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WuXi PharmaTech (Cayman) (WX)

Q4 2012 Earnings Call

March 08, 2013 8:00 am ET

Executives

Ronald Aldridge - Director of Investor Relations

Ge Li - Co-Founder, Chairman, Chief Executive Officer, Member of Strategy Committee and Member of Compensation Committee

Edward Hu - Chief Financial Officer and Chief Operating Officer

Analysts

David H. Windley - Jefferies & Company, Inc., Research Division

Ingrid Yin - Oppenheimer & Co. Inc., Research Division

John Kreger - William Blair & Company L.L.C., Research Division

Timothy C. Evans - Wells Fargo Securities, LLC, Research Division

Tycho W. Peterson - JP Morgan Chase & Co, Research Division

Jack Hu - Deutsche Bank AG, Research Division

Christopher Eoyang - Goldman Sachs Group Inc., Research Division

Bryan Kipp

Isabella Zhao - Morgan Stanley, Research Division

Operator

Ladies and gentlemen, thank you for standing by, and welcome to WuXi PharmaTech Fourth Quarter 2012 Earnings Conference Call. [Operator Instructions] I must advise you that this conference is being recorded today, 8th of March 2013.

I would now like to hand the call over to your first speaker for today, Mr. Ron Aldridge. Sir, please go ahead.

Ronald Aldridge

Thank you, Chi, and good morning or good evening to everyone participating in our fourth quarter 2012 earnings conference call. Hosting this conference call is Dr. Ge Li, Chairman and Chief Executive Officer; and joining him is Edward Hu, our Chief Financial Officer.

During today's presentation and question-and-answer session, we will make forward-looking statements. These forward-looking statements represent only our belief regarding future events, any of which, by their nature, are inherently uncertain and partially or completely outside our control. I would also like you to refer to the risk factors inherent in our business that you see here and that have been filed with the SEC and are on our company website under the Investor Relations section. Actual results can be materially different from any forward-looking statements we make today.

Also, in discussing our financials, we will use certain non-GAAP measures, which exclude share-based compensation expenses; amortization and the deferred tax impact of acquired intangible assets; impairment charges for goodwill and intangible assets relating to the Abgent acquisition; and revaluation of contingent consideration relating to Abgent . We believe these non-GAAP operating measures are useful for understanding and assessing underlying business performance and operating trends. Reconciliations of our GAAP to non-GAAP fourth quarter and full year 2012 results of operations are found in today's earnings release, which has been posted to our website and in the appendix to this presentation.

[Operator Instructions] Now it's my pleasure to introduce Dr. Ge Li to review our fourth quarter 2012 performance and to discuss our first quarter and full year 2013 business outlook. Dr. Li?

Ge Li

Thank you, Ron, and good evening or good morning, everyone. Slide 3, please. I'm glad to report that WuXi completed a successful 2012, with a solid fourth quarter. Our company is succeeding on 3 fronts: growing, investing and then returning capital to shareholders. We achieved double-digit revenue growth in the fourth quarter and the full year 2012, and despite continuing margin pressure, we also achieved double-digit EPS growth on both a GAAP and non-GAAP basis for the full year of 2012. We continue to invest to build capabilities and the capacity in order to sustain revenue growth and EPS growth for the long term.

Our dream is to build a comprehensive open-access technology platform of integrated service offerings that will enable anyone and any company to discover and develop medicines more efficiently and cost-effectively. We are making a substantial progress toward achieving this dream. And while we are growing and investing to sustain our growth, we also are returning capital to shareholders through share buyback programs while generating strong free cash flow that allow us to purchase our shares, which we believe are undervalued. We purchased a sizable number of our shares last year, and today, we're announcing another substantial share repurchase program of $100 million over the next 18 to 24 months.

Slide 4, please. This slide shows the result of our 12 years of growth on the investment, WuXi's integrated R&D service platform as it stands today. We have built our R&D service platform for 3 product areas: small molecules, biologics and the medical devices. This service platform is one of the broadest of any CRO and possibly the broadest. The service runs from the earliest discovery work, synthetic chemistry and the monoclonal antibody discovery through our broad program of preclinical service to Phase I through Phase IV clinical trials. I would not take the time to go over every service but you can do so to fully understanding the breadth and the specification of our service offerings and the value of this continuing service to help our customers advance their products as quickly and efficiently as possible. And we'll continue to add capabilities and the capacity to better serve the needs of the world's life science companies.

Slide 5, please. Here you'll see our fourth quarter 2012 financial results. We achieved strong broad-based year-over-year revenue growth of 15.8%, driven by continuous growth in demand for WuXi's comprehensive, integrated service platform. That growth was led by China-based Laboratory Service, which grew 22.2% year-over-year, so virtually, all areas of China Lab Service grew. Growth was particularly strong in drug development service, which are newer and in the early phase of their revenue ramp-up. We were pleased to achieve higher quarterly GAAP and non-GAAP gross margin and operating margin versus the first 3 quarters of 2012. And as we have done for much of the past 4 years, we met or exceeded our financial guidance for the quarter.

