CITIC SEC Healthcare 2025 Investment Strategy: Innovation Trends are Already Evident, Seize the Industry's Alpha of Certainty.

CITIC SEC released a research report stating that in 2024, the pharmaceutical industry gradually emerged from the most severe healthcare anti-corruption storm in nearly a decade that began in the third quarter of 2023. Hospital-side demand is beginning to normalize. The impact of centralized procurement, which was the largest valuation factor in the healthcare industry, has faded away. In the post-centralized procurement era, excellent product quality and innovation are key drivers of company performance growth. "Innovation-driven + specialized and novel manufacturing" remains the main high-growth and high-certainty performance track, with the most significant beta effect, and the pharmaceutical industry going global + state-owned enterprise reform and mergers and acquisitions integration + undervalued dividends + increased market share of leading companies are gradually showing an accelerated realization trend, becoming a new hot spot in the pharmaceutical industry and the most alpha-effective sector. CITIC SEC's main points are as follows: Under the background of major reforms in the industry, the trend of innovation-driven investment is becoming increasingly apparent. In 2024, the pharmaceutical industry gradually emerged from the most severe healthcare anti-corruption storm in nearly a decade that began in the third quarter of 2023. Hospital-side demand is beginning to normalize, with drugs and supplies within hospitals gradually stabilizing as surgical and outpatient volumes increase. With the release of the tenth batch of nationally centralized procurement drug list at the end of 2024, the market impact and volatility have become very weak, indicating that the influence of centralized procurement, the largest valuation factor in the healthcare industry, has faded away. In the true post-centralized procurement era, excellent product quality and innovation are the key drivers of outstanding company performance growth. The "Implementation Plan for Supporting the Development of Innovative Drugs throughout the Chain" approved at the State Council executive meeting in July 2024 has elevated pharmaceutical innovation to new heights. Against the backdrop of major industry reforms, the trend of innovation-driven investment is becoming increasingly apparent. The trend of medical insurance cost control reform will continue to be under pressure next year, focusing on certain alpha opportunities. The trend of industry reform by the medical insurance bureau to enhance centralized procurement and control cost has not changed, with more industry inspections expected next year, and the medical insurance bureau reform task to implement DRGs in most cities by the end of 2026. The bank believes that the medical and health industry is accelerating into a new phase of significant reforms, and the post-centralized procurement era is the first step in the industry's acceleration of restructuring. The industry is expected to accelerate into the second phase of development in 2025. Overall holdings in the pharmaceutical sector in the first three quarters of 2024 reached the lowest level in history, reflecting concerns in the secondary market about the overall industry being in a phase of transition and adjustment, with sentiment at a noticeably low level. The bank believes that 2025 is the best opportunity to invest in excellent race tracks and top core companies in the pharmaceutical industry in a bottom-up layout. The bank has always emphasized that "Innovation-driven + specialized and novel manufacturing" remains the main high-growth and high-certainty performance track, with the most significant beta effect, and the pharmaceutical industry going global + state-owned enterprise reform and mergers and acquisitions integration + undervalued dividends + increased market share of leading companies are gradually showing an accelerated realization trend, becoming a new hot spot in the pharmaceutical industry and expected to be the most alpha-effective sector. Pharmaceutical sector: Concentrated realization of innovative pipelines, continuous gains in internationalization; four positive factors resonate, sector expected to reach a turning point. Looking ahead to 2025, the bank believes that the sector is expected to experience a synergy of fundamentals and beta, with the innovative drug track expected to receive multiple positive catalysts, including: 1) Policy side: Continuous optimization of the medical insurance simplified renewal rules, reducing the impact of large varieties under regular centralized procurement. The National Health Insurance Administration is exploring new drug price management mechanisms, and regions such as Beijing, Guangdong, and Shanghai are introducing policies to support innovation in drugs. 2) Capability side: With years of accumulated innovation environment, several domestic companies have shown products with the best global efficacy potential, including PD-1/VEGF dual antibodies, PD-1/IL-2 dual antibodies, and Trop2 ADC, which are expected to significantly enhance global market competitiveness and potential valuation gains. In addition, driven by a large unmet clinical demand, it is expected that innovative drugs will quickly gain approval in the domestic market after entering the medical insurance system, leading to continuous optimization of Pharma company revenue structure, some biotech companies reporting profits, and investment opportunities brought about by a switch in valuation methods (from DCF to PE valuation). 