Chinese drug maker CStone Pharmaceuticals (2616.HK) is having to swallow a bitter pill after being dropped from a system that gives mainland investors access to Hong Kong stocks.

The reaction was swift and painful after the company lost its status as a Hang Seng index component and was therefore ejected from the Stock Connect list. After the news broke, the share was hit by waves of selling and ended last week down 39.2%.

With the Hong Kong stock market in a sustained slump, unprofitable biomedical companies have been keen to attract mainland investors through the program that allows Hong Kong stocks to be traded via exchanges in Shanghai and Shenzhen, known as the Southbound Stock Connect List. Falling off the list can trigger a plunge in transaction volumes.

The developer of cancer immunotherapies and precision medicines fell below the threshold for inclusion in the Hang Seng Composite Index, which in turn cost the company its place on Stock Connect.

With a market value hovering around HK$2 billion ($256 million) in the second half of 2023, the company was far short of the HK$6 billion eligibility level and was removed from the index after a review on Feb. 26. The company issued a statement on March 4 insisting there had been no major changes to its business and financial conditions, but investors still turned tail.

Once a company is removed from Stock Connect, mainland investors can no longer buy the shares, but they are still allowed to sell them. Exclusion from the Hang Seng means funds that were tracking the index will shed the relevant shares. The forces combine to generate strong downward pressure on a stock.  Aside from CStone, other stocks that found themselves dropped from the list also took a battering. Brii Biosciences (2137.HK) fell 41.8% last week, Jacobio Pharmaceuticals (1167.HK) sank 34.3% and Yonghe Medical (2279.HK), the first hair transplant business with a Hong Kong listing, dropped more than 26%.

After the sell-off, CStone's share price was left languishing at around HK$0.9, more than 90% below its initial offering price of HK$12 in 2019, and daily turnover last Friday shrank to HK$3 million. During the last major biopharma rally in 2021, CStone's share price reached a peak of HK$19.12.

Jason Yang, who took over as CStone's CEO in August 2022, has not been short of confidence in the company. Since taking up the post he has raised his personal stake several times, at prices ranging from as much as HK$4.6 in September 2022 to a low of HK$1.66. Yang's last purchase took place on Jan. 22, taking his stake to 4.79% of the outstanding issuance, close to the 5% that would rank him as a substantial shareholder.

CStone has enjoyed success with a licensing-in business model and R&D capability. Since its launch in 2015, the company has brought more than 10 innovative drugs to the market, including pralsetinib, avapritinib, ivosidenib and sugemalimab. The right to market sugemalimab was licensed to Pfizer(PFE.US) while the other three were managed by CStone's own sales team.

Aside from sugemalimab, which was developed by CStone, the other three products were licensed from other developers, requiring CStone to pay sizable fees and a big cut of sales to its partners when reaching milestones such as completing clinical trials or launching drugs on the market.

For the first half of last year CStone posted revenue of 261 million yuan ($36.3 million), with 247 million yuan of that coming from commercialized products, a year-on-year increase of 53%. The company's gross margin rose from 58.7% to 64.6% in the period, while its adjusted net loss shrank 29% to 183 million yuan. As of June 30 last year it was sitting on approximately 1 billion yuan in cash reserves.

Scaling back

As financing grew tighter last year, several innovative drug companies, including CStone, sought to tap into new revenue sources and cut back on spending. The measures included selling existing projects while minimizing all non-essential expenditure.

CStone announced on Dec. 21 that it would sell exclusive rights and interests in the leukemia drug avapritinib in Greater China and Singapore to the original research company Servier for $50 million. A month ago, it sold the exclusive right to market and promote pralsetinib in mainland China to Allist Pharmaceuticals for an undisclosed amount. And very soon its entire pralsetinib sales team was let go.

Around the same time, CStone also signed an agreement granting 3SBio (1530.HK) the rights to develop, register, produce and commercialize the anti-PD-1 monoclonal antibody nofazinlimab, used in cancer immunotherapies.

Spending has also been cut. CStone's sales and marketing expenditure fell 15 million yuan to 131 million yuan in the first half of last year, while R&D spending dropped 79.8 million yuan to 187 million yuan, and it is still obliged to pay 122 million yuan of milestone payments and other third-party expenses. Currently, ivosidenib is the only product still being managed by CStone's own team and the project could see further cost-cutting. Investors will pay close attention to the company's finances when it announces full-year results at the end of March.

At a business review meeting on Dec. 20 last year, CStone said it would put greater strategic emphasis on R&D to bring products to market more efficiently and reach commercial cooperation deals.

CStone's latest price-to-sales (P/S) ratio is only 2 times, far lower than the 7 times for Zai Lab ( ZLAB ), which operates a licensing-in model. After scaling back its commercialization efforts and transferring out the rights to drugs, CStone is banking on R&D to widen the approved uses of existing drugs. Investors will be watching closely to see if the leaner model can pay dividends in the future.