Slide 6, please. Here are our full year 2012 financial results. We achieved 22.8% of revenue growth. Our growth was led by China-based Laboratory Service, with 26.8% revenue growth, and we've seen China-based laboratories by 25% growth in integrated drug discovery service, which include medicinal chemistry, biology, ADME and DMPK, and 75% growth in drug development services. We achieved a 10.8% GAAP and 13.3% non-GAAP EPS growth, in spite of the margin pressure. We invested 60 -- $67.8 million in capital expenditures for new facilities and equipment, the most we have ever invested in 1 year. This CapEx was invested broadly, including strong investment in new areas with great promise, such as biologics services. We have purchased 7% of the ADS that were outstanding at the beginning of 2012, and we met or exceeded all of our financial guidance.

Slide 7, please. Here are some of the operational highlights of 2012. We opened a new chemistry facility in Wuhan in February. We now have about 400 working there. These pilot chemists, many of whom transferred from our chemistry facilities in Shanghai and Tianjin, quickly achieved the productivity levels comparable to their WuXi colleagues in Shanghai and Tianjin. We opened a cGMP drug-substance biologics manufacturing facility in Wuxi city in October, the first such a facility in China to meet GMP standards of the United States, the European Union and China, and we are the first, globally, to utilize 100% disposable equipment.

We also formed a joint venture with MedImmune to develop MEDI5117, an anti- IL-6 antibody for rheumatoid arthritis and other autoimmune disease for the China market. In addition to receiving rights to sharing potential income from commercializing products in China, WuXi will earn revenues from services provided to the joint venture. We entered into an agreement to form a joint venture with PRA International to offer clinical research services in China. Very rapid growth of Chinese pharmaceutical market, which is the third largest in the world currently, is producing an increasing need for conducting clinical trials in China. This JV gives WuXi access to the expertise of PRA's 35 years of running high-quality clinical trial experience. We performed numerous integrated drug development projects from API synthesis to GLP toxicology studies for IND filings in China and globally for our customers, and we increased our workforce to about 7,000 employees worldwide.

And now Ed will discuss details of our fourth quarter 2012 financial performance. Ed, please.

Edward Hu

Thank you, Dr. Li. Turn to Slide 8, please. So here, you can see the details of our revenues. We achieved about $0.5 billion in annual revenue for the first time in our company's history, and we achieved a double-digit growth for the year in each of our 3 businesses, with China-based Laboratory Service growing 26.8% and Manufacturing Services growing 22.9% (sic) [22.5%] and U.S.-based Laboratory Services growing a solid 11.6% in a mature market.

Turn to Slide 9, please. This slide shows the quarterly progression of our revenues. China-based Laboratory Service revenue continues to achieve strong sequential quarterly growth in revenues. U.S. Laboratory Service is a steady performer, and Manufacturing Service still has the most variable performance of the 3 businesses because of the smaller number of customers and a more variable price and timing of its projects. We delivered a large order for commercial products in the first half of the year. We expect that this variability in Manufacturing Services will diminish over the next few years as its customer list and pipeline of commercial products continue to grow.

Slide 10, please. Here are our GAAP financial results for the quarter and the full year. In the fourth quarter of 2012 compared to the same quarter in 2011 revenue grew 15.8% and gross profit increased by 14.6%. Fourth quarter 2012 gross profit margin was 39.2% (sic) [38.8%], the highest in 2012, primarily due to the benefit from a VAT tax refund and government subsidies received in the fourth quarter, as well as revenue mix of higher Lab Service revenue contribution in the fourth quarter, which had a higher gross margin than Manufacturing Services.

Fourth quarter 2012 operating income margin was 18.6% (sic) [18.7%] due to higher gross margin. In the fourth quarter, revaluation of contingent consideration relating to the Abgent acquisition brought in approximately a $3.4 million reduction in the contingent payment, offset by an approximately $3.4 million impairment charge of goodwill and acquired intangible assets associated with the Abgent acquisition.

Fourth quarter 2012 net income was $23.8 million, a 1.4% increase versus the fourth quarter of 2011 due to a 16.5% year-over-year increase in operating income, offset by a 33.6% increase in other income and expenses net, which was driven by lower gains on foreign exchange forward contracts of about $1.5 million and the loss from the joint venture with MedImmune of about $600,000 and the 15.1% increase in income tax expenses. Diluted EPS was $0.33, a 6.5% increase compared to the fourth quarter of 2011, primarily due to a 4.7% decrease in weighted outstanding shares.

