a major part of our businesses, like our capability for global arrangement and the control of a full industrial chain, is actually located “under” the visible plane”, said Lam Kong. He also commented that those who are engaged in the overseas business development all know that buying drugs overseas is not simply about “buying.” Besides overseas MAH conversion, reselection of manufacturing factories, re-control of the factory quality and so on, the understanding of overseas business cultures and law systems directly affects the success and efficiency of the negotiation. Quality management, production management and control management, as well the entire global logistics supply chain, present big challenges to a company’s capabilities.

For example, Lamisil that China Medical System introduced from Novartis in 2014 has completed the localization and now is produced by China Medical System in its production site in Hunan. The localization covers a series of complicated procedures including MAH conversion.

“What the public knows about China Medical System is only our CSO businesses in China. But the whole China Medical System group also includes the global industrial chain formed by our overseas groups, like those in Malaysia. The entirety of China Medical System is not a CSO company”, said Lam Kong.

According to the interim report of 2019, by 30th June 2019, China Medical System had owned 13 innovative products in the fields of ophthalmology, dermatology, neurology, oncology, immunology, gastroenterology, anti-infection and endocrinology. Some of products have acquired marketing authorization from the FDA, EMA and Health Canada, respectively. The domestic R&D, development and sales of these products are also underway.

Products are the soul of pharmaceutical companies. A portfolio of products with differentiated advantage is the most important factor for a pharmaceutical company to become a global innovative one. Driven by policy and technology, the Chinese pharmaceutical industry is undergoing a great, game-changing transformation and upgrade. The industrial development focus on the clinical needs and the transformation will be no less than an earthquake in the industry before it is done.

Hardship brings success. Leading the transformation along with a decade of deployment, this new iteration of China Medical System is thriving. When a brand new China Medical System appears in the Chinese medical industry, the biggest inspiration is its inner logic and path: one is to develop innovative products that could offer Chinese patients new treatment solutions through a global vision, and the other is to deepen the national academic network to consolidate the academic differentiation of the current products.

By Yong Tan and Xinyuan Yang of Healthcare Executive

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