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Zai Lab: China’s Next Biotech Superpower?


NASDAQ: ZLAB


Key Points

  • Zai Lab is fast becoming the “Gateway to China” for the global biopharma company and offers investors a unique investment opportunity
  • The company has four products on the market, and a strong pipeline of 10 development candidate launches in the near-term
  • Despite the volatile regulatory environment in China, improvement in healthcare is still a top priority for the Chinese government
  • Listed in both New York and Hong Kong with a market cap of ~11B, the company has a strong capital position with cash of $1.77B and is projected to reach >$1 billion in product sales by 2024

(Reading time: 18 minutes)

Zai Lab is a commercial-stage biopharmaceutical company focused on bringing transformative medicines for cancer, infectious and autoimmune diseases to patients in China and around the world.

The company aims to address significant unmet medical needs in large, fast-growing segments of the pharmaceutical market. To that end, Zai Labs acts as a “Gateway to China” and has secured partnerships with leading global biopharmaceutical companies to generate a broad pipeline of innovative marketed products and drug candidates.

Zai Lab is currently diversifying its revenues by allocating resources to in-house drug discovery by building an internal research centre alongside manufacturing facilities in China, where the company aims to produce 1-2 global Investigational New Drugs (INDs) per annum.

Government regulations are one of the most significant investment factors one has to make before investing in a Chinese company. This summer, Chinese industries have experienced significant regulatory changes in sectors such as for-profit education and technology 7,8. Other industries, including healthcare, have been caught up in the volatility.

With the Chinese government in favour of supporting the Biopharma industry and a global growing Biotech presence in China, does this signal a potential investment opportunity?

1. The Company

Zai Lab is a Shanghai-based, global biopharmaceutical company that was founded in 2014. The company is focused on becoming a fully integrated biopharmaceutical company that specializes in research and development, business development and commercialization of innovative medicines. The company was founded by one of the most influential biotech entrepreneurs in the industry – Samantha Du – who recognized that there was a gap in bringing innovative medicines to the Chinese market. The company offers investors a proxy to invest in worldwide drug development and China’s enormous market. Zai Lab has positioned itself as a global leader in the industry. It is poised to take advantage of the tailwinds coming from the biopharma industry in the coming decades.

Select Members of Management Team1

2. Qualitative Analysis

To truly understand a business, one must acquire extensive knowledge of how the company generates revenues and the primary factors that drive its future growth and profitability. Here in this section, our team of analysts will break down complex regulatory, financial and economic concepts for your convenience. Continue reading!

Zai Lab Business Model

When people think of the biopharma industry, the traditional drug developer often comes to mind. Based on a new technology or discovery, a company is created to help bring a development candidate from an idea to an approved medicine. The development pathway starts by testing the hypothesis in the lab and then testing a development candidate/product in pre-clinical animal models before entering clinical trials. Suppose a product has successful clinical trial results. In that case, the biopharma company can then commercialize the drug and use the revenues to help grow their company.

Zai Lab, like other biopharma companies, focuses on bringing drugs to patients. However, the company’s core competency is not in its drug development capabilities but in its ability to partner with biopharma companies and bring their products to China. As products progress through the development stage, biopharma companies will often seek partners to commercialize the product in challenging regions of the world, such as China, in exchange for an upfront payment and/or royalties from any future sales (usually single digits to mid-teens % of sales). This is often referred to as the “license-to-sell” strategy.

Samantha Du founded Zai Lab to become the “Gateway to China” to bring Western drugs to the region2. The commercial organization has ~830 full-time employees to help achieve this. Notably, the company already has three products on the market and one more under review in China3.

While sales from their current commercial portfolio are important drivers of the stock ($57M in the 1H21, already greater than 2020 sales of $49M), the key driver that investors focus on is the company’s development pipeline. In just a few short years, Zai Lab has built up a very impressive development pipeline with global biopharma partners. This reflects the expertise of the business development team at Zai Lab and the demand from multinational companies to pick a partner to help them navigate the Chinese regulatory and commercial environment. The company expects 10 new launches in the medium term to complement their existing commercial portfolio.

The business development strategy is specifically geared to building a pipeline around China’s significant unmet medical needs. The company focuses on partnering with companies that have products in women’s cancer, GI cancer, lung cancer (China’s most common cancer), brain cancer, haematology, autoimmune and infectious diseases, which are all large unmet needs in the country.

Zai Lab’s partnership with Five Prime Therapeutics (now Amgen) is one example of how a successful business development team can lead to significant value creation. In 2017, Zai Lab entered into an exclusive license agreement with Five Prime Therapeutics to develop and commercialize bemarituzumab – a targeted therapy for gastric and esophagogastric junction (GEJ) cancer – in Greater China. In 2020, Five Prime announced that bemarituzumab met all three efficacy endpoints and led to clinically meaningful improvements in progression-free and overall survival. The data was so promising that Amgen paid $1.9B to acquire Five Prime in 2021. By entering into an agreement so early on, Zai Lab was able to gain the right to develop and commercialize the product in China for a small upfront payment of $5M (additional milestone payments of up to $37M and royalty payments ranging from high teens to low twenties). They are now leading the clinical development in China and are working closely with Amgen as final data and commercialization approaches4.