For the full year, revenue grew 22.8% to about $0.5 billion. Gross profit increased 17.1% despite labor cost inflation, appreciation of renminbi versus U.S. dollar, investments in new business and pricing pressure in synthetic chemistry services. Profit income increased 6.7% year-over-year, driven by a 17.1% increase in gross profit, partially offset by increased spending in SG&A expenses associated with the hiring of new staff, increased investment in R&D and developing new capabilities and an increase in share-based compensation charges. Net income grew 6.9% year-over-year to $86.6 million, primarily due to a 6.7% increase in operating income. Diluted EPS increased 10.8% to $1.19 due to 6.7% increase in operating income and 3.5% reduction in average diluted outstanding shares as a result of the share buyback program.

Turn to Slide 11, please. Here, you can see the quarterly progression of our GAAP results. Our fourth quarter gross profit was the highest in 2012 due to the benefit of a VAT tax refund and government subsidies we received in the fourth quarter, as well as revenue mix of higher Lab Service revenue contribution in Q4. Fourth quarter operating margin of 18.7% was the highest of the year for the same reasons.

Slide 12, please. On non-GAAP basis, non-GAAP results was similar to our GAAP results driven by the same factor I just discussed. Full year 2012 non-GAAP operating income and non-GAAP net income grew 9.2% and 9.4%, respectively, and diluted EPS increased by 13.3% to $1.40. Slide 13, please. Here, you can see the quarterly progression of our non-GAAP results. Our non-GAAP results gross margin and operating margin trends had the same effect as GAAP financials. Without these factors, basically, gross margin and operating margin in the fourth quarter would be in line with the second and third quarter level.

On Slide 14, our balance sheet and cash flow continue to be robust. We had cash and short-term investments of $229.4 million at year-end and total bank loans of $64.8 million. Operating cash flow was $33.8 million for the fourth quarter and $131.2 million for the full year. Capital expenditures were $15.6 million for the fourth quarter and $67.8 million for the year. That means, we had $63.3 million free cash flow in 2012 versus $37.1 million in 2011.

Turn to Slide 15, please. So much of the free cash flow was returned to shareholders in 2012 in the form of share repurchase, and we are aiming to continue doing so in 2013. While investing aggressively in our growing business, we also spent $67 million in 2012 to purchase about 7% of our shares that were outstanding at the beginning of 2012. Today, we announced a new share buyback program of $100 million over the next 18 to 24 months.

Now Dr. Li will discuss our expected performance in 2013 and strategies in key business units. Dr. Li?

Ge Li

Thank you, Ed. Slide 16, please. We expect continued success in 2013 in the 3 elements I mentioned earlier: growth, investment and the return of capital to shareholders. In terms of growth, we expect total revenue of $565 million to $575 million, up 13% to 15% versus 2012. We expect a solid growth on bottom line as well. Specifically, we're forecasting GAAP diluted earnings per ADS of $1.26 to $1.30, up 6% to 9% and a non-GAAP diluted earnings per ADS of $1.49 to $1.53, up 60 -- up 6% to 9%, as well. This EPS forecast does not consider the impact of mark-to-market gains or losses from our foreign exchange forward contracts. In 2012, we had approximately $2.1 million mark-to-market gain from foreign exchange forward contracts, which add about $0.03 to earning per ADS. We'll continue to invest to support future revenue growth. We expect 2013 capital expenditures of about $60 million, and our headcount will grow rapidly in line with the revenue growth.

Slide 17, please. This slide shows what we expect to get to our EPS growth in 2013. In growing our GAAP EPS from $1.19 in 2012 to the range of $1.26 to $1.30 in 2013 and the non-GAAP EPS from $1.40 in 2012 to the range of $1.49 to $1.53 in 2013, we expect the business grows mainly from increasing volumes across virtually all of our service lines. We expect the business growth will increase GAAP EPS by about $0.32 and the non-GAAP EPS by about $0.30. The factors that have pressured our margin in recent years, labor inflation and RMB appreciation, will likely to continue in 2013. We estimate that our labor cost for Chinese workforce will increase about 10% and will reduce EPS by $0.07. We also expect RMB appreciation versus the U.S. dollar to reduce our EPS by about $0.04.

Our investment for future will have impact of $0.13 on EPS. There are many ways to define investment, but in this slide, we want to highlight the several investments that are particularly large and important, biologics R&D; the ramp-up of our biologics manufacturing facility; the JVs we entered into 2012 with MedImmune to develop MEDI5117 and with PRA International in clinical research. Those will generate losses in 2013; and the several risk sharing projects we are undertaking. We expect that these various investments to reduce our 2013 EPS by $0.13, but will be a source of future growth for the company for many years to come.

It is worth mentioning through the investment on building new capability, WuXi has transformed itself from a pure country-based service company to a fully integrated service company with very broad capabilities. Revenue contribution of synthetic chemistry was 100% a few years ago, now it only accounts about 18%. Finally, we expect our share repurchase program to increase our EPS by about $0.03 by reducing our ADS count. The exact amount of shares we'll buy back depends on market conditions and our stock price.