3) Internationalization: Since 2023, several innovative drugs have been approved for marketing overseas, including Zebularine, Fruquidene, Sida-Guinocin, etc., which have greatly improved the commercial value of domestic new drugs after receiving approval in the United States. In terms of authorized cooperation, significant advances have been made in cooperation agreements between companies and pharmaceutical giants like BMS, MSD, GSK, Merck, and Takeda. Domestic innovative drug companies are gradually moving towards globalization through various innovative models. The bank expects more differentiated international cooperation agreements in various sub-fields (such as self-immunity, blood tumors, weight loss/diabetes, solid tumor fields to be reached by the end of 2024 to 2025). 4) Funding side: On September 19, 2024, the Federal Reserve cut interest rates by 50 basis points at the Federal Reserve interest rate meeting, the first interest rate cut since the start of the rate hike cycle in March 2022. On October 21, 2024, China's loan market quoted interest rates (LPR) decreased by 0.25 percentage points, the third decrease this year. From the perspective of segmented industries: analyzing past financial data, domestically focused hospital-based formulations/generic drug companies are showing steady growth, while leading companies in the large IV infusion industry are expected to further improve industry concentration through continuous product structure optimization + cost reduction and efficiency enhancement. Many varieties in the domestic market have been approved for submission/listing in Europe and the United States, with additional demand expected in 2025, with a focus on specific areas such as antibiotics, antivirals, and biosimilars. CXO: Overseas investment and financing environments are gradually improving, and orders for leading CXO companies' overseas businesses are expected to continue to improve; the enthusiasm for research and development in new molecules (peptides, ADCs, etc.) remains high, expected to continue to drive industry chain prosperity.Domestic policies frequently support true innovation, and the top effect and competitiveness of domestic CRO companies are expected to further manifest in the future.2025 Although the progress of the biosafety bill still needs further observation, with the end of the Fed's interest rate hike cycle, signs of initial recovery in overseas biopharmaceutical investment and financing have emerged. Downstream demand for CRO enterprises has shown a bottoming out and recovery trend in 2024 (some companies' overseas business has shown a more obvious recovery trend in 24H1/24Q3). It is expected to see further recovery in 2025; enthusiasm for research and development in new molecules, such as peptides (weight loss drugs), oligonucleotides, ADC, and other fields remains high and is expected to continue to drive benefits along the industrial chain. Domestic investment and financing are still at a low level. The bank believes that it is currently at the bottoming stage. On the other hand, domestic policies continuously support true innovationsince April 2024, Zhuhai, Beijing, and Guangzhou have successively introduced policies to support innovative drugs. With strong policy support, the bank believes that domestic enthusiasm for innovative drug research and development is expected to warm up, and the top effects and competitiveness of domestic CRO enterprises are expected to further emerge in the future. In the scientific services and upstream supply chain of the biopharmaceutical industry: industrialization, internationalization, and accelerated mergers and acquisitions await the industry turning point. Although the sector's performance in the first half of 2024 has been under pressure due to external factors such as macroeconomic uncertainty and tightened investment and financing in the biopharmaceutical industry, the bank sees signs of a bottoming out in the investment and financing environment for the biopharmaceutical industry in 2025. Price competition in the industry has eased, competition in some sub-sectors has improved, and there is policy support. Domestic enterprises are accelerating their layout in overseas markets, and the bank expects potential future upward elasticity due to mergers and acquisitions. In the upstream drug industry chain, the bank expects that with the rapid expansion of downstream customer products, segments such as culture media, excipients, pharmaceutical glass, and other areas are likely to see sustained rapid growth opportunities. Overall, the industry is gradually seeing improvements in 2024, and revenue growth and profitability are expected to recover in 2025. Raw materials and intermediates: the end of destocking is expected to enter an upward cycle, and the cliff of patent expiration and formulation integration is expected to open up in the medium to long term. The domestic API industry is currently at a cyclical bottom, with low prices and volume, and there is ample room for a turnaround. The bank believes that as the inventory levels of global downstream leading generic drug companies have fallen compared to the epidemic period and with the bottoming out of some raw material prices, the performance of raw materials and intermediates companies in 2024 and 2025 is expected to continue to improve amid fluctuations. In the medium term, a peak in patent expiration of innovative drugs is expected after 2023. From 2023 to 2028, the bank estimates the total sales risk of drugs with expired patents to be as high as $354 billion. With the significant expansion of the characteristic raw materials market, domestic companies are expected to accelerate entry into overseas markets based on their