However, Zai Lab also partners with companies with a more advanced clinical profile (i.e. further “de-risked”). In May 2021, Zai Lab entered into a collaboration and license agreement with Mirati Therapeutics to obtain the right to develop and commercialize adagrasib in greater China. Adagrasib is a small molecule inhibitor of KRAS G12C, a target for lung cancer, colorectal cancer and other cancers that were previously deemed as “undruggable.” Zai Lab made an upfront payment of $65M (additional milestone payments of up to $273M and royalty payments ranging from high teens to low twenties)5.

Zai Lab’s partners range from some of the largest healthcare companies in the world (Amgen, BMS, GSK etc.) to promising biotechnology companies (Decipher, Incyte, Mirati etc.)6.

Large BioPharma

  • Amgen, Bristol-Myers Squibb, GlaxoSmithKline, Regeneron

Smaller Biotechs

  • Cullinan Oncology, Deciphera, Incyte, MacroGenics, Mirati Therapeutics, Novocure, Schrodinger, Turning Point Therapeutics, Argenx, Crescendo Biologics, Entatis Therapeutics, Paratek

In addition, for long-term investors, Zai Lab is building out its own R&D organization to advance internally discovered novel therapeutics. The company is leveraging the talent they have attracted to build out a drug discovery and development team to identify pre-clinical assets. They currently have three products in Phase 1 and more than 400 R&D employees in the organization. In early August 2021, they signalled their strategic intentions to develop their own drugs by entering a collaboration with Schrödinger, a provider of a physics-based software platform that enables the discovery of molecules. This collaboration focuses on a novel oncology program targeting DNA damage response and, importantly, Zai Lab will assume global responsibility for development and commercialization.

Regulatory Environment

Government regulations are perhaps one of the most significant investment factors one has to make before investing in a Chinese company. This summer, Chinese industries have experienced significant regulatory changes in sectors such as for-profit education and technology7,8. Other industries, including healthcare, have been caught up in the volatility as well. However, China’s long-term plans emphasize having a world-class health care system that adequately serves China’s large and ageing population. Currently, Western companies offer the most advanced innovative drug development, and the regulatory environment should support bringing these innovations into the country.

Recent improvements in the regulatory and clinical development environment include9:

• Approval time for a clinical trial application (CTA) changed to 60 days from two three years

• Multiple accelerated drug approval pathways that have been defined, such as breakthrough, conditional approval, priority review, and special approval (similar to U.S. FDA)

• Just last month, the Center for Drug Evaluation at China’s National Medical Products Administration released draft guidance for conducting oncology drug trials. It stressed that all cancer drug R&D efforts should focus on creating “clinical value,” namely, meeting patients’ needs. It states that late-stage trials should use the best standard of care as a control rather than older treatments.

The last policy changes recently caused a summer sell-off in Chinese biopharma companies but is an example of how policy is catching up to global standards. In the long run, the Chinese biopharma industry should have clinical trial standards on par with Western standards (leading to more confidence in the market and better understanding of a product’s true safety and effectiveness).

As China’s population ages, the country is expected to experience rapid growth in new cancer cases (chart below)10. The government’s priority should be to promote the highest standard of clinical development in the country.

Commercial Environment One of the reason’s western biopharma companies needs a partner in China is for help navigating the National Centralized Drug Procurement (NCDP) policy. Since 2012, the government has been introducing a series of policies to promote the evaluation of generic drugs. In 2019, the NCDP was issued, the first volume-based drug procurement work at the national level in China. The NCDP policy includes both original (i.e. innovative) drugs and generic drugs. The goal of the policy is to implement “volume-based procurement.” Suppose a drug is selected to the procurement list. In that case, the government contracts directly with the drug company to secure supply while negotiating prices due to the large volume commitments associated with the Chinese market. Zai Lab’s Zejula was included in the NRDL in late 2020.

3. Quantitative Analysis

Financial Performance

This section is beating the heart of any informed investment decision that separates the speculators from the professional investors. We at ChineseAlpha want our readers to have the best quality experience to make the best investment decisions of their life. Keep reading, and we will break down key financial metrics and how valuing biopharma companies typically works.

Valuing biotech companies can often be tricky (and controversial) as companies can be worth billions of dollars but have no revenues from product sales. This is different from the phenomenon seen in loss-making companies that have been popular since 2010 (typically technology companies), which usually have strong revenue growth along with growing expenses. This makes biotech a unique sector when it comes to valuation methodologies.

We believe it is crucial to provide context for how investors typically approach biotechnology companies. To start, analysts and investors model the amount of revenue that a company’s development candidate would bring in if it were to reach the market. This includes thinking about how many patients would need the medicine, competition, pricing, reimbursement with insurance or governments and a myriad of other factors. For larger indications, such as oncology and cardiovascular/autoimmune/infectious diseases, this can range into the billions of dollars. As investors and the market gain more confidence in a specific program (i.e. due to exciting pre-clinical and then clinical data and clinical trial progression), they will increase their Probability of Success (PoS) for the program. PoS essentially discounts the projected revenues from a successful drug.