Turn to Slide 18, please. For the fourth quarter of 2013, we estimate total revenue of $129 million to $131 million, up 9% to 11% year-over-year. First quarter is typically the low quarter for our Lab Service business. We expect GAAP and non-GAAP diluted earnings per ADS of $0.26 to $0.27 and $0.31 to $0.32, respectively. Again, this estimate does not consider the mark-to-market gains or losses from foreign exchange forward contracts. We expect our year-over-year revenue growth rate to accelerate in later quarters of 2013, particularly in integrated drug discovery, biologics and drug development services. And because of this accelerating quarterly revenue growth, as well as the lower sequential expense growth, and share repurchase that is starting a few months into the year, we expect our year-over-year diluted EPS growth rate also to accelerate in the later quarters of 2013.

Slide 19, please. Here you can see that in spite of the headwinds like labor inflation, RMB appreciation and investment, WuXi has a good track record of strong revenue and profit growth. Our past investments have paid out, and we expect our current investment will do the same. Slide 20, please. Our earliest investment beginning in 2001 were in synthetic chemistry service, designed systematically to go into medicinal chemistry, biology, DMPK and other discovery services. More recently, we have invested increasingly in drug development service. We capitalize this service as you'll see on this slide and the next slide.

Slide 21, please. This slide shows our revenue distribution by major service offerings. As you can see from the chart, the fastest-growing service are development service, which grew 75% in 2012 and now account for 12.3% of total company revenues. The medicinal chemistry and other discovery service which have grown to be 28.1% of the total company revenues. Synthetic chemistry decreased to 18.3% of total company revenues in 2012 from 21.6% in 2011. Slide 22, please. Here, you can see growth rate in our drug discovery and development services in recent years and our expectations for 2013. As you can see, we expect to achieve double-digit growth in both areas, with particularly strong growth in drug development service, as the life science companies increasingly focus their resources on mid- and the late-stage product pipeline, advancing products into the China market.

Slide 23, please. Let's look in more detail at the current and future performance of some of our key functions. I'll begin with synthetic chemistry. The synthetic chemistry market has become increasingly competitive, particularly in China and India, producing pricing pressure. Our synthetic chemistry business continue to grow, achieving single-digit revenue growth in 2012 through volume growth that more than offset this pricing pressure. We have implemented a Lean Sigma program that has helped control costs, improve productivity and increase margins. Part of our strategy for success in this business is the geographic diversification. Our new Wuhan facility offers our customers attractive prices through lower operating costs and the government subsidy and deliver good margins to our shareholders. We anticipate this revenues will allow us to achieve single-digit revenue growth in this business in 2013. While synthetic chemistry was once our entire company, it is now about 18% of company revenues.

Slide 24, please. Our other drug discovery services, including medicinal chemistry, biology and DMPK, are growing significantly faster than synthetic chemistry. Medicinal chemistry, which involves teams of chemists and biologists refining the structures of a molecule to improve its performance, and other discovery service are now WuXi's largest function, with differentiated capabilities and good profitability. The unit was quite productive in 2012. We delivered 9 small-molecule preclinical drug candidates and one proof-of-concept compound for customers. The pipeline of preclinical candidates is large, with 41 lead-optimization programs ongoing at the year-end of 2012. We expect mid-teen revenue growth from these combined functions in 2013, with particularly strong growth in biology. While this business mainly earn revenues through full-time equivalent or FTE contracts, increasingly, we are eligible to earn bonuses based on success, such as advancement of product candidates into a first-in-human clinical trials.

Slide 25, please. As I mentioned earlier, we expect growth of about 30% in our drug development service revenues in 2013. Toxicology will be an important contributor to this growth, while continuing to build our position as the #1 toxicology CRO in China, domestic and international clients. In 2012, we were recertified as a GLP by Belgian regulators representing the OECD and by the SFDA. Both certifications had a broadened scope to cover all preclinical studies needed to support small and large molecule safety studies. We completed more than 400 individual products in 2012 and as a result, more than doubled our tox revenues versus 2011. We're targeting more than 40% increase in tox revenues in 2013, at a time when toxicology, globally, is seeing a little growth.

Our facility in Suzhou is currently operating at about 50% to 60% of its capacity, and we expect it to grow in 2013. We expect to reach full capacity of about 80% to 85% in our built-out rooms within a year. We will consider building out additional rooms in the remainder of the facility early next year. We're also planning to expand our small and large molecule bioanalytical testing capabilities at the Suzhou facility to support an increasing number of both small molecule and large molecule tox studies.