registration and production capabilities. In the long term, as drug quality requirements increase and tender pricing pressures, API+formulation integration companies with cost advantages and quality control are expected to stand out. Downstream extended formulations can bring potential high-value increments. The bank believes that API+formulation integration can help companies unlock revenue ceilings. Blood products: In the short term, the bank believes that with the gradual recovery of the phlebotomy industry to normal rhythm in 2023 and high industry demand (especially for routine products such as intravenous immunoglobulin), under the supply-side recovery, the industry performance is expected to achieve stable growth from the end of 2024 to 2025. In the medium to long term, blood products derived from plasma are scarce resources, and under rigid demand, there is potential space waiting to be developed. The bank believes that in the "14th Five-Year Plan" period, the country is expected to accelerate the construction of domestic plasma stations, and domestic blood product companies have strong growth certainty. Medical devices: short-term equipment benefits from debt-to-equity, long-term outlook for significant space. Anti-corruption is becoming normalized, equipment updates and transformations are gradually being implemented, and centralized procurement is maturing. The medical device industry is entering a period of accelerated policy changes, and under the trend of industrial development, including marginal changes brought about by factors such as policy changes, the industry is experiencing small cycles. The bank recommends exploring opportunities from two perspectives: 1) Short-term view on equipment: Equipment updates in 24Q1-3 have not been fully implemented yet, and medical institutions are in a wait-and-see mood. With the debt-to-equity policy, it is expected to be implemented in 24Q4, and the bank expects performance to start low and then increase. 2) Long-term view of significant space: Focus on medical device companies with continuous innovation capabilities, penetration rate, market share improvement, and gradual internationalization, such as CGM (Continuous Glucose Monitoring), ICL (Independent Clinical Laboratory), electrophysiology, neurointervention, orthopedics, joint surgery, optical surgery, dental implants, flexible endoscopy, large imaging equipment, gene sequencers, and low-value consumables. Vaccines: blockbuster products are about to enter their harvest period, and domestic vaccines are setting sail for overseas markets. Since 2024, the vaccine industry has been under pressure due to policy disturbances. In addition, with the continuous decline in the number of newborns and a slowdown in sales growth of some self-paid vaccines for newborns, the industry is facing challenges. Looking ahead, the bank expects the Year of the Dragon to bring a short-term rebound in the birth rate, benefiting children's vaccines such as MCV4 and PCV13. "Varieties are king" is the basic investment logic of the vaccine sector. The domestically produced nine-valent HPV, varicella, and RSV vaccines will become the focus of attention. Some domestically developed products are about to enter the harvest period, combined with the opportunities of vaccines going global. Overall, the bank recommends focusing on stocks that have launched blockbuster products and are expanding into overseas vaccine markets. Traditional Chinese Medicine and Health: state-owned enterprise reform, consumption rebound, equity incentives, and high dividends remain the main themes for the sector. In the long term, traditional Chinese medicine has consumer and health product attributes and has long-term growth logic under population aging and consumption upgrades. In the short term, the traditional Chinese medicine sector maintained a high level of prosperity in 2024, with state-owned enterprise reform, consumption rebound, equity incentives, and high dividends remaining the main investment themes. Benefiting from policy support and population aging, the traditional Chinese medicine health sector is expected to achieve further growth in 2025. Overall, the demand for the traditional Chinese medicine industry is still on the rise, and the market for Chinese medicine sector is sustainable. It is recommended to choose targets from three major directions: 1) Establishing brands deeply rooted in people's minds, focusing on self-medication and leading in segmentation; 2) Innovating research and development of Chinese medicine, focusing on logic of increasing new products; 3) Leveraging the brand strength of traditional Chinese medicine old brands, with main products having pricing power.Medical services: It is expected to continue to marginally recover by 2025, with a promising future under the new medical reform. According to the China Health Insurance Bureau, China's total medical and health expenditures reached 9.06 trillion yuan in 2023 (CAGR from 2014 to 2023 reached 11.1%), accounting for about 7.2% of GDP. At the same time, the increasing prevalence of chronic diseases and aging population will continue to promote the growth of the medical services industry. In 2024, the industry as a whole showed signs of weak recovery, and it is expected that by 2025, with the recovery of diagnosis and treatment, the industry is expected to further warm up. Under the trends of DRG/DIP reform and deepening of medical service price adjustments in recent years, combined with sector valuation, the current position of the medical service sector presents attractive long-term investment opportunities. Considering factors such as the prosperity of specific