One of the reasons why traditional valuation is so difficult in the biotech market is because the probability that a drug makes it to market is incredibly low. The chart below shows the Overall Estimates of PoS by Therapeutic Area from 2006 to 2021Q2 – the orange bar (from Phase 1 to approval) shows the <20% chance a drug has for making it from Phase 1 approval12.

We believe Zai Lab is a great investment opportunity precisely because an investor does not have to bet on a single key program but can invest in the management team choosing the right partners.

Zai Lab is in a solid position financially. They already have four products on the market and recognized $49M in revenue sales last year (Zejula and Optune, the two products on the market), which doubled in the first half of 2021. A company’s cash position is also very important as most biotechs are unprofitable. Zai Lab had a strong cash position last year ($1.1B) but recently just completed an additional equity offering in April 2021, increasing their cash position to ~$1.77B as of 2Q21.

Despite the difficulties in modelling biotech companies, we wanted to show what a DCF valuation could look like for Zai Lab.

• Revenue: Bloomberg analyst consensus estimates suggest Zai Lab has the potential to reach >$1 billion in sales as early as 2024. The sales growth represents Zai Lab’s impressive pipeline that the market is expecting Zai Lab to commercialize in the coming years. It is important to note that these estimates already discount (using Pos across Zai Lab’s development pipeline) to account for the inherent risk in drug development.

• Expenses: The cost of development (early-stage research, clinical trials) are the leading costs for Zai Lab and other biotech companies. However, once a medicine reaches the market, the gross margins are quite attractive (Zai Lab’s cost of sales of ~35% is projected to decrease to ~25% in the coming years). While Zai Lab actually has lower gross margins than other companies in the industry (typical range is 80-90% gross margin vs ZLAB at 65-75%), if Zai Lab is successful in developing their own medicines, then their gross margins could increase in the future.

• Valuation: We use a standard 2% terminal growth rate to represent Zai Lab’s exposure to favourable demographic and industry trends. A discount rate of 8-12% is what is usually used when valuing biotech companies. Since Zai Lab has a diversified pipeline across clinically advanced and “de-risked” assets, we believe an 8% discount rate is appropriate.

We believe that this DCF is an example of how an investor could value Zai Lab. In the base case, we discount Zai Lab’s NPV even further (by an additional 20%) to account for volatility in drug development. Even in this base case, the upside is >20% from the current share price of ~$123. With the stock trading down recently mainly due to Chinese equities volatility, it offers an attractive entry point if you believe in Zai Lab’s management and continued commercial execution. Over the long term, Zai Lab has an attractive runway of revenue and profit growth.

4. Risks

Investing in biopharma has inherent risks related to drug development. In pre-clinical experiments and even in Phase 1 and Phase 2 studies, pipeline candidates that look promising can fail in pivotal Phase 3 trials. Even once a drug is proven safe and efficacious for a specific indication, worldwide regulators process can provide significant delays in commercialization. If a drug makes it to commercialization, competition can erode its competitive positioning.

In the Chinese biopharma industry, drug pricing regulations and access could lead to significant volatility in Chinese biopharma companies.

Zai Lab also likely has a “key man risk” in their Founder and CEO, Samantha Du. Her vision for the company has allowed it to grow into a >$10B company in less than eight years. If she steps away from the company, the business development and internal R&D capabilities could erode their strong position.

5. Conclusion & Investment Strategy

Investors

One of the most critical factors to look at before investing in a company is to study who the top investors in the company are. In Zai Lab’s case, they have an impressive list of long-term oriented investors at the top.

Standout long-only U.S. investors Capital, Fidelity and Wellington are some of the best names in the business. In addition, Scottish investor Baillie Gifford is known for their extraordinary investment in Tesla and their long-term time horizon.

Source: FactSet

Other Industry Players

The Chinese biotechnology industry is growing incredibly quickly. A quick look at the chart below shows the trend in Chinese biopharma companies that have been created in the past decade13.

When looking at investing in the Chinese biopharma industry, investors can choose from companies that are manufacturing/contract development and manufacturing (CDMO) experts (Wuxi Biologics), innovative drug companies (Innovent, Junshi, CanSino, etc.) or even traditional Chinese medicine companies. However, for investors looking to gain exposure to the growing innovation in drug development worldwide, Zai Lab offers the largest runway for growth in the most de-risked way. An investor won’t have to make judgement calls on key development candidates but can have confidence in the broad pipeline and management’s successful track record.  Zai Lab reviews a buy recommendation.


Disclaimer: Our content is intended to be used solely for informational and educational purposes, and not as investment advice. Always do your research and consider your personal circumstances before making investment decisions. ChineseAlpha is not liable for any losses that may arise from relying on information provided.



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