Slide 26, please. Biologics service will be particularly exciting growth area for the company over the next several years. WuXi is the partner of choice for biologics services in China, with a few competitors. We have a deep understanding of Chinese regulations, which requires that biologics used to -- used in clinical trials either be approved in other markets or manufactured in China. Our product portfolio is expected to be a mixture of biosimilars and novel biologics, with both multinational and the Chinese companies as customers. We have assembled a highly capable team of about 300 people, including about 30 returnees with U.S. or EU industry experience, and we'll be adding more staff progressively during 2013.

We have made about $30 million in capital expenditures to date in biologics, with $16 million to $18 million more planned in 2013. We have gained contracts with about 50 customers. The value of backlog of products is about $33 million as of now and growing. Biologics could be an important swing factor in WuXi's financial performance over the next few years. Today, this function is operating at a loss and reducing total company margins by about 2 percentage points, which, in 2 years, we expect this business to turn to operating profit through strong revenue ramp-up.

Slide 27, please. Another area we expect significant growth in coming years is clinical research. In December, we announced that we were forming a joint venture with a global clinical CRO, PRA International. The JV brings together complementary strengths of both companies to build a leading clinical CRO in China. WuXi brings to the JV an existing clinical research organization, with strong China operation experience, integrated drug discovery and development capabilities that are unmatched in China and a strong management team. PRA has a proven track record as a leading global clinical CRO, with operations in over 80 countries and strong capabilities to conduct Phase I to IV clinical trials globally, as well as state of the art IT systems.

WuXi is an existing clinical research organization of about 90 people, and PRA's 11 China- and Hong Kong-based employees will join forces to form the JV initially, with rapid hiring of additional staff planned in 2013. The JV will offer a broad platform of Phase I to IV clinical trial service in China, including those you see here. Starting in second quarter, our clinical research business will now be consolidated into WuXi's P&L but rather will be accounted for in a separate line item, equity investment income or losses.

Turn to Slide 28, please. Our small molecule Manufacturing Service business will continue to be a strong growth business. There's a number of moving parts with different growth opportunities. We expect this business to grow revenue at a mid-teens rate in 2013, led by research manufacturing and process chemistry. Commercial Manufacturing revenue declined moderately in 2012 and will be relatively flat in 2013, as we continue to diversify our portfolio beyond the one large product. We manufactured advanced ingredients for 5 commercial products in 2012 versus 1 large product in 2010. Aside from these 5 commercial products, we have 7 additional commercial product opportunities on our near-term pipeline starting in 2014, including some that could have large revenue potential for WuXi in future years.

Slide 29, please. Our U.S.-based Laboratory Service business has grown very well since we acquired it 5 years ago. It has grown at a 9.2% CAGR since 2008, with a substantial improvement in profit margins. 2012 was another good year, with the revenue growth of 11.6% driven by double-digit growth in both medical device and the biologics testing services. We expect high-single digit revenue growth in 2013 with stable profitability. Revenue and net income growth is expected to increase sequentially throughout the year, driven by seasonality of the business in both 2012 and 2013.

Slide 30, please. So to sum up, 2013 will be another year of solid revenue growth, with many of the same drivers that drove growth in 2012: continued revenue growth across China-based Laboratory Service, driven by our ability to deliver high-quality service and the drug candidates for customers; increasing utilization of our integrated drug development service through API manufacturing, IND-enabling tox studies and IND filings with the Chinese FDA -- Chinese SFDA and global regulatory authorities; a steady growth in revenue in U.S.-based Laboratory Services; continuing growth in Manufacturing Service driven by research manufacturing and growing our commercial manufacturing pipeline; the early ramp-up of biologics drug discovery, development and the Manufacturing Service; and the expansion of our clinical development platform through our JV with PRA.

Slide 33 (sic) [31], please. We'll continue to be very optimistic about our future. Our dream for WuXi has 3 main elements, an open-access platform for health care based in China. We are confident that our dream will become a reality because we believe an open-access platform is the most effective and efficient way to allow researchers to capitalize their knowledge and experience and help solving the problem of low productivity in the pharmaceutical industry. Health care spending will continue to grow globally as world patients will demand and be willing to pay for high-quality medical products and a better quality of life and because operational strengths in China is important to capitalize on the rising demand by the large and rapidly growing Chinese middle-class for the same treatments prescribed for Western patients.

So thank you for your attention. And now, we'll be happy to answer your questions.

[Technical Difficulty]

Ronald Aldridge

So I think we're ready for questions from the investors and analysts. I apologize for the technical difficulty.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from David Windley from Jefferies.

David H. Windley - Jefferies & Company, Inc., Research Division

Thanks for the detail in the slides, really appreciate and think it's very helpful that you laid out this matrix of your services. So my first question is, in terms of investment and building capability, which is a path you've been on for some time, as I look at Slide 4, with all these boxes of your different services, do you view that as now pretty complete? Or are there still de novo new services that need to be added to this matrix to complete your blanket or platform of services?