sub-sectors, industry barriers, and characteristics of standardized expansion, there is a strong recommendation to focus on sub-sectors with advantages in management, brand, and technology. Consumer healthcare: Consumer recovery can be expected, and the sector is expected to return to rapid growth. The bank has examined the ophthalmology industry chain and medical beauty sectors: 1) Ophthalmology industry chain: The trend of domestic substitution of ophthalmic consumables has become apparent, and ophthalmic services are expected to continue marginally improving throughout the year. Regarding the ophthalmic consumables sector, the bank believes that there is vast long-term space for development, and domestic enterprises are expected to continue to achieve domestic substitution. With the gradual recovery of the macro-consumer environment and enterprises' layout of new products such as contact lenses, the bank predicts that the sector will see rapid growth in 2025. In terms of ophthalmology services, according to the prospectus of Huaxia Eye Hospital Group, the ophthalmic medical services sector has exceeded a scale of over 100 billion yuan, and policy favors private hospitals. The bank assesses that with the gradual recovery of the consumer environment, the ophthalmology services sector is expected to maintain a marginally improving trend throughout the year. 2) Medical beauty: The growth rate of the Chinese medical beauty market is much higher than the global market. Even in a relatively weak consumption background, the willingness of middle-aged and high-end clients to engage in medical beauty remains strong, and there is still significant potential for increase in market penetration rates. At the same time, with the iterative upgrade of material technology, collagen, regenerative injections, and botulinum toxin are expected to be high-growth engines for the entire year. Pharmaceutical business: Benefiting from debt securitization, reform is imminent, and the strong will continue to prosper. Regarding pharmaceutical distribution: The resonance of debt securitization, anti-corruption, centralized procurement, and interest rate cuts has brought a new dawn to the distribution business. Leading enterprises will continue to prosper, and policy support will increase industry concentration. The extension of the industrial chain has spawned a second growth curve: 1) SPD: Integrated management platform for hospital-end supply chain, facilitating the transparency and efficiency of healthcare institution operations. 2) CSO: A more compliant marketing service model that empowers pharmaceutical companies. In terms of pharmaceutical retail, the bank expects that by 2025, with the normalized regression of base numbers; the reform of individual medical insurance accounts no longer has a significant negative impact; as the consumption level gradually recovers, sales of traditional Chinese medicine and non-drug products are expected to resume growth; under the push of national procurement, the acceleration of prescription drug outflow under the dual-channel system, and outpatient coordination, same-store sales growth will stabilize; leading retail enterprises maintain stable growth in the number of stores, and the pharmaceutical retail industry is expected to gradually recover season by season. In terms of professional medical platform, as anti-corruption efforts in the medical field continue, leading companies are expected to achieve higher income and profit growth due to increased orders. Investment strategy: It is recommended to layout around the following main themes in 2025 from a horizontal perspective: 1) Innovation breakthrough: Achieving breakthroughs with "innovative/explosive products" and entering a period of diversified returns for truly innovative enterprises; 2) Pharmaceutical manufacturing going global: Strengthening companies that have actively expanded internationally, particularly in the areas of biopharmaceuticals, formulations, and raw material exports; 3) Expansion of centralized procurement: Selecting winners in the post centralized procurement era and the market share/growth of domestic substitutes for leaders expected to increase significantly; 4) Recovery rebound: Industry destocking cycles ending, along with necessary products expected to reach a turning point in price and volume in upstream raw material industries, along with other bottom-industries; 5) Marginal changes and catalysts in macro policies: In the macro context of local government debt and aging populations, top-down macro policies are also evolving. Policy changes will give rise to investment opportunities, and within the pharmaceutical industry, the bank recommends focusing on national reforms, debt securitization through mergers and acquisitions, and child policies. Given the current regulatory emphasis on encouraging mergers and reorganizations, there are many listed companies in the pharmaceutical industry and various sub-sectors, which are expected to generate numerous merger and acquisition opportunities around the industry's hot spots by 2025, which are worth special attention. Risk factors: Intensification of geopolitical frictions; risks associated with macroeconomic recovery falling short of expectations; risks associated with volume-based procurement; risks of decreased financing popularity for biopharmaceutical companies in the primary market; risks of higher-than-expected reduction in high-value consumables prices and progress of centralized procurement; risks of clinical research and development failures in innovative drugs; risks associated with medical services and medical insurance policies; risks associated with medical accidents.