Ge Li

Yes, I'll answer that. We recently completed -- but as you know, in each boxes, we want to build a deeper capability and to make our service better.

David H. Windley - Jefferies & Company, Inc., Research Division

Okay. And if I -- later in the slide deck where you show revenue breakdown, again very helpful. The revenue breakdown between synthetic chemistry, medicinal chemistry, development, et cetera, if I were to think about the breakdown between, say, small molecule activities and large molecule activities, what would that look like? And I assume large molecule is pretty small at this point. Does that have the opportunity to grow to a business that is as large as the small molecule side? So how big is biologics and how big can it be?

Ge Li

Well, I think so. Actually, our customers are moving to a balanced mixture of small molecule and large molecules. Our current revenue, as you point out, the majority is from small molecules. But I think in a few years, it's going to be a balance, both small molecules and the large molecules.

David H. Windley - Jefferies & Company, Inc., Research Division

Could you put a number on like what percentage of your total revenue comes from large molecule?

Ge Li

Well, I think, eventually, it could be 50-50.

David H. Windley - Jefferies & Company, Inc., Research Division

And what is it now?

Ge Li

Now actually, our biologics is quite small. I think roughly it's about 90-10.

Operator

Your next question comes from Ingrid Yin of Oppenheimer.

Ingrid Yin - Oppenheimer & Co. Inc., Research Division

My question is around the guidance for 2013, 13% to 15% growth. And what are the growth assumptions if you look at the 5 business service segments you break out? I know you mentioned synthetic chemistry as single digit; and medicinal, mid-teen; U.S. Lab, high-teen -- high-single digit. What about development and manufacturing? And also, for the $33 million backlog for biologics, how should we think about it? Is it growing over time? And what time frame these orders will be filled? And lastly, can you talk about the sequential improvement in margins in 4Q? Why is that? And should we expect that trend to continue?

Ge Li

You have too many questions in one question. For you Ingrid, I just -- I'll try to address the -- answer all your questions. One is the guidance for 2013, so overall, 13% to 15% growth, and we said that probably the Chinese-based Lab Service will grow in the mid-teens. And manufacturing -- small molecule manufacturing business probably also growing around the mid-teens levels, and the U.S. Lab Service will grow about high-single digits. And the biologics business, the $33 million backlog will be realized over probably 2-year period, as most of these projects take quite some time from beginning -- from cell line generation all the way to GMP manufacturing. The backlog has been -- is growing every quarter. Regarding Q4, margin is higher than previous 3 quarters, as I've said in the prepared remarks. We had received a VAT tax refund and also, government subsidy in fourth quarter. And also, we have a higher Lab Service revenue contribution in the revenue mix, which had a higher margin. So if we'll remove those factors, then our Q4 gross margin and operating margin probably should be in line with the previous -- second quarter and third quarter.

Operator

Your next question comes from John Kreger from William Blair.

John Kreger - William Blair & Company L.L.C., Research Division

My question relates to your clinical research JV. It sounds like that's in the process of forming. Could you just elaborate a bit more on when that business will be up and running, when you will be signing contracts and building a backlog and perhaps, when you'd expect that to be a positive contributor to your bottom line?

Edward Hu

So John, the JV with PRA will be formed probably early second quarter. We are right now in the process of registering the JV and getting the Chinese government approval and then it's up running. But the preparation of the JV has already began, and both companies started already to promote the JV service to our respective customer bases. But it is -- obviously, it's on building up phase. And in China, because the clinical trial approval, the R&D approval in China is very long, it takes somewhere between 9 to 12 months, so we'll be building up the backlog this year. But the JV will be probably in launch position for 2013, but for 2014, definitely, the JV will start making positive contribution to the bottom line.

John Kreger - William Blair & Company L.L.C., Research Division

And a quick follow-up. How broadly do you want this clinical business to be? Are you going to move the whole way through into Phase III and even Phase IV? Are you going to stay more focused in Phase I and II?

Ge Li

This JV will be covering broad service, from Phase I to Phase IV. In fact, actually, through PRA, we -- a lot of the clinical business from PRA global trial will be for Phase II and Phase III trials.

Operator

Your next question comes from Tim Evans of Wells Fargo Securities.

Timothy C. Evans - Wells Fargo Securities, LLC, Research Division

I was wondering if you could talk about the competitive dynamics and specifically, pricing in some of the other areas of your business. Specifically, I'm wondering if -- as competitors view your success in some of these downstream services, if you would expect pricing in those areas to also come under pressure over the next couple of years?

Ge Li

Okay, Tim. The pricing pressure of our downstream services is relatively light. As you know, it takes time to build the capabilities and also to get certifications from, like, authorities. The major pricing pressure actually came from synthetic chemistry, which became commoditized.

Edward Hu

So let me just add on. Downstream services all requires more capital and also knowledge because it's our GMP, GLP, EDT combined services, which have higher entry barrier for the small competitor to come in.

Ge Li

It takes time to build a quality system and validate the system and get the system audit and approved.

Timothy C. Evans - Wells Fargo Securities, LLC, Research Division

Okay, that's helpful. And just real quick, are the VAT tax refund and the government subsidies a real onetime item or would you expect some of that to repeat in 2013?

Edward Hu

So in 2012, the Chinese government adjust to spot in -- piloting VAT, from a so-called business tax into a VAT tax. We did not get a refund early in the year. We've got it in the fourth quarter. But for 2013, we actually want to get a refund as we go, so it's been built into the budget.

Operator

Your next question comes from Tycho Peterson from JP Morgan.

Tycho W. Peterson - JP Morgan Chase & Co, Research Division

I want to go back to maybe one of the earlier questions on gross margins. I'm just wondering if you can talk about -- give a little bit more color on the divisions. I know you talked about some pricing pressure in synthetic chem. Are you able to give us just any granularity on the margins for the different divisions? And you also commented on Lean initiatives offsetting some of the margin pressures. So can you also talk about where you are in the process with Six Sigma and some of the other Lean initiatives?

Ge Li

Well, actually, I think our margin pressure mainly came from labor inflation and RMB appreciation so of course -- and also, from our investment on current loss business, but we build it for future.

Tycho W. Peterson - JP Morgan Chase & Co, Research Division

How about -- do you want to maybe just elaborate on your Lean initiatives? I mean, how widespread is -- are they and how much potential do they have to offset maybe some of the pricing pressures?

Ge Li

It's definitely a company-wide initiative. We started at the beginning of 2012. We definitely see the improvement now or the efficiency and the cost savings, and we expect to continue seeing that in 2013 and the future, so we're actually gearing up the effort of Lean Sigma.

Tycho W. Peterson - JP Morgan Chase & Co, Research Division

And then on tox, you talked about being it 50% to 60% capacity now and that goes to 80% to 85%. How do we think about the pricing dynamic there? I mean, are you able to extract better pricing as you cross over that 80% threshold? And then, did you say you'll be adding new rooms this year or is it next year?

Edward Hu

On the pricing dynamics right now in tox is actually, I would say, stable. We don't see downward pricing, particularly coming from the U.S. So -- but also interestingly enough is that more and more study we do is to integrate. So essentially, those are the projects that WuXi takes on from API services to toxicology. For that, actually, we'll can actually charge a premium because no other company can do that.

Ge Li

And then, we also have many domestic customers who are willing to do tox study in international standard to get ready to file globally.

Edward Hu

So into the room expansion, we're planning to begin probably later this year or early next year. We still have about 46 new rooms of space in our current facility. We'll invest about $5 million CapEx so we can build additional 46 rooms.

Tycho W. Peterson - JP Morgan Chase & Co, Research Division

Are you able to say how many tox customers you have at this point?

Ge Li

We have more than 50 customers now.

Operator

Your next question comes from Jack Hu of Deutsche Bank.

Jack Hu - Deutsche Bank AG, Research Division

My first question is on Slide 17. Thank you for providing this slide. It's the first time we saw you actually dissecting all the impact actually. So I want to go into each item, mainly on labor, renminbi and actually on the share buyback. So the first one, on the labor, what kind of assumptions you build in this year, actually for labor inflation for this year versus last year? Secondly, renminbi appreciation, what's the assumption for renminbi depreciation or appreciation you're building in? And finally, for the share buyback, you quantified about a $0.03. I did a really quick math actually, that actually is under USD 25 million buyback actually, if we were assuming current share price. So is that a bit too conservative? That's my first question.

Edward Hu

Jack, on the labor inflation, we assume about a 10% -- average of 10% salary increase year-over-year. And then, foreign exchange, RMB, average exchange rates 2013 versus 2012, we assume about 3 percentage point increase of RMB value.

Ge Li

RMB appreciation.

Edward Hu

RMB appreciation against the U.S. dollar. On the share buyback, this $0.03 estimate is based on actually share buyback through the open market purchase. So we cannot really go out and buy $50 million of shares right away. So we buy through several quarters, you don't see the impact immediately. As shares are retired, then you see impact.

Jack Hu - Deutsche Bank AG, Research Division

My follow-up question actually is on your percentage distribution between fee-for-service and FTE right now. And also what type of new service are signed up as FTE and what type are signed up in fee-for-service in this space?

Ge Li

Currently, our fee-for-service business are growing much faster than FTE service because most of the development services and downstream services are entirely people service, and FTE service is primarily is in the discovery and chemistry space, which is -- don't have a defined outcome, so those are based on FTE.

Operator

Your next question comes from Wei Du of Goldman Sachs.

Christopher Eoyang - Goldman Sachs Group Inc., Research Division

This is Chris asking a question on behalf of Wei. The question is on gross margins sequentially for the Lab Services and the Manufacturing Services. You'll see that Lab Services actually is growing sequentially from Q2 to 4Q and Manufacturing is going sequentially down from 2Q to 4Q. So would you tell us what causes the trend? Is this kind of like business mix change or efficiency? And what kind of contribution due to such 2 different trends?

Edward Hu

So in the Q4, gross margin for Lab Service growing is partially -- as I explained before, there's a VAT tax refund and some government subsidy, and also the Lab Service have a higher margin, in general. Of the revenue growth, the cost did not really grow in sync. Manufacturing in Q4, because revenue is lower and the utilization of our commercial manufacturing facility was lower. That's the primary reason that the manufacturing margin was down in Q4 compared to Q2 and Q3

Christopher Eoyang - Goldman Sachs Group Inc., Research Division

So as we go into the first quarter of 2013, are we seeing any stabilization of Manufacturing gross margin or -- and then, we've seen or we'll be seeing that...

Ge Li

The manufacturing business, as I said, it's more variable in performance quarter-over-quarter. You really have to look at it annually because it really depends on the production schedule and delivery schedule. So in fourth quarter, we probably delivered still a significant amount of product. So the fourth quarter Manufacturing revenue will be much higher than the fourth quarter last year.

Operator

Your next question comes from Paul Knight of CLSA.

Bryan Kipp

This is Bryan Kipp on behalf of Paul. You guys talked about your broad-based expansion of your service platform, but going in a little bit more specificity here. The teleprevir drugs that you guys were manufacturing for a little while, the drug looks like it's going from a $1.2 billion drug to around $600 million in 2013. What's the pipeline looking like to replace that?

Ge Li

Well, actually, right now, we are producing intermediaries for 5 commercial products, and we have 7 products in production after proof of concept, basically Phase II. And another thing is we're particularly strong in research and manufacturing, which actually grow very fast. Research and manufacturing is in the combination of process research and the manufacturing to produce research APIs and some of the research APIs will move down from Phase I, Phase II, Phase III. So essentially, we build our commercial manufacturing pipeline, so it seems this model works very well for us.

Bryan Kipp

And just a follow-up. A lot of people have been asking about gross margin, the pressure you guys have seen. Obviously, year-over-year, there's been some declines. You cited some synthetic chemistry pricing issues, biological service drag and the implementation of Lean Sigma. But it looks like over the last, say, 3 to 5 years, you seem to pressure on op margins. What else are you guys doing to try to expand those? Any initiatives specifically?

Ge Li

Well, primarily improve efficiency and the cost savings and also building our capabilities, which has a large pricing pressure.

Edward Hu

But I also would add, overall, if you look at the CRO space, we probably are still the high -- or most profitable company compared to the large public CROs there.

Bryan Kipp

Okay. And for '13, it looks like it's somewhat flat, maybe up, maybe a little bit down in the range that you guys have. Do you expect that trend to continue for the next couple of years? Do you see a benefit from Lean Sigma and other things?

Ge Li

I think we'll see margin improvement as our investment on new capabilities just start to pay off.

Operator

Your next question comes from Bin Li of Morgan Stanley.

Isabella Zhao - Morgan Stanley, Research Division

It's Isabella on behalf of Bin Li. Actually, most of the questions have been answered. I just have a small question regarding for the CapEx. I know your CapEx budget for 2013 is $60 million and average $60 million and $80 million will be depending on the biological services. Can you give us more color about the rest of the CapEx? How much will be spent in other area?

Edward Hu

We have many area that require CapEx to continue to expand capacity, so in manufacturing, small molecule manufacturing area. We also will install new reactors and expanding capabilities, including building specialty labs like a high-potency manufacturing suites. And also, we have other area. We're building about 50 testing labs in China, which is essentially we have to leverage what we have in the U.S. and building the same-quality lab in China. So those area all require investment and perhaps on top of that, maintenance capital.

Isabella Zhao - Morgan Stanley, Research Division

Okay. And one follow-up question is for the biological services. What's your expectation? Are they requiring more investment in the future in terms of the CapEx?

Ge Li

Yes. It will require investment in CapEx, but probably it's not going to require $46 million again. So during the last 2 years, we have already built a platform from discovery to development to manufacturing.

Isabella Zhao - Morgan Stanley, Research Division

Okay. And how much did you spend on biological services in like CapEx in 2012?

Edward Hu

I think in 2011, 2012 combined, we spent about $30 million.

Ronald Aldridge

We thank everybody for participating in this call. I apologize for the technical problems. My telephone line went dead, but it seems like the rest of you were fine, so thank you for calling. We look forward to speaking with you again in May to go over our first quarter results.

Ge Li

Thank you.

Edward Hu

Thank you.

Operator

Thank you very much, ladies and gentlemen. That does conclude our conference for today. Thank you for participating. You may now disconnect.

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