Magazine
The Perfect Storm
Outsourcing demand slows as industry capacity peaks
By Steve Snyder
If you read my last article (The Preclinical Year in Review, Contract Pharma, Nov-Dec 2008), I noted the risk in writing a yearly review article in October (that timing was necessary to meet the submission date for the aforementioned issue). Yikes! How prophetic! So much happened in the preclinical outsourcing industry from mid-October through December of 2008 that I have made a mental note to hold off on writing the next annual review article until after 2009. What a novel idea! I have been working in this industry for over 30 years, but even I was surprised at the magnitude of the news during the last quarter of 2008. In this article, we’ll take a look at what happened, why it happened, what impact it may have on the industry, and what it all means for preclinical outsourcing customers.
What Happened?
- After rapidly increasing facility capacity and headcount, MPI Research announced that it would layoff staff due to worsening economic conditions and a slower demand for preclinical services.
- After preparations to refurbish, equip, and staff a preclinical toxicology facility in the Toronto area, Harlan suddenly closed the facility and laid off the staff.
- WIL Research announced changes in its senior management ranks and cited potential expansion plans.
- Covance noted a slower demand for toxicology services in the third and fourth quarters of 2008 as some clients pushed work from 2008 to 2009.
- Charles River noted slower demand for toxicology services during the third quarter of 2008 and rescheduled a 2009 financial guidance release from December 2008 until February 2009.
- The stock prices of both Covance and Charles River plummeted during the fourth quarter of 2008.
- Many preclinical CROs in North America reported open facility capacity during the fourth quarter of 2008 when just six months earlier sponsors reported waiting months for available capacity.
Why Did All of This Happen?
With the exception of the news out of WIL Research, which was related to the retirement of its longtime company president, much of this news was blamed on the current economic hard times. Certainly, the economy is a mess and it is understandable that sponsor companies would “hunker down” until they get on a new budget cycle in 2009.
It seems to me that people blame the economy for everything. Regardless of the industry, wouldn’t you like just once to hear a management team say, “We messed up!”? Don’t hold your breath; it won’t happen. Did you ever notice how some of these same management teams don’t hesitate to pat themselves on the back for their company’s performance when it was seemingly just due to good economic times? Besides economic influences, the performance of a preclinical CRO is largely based on the effectiveness of its internal operations. Every CRO develops a reputation for operational performance and savvy sponsors will at least consider this reputation when selecting a CRO to conduct their research. Accordingly, economic challenges could amplify the impact of operational challenges or vice versa.
The problem is that there is no database where unfavorable sponsor experiences are captured, and the CROs themselves certainly won’t speak publicly about their own operational challenges. Sponsors largely rely on sharing their own experiences as a means of learning about CRO performance. Consider the following “news from the grapevine” that came out of a recent national meeting:
- Sources that are familiar with the company reported that Charles River laid off the general managers at its Arkansas and Shrewsbury facilities. Individuals in these positions are responsible for all activities that relate to the performance of a preclinical research site. If these reports are true, are Charles River’s business challenges solely related to the economy? Were there operational issues? Was it just a time for a change in leadership at these sites?
- MPI Research added a lot of facility capacity and hired staff aggressively prior to announcing layoffs in the fourth quarter of 2008. Those of us who are knowledgeable understand that it is difficult to grow a preclinical operation while maintaining quality and customer satisfaction. This aggressive growth phase was a concern to many in the industry. Now, MPI has the same amount of facility space but has reduced its headcount due to a lower demand for preclinical services. How will revenue be generated from the new space with a lower headcount? Will there be an impact on quality? Did the demand decline due to economic reasons, operational reasons or both?
- It has been said that the closing of Harlan’s Toronto facility has been attributed to the realization that the facility would not provide an acceptable return on investment. In fairness, this facility had not been operational long enough to develop a reputation in the industry. Was this solely an economic casualty or an operational strategy gone wrong?
Remember, even with news from the grapevine, it is incumbent on sponsors to seek the facts. They should never make outsourcing decisions based on hearsay and gossip. The items above suggest that operational factors could influence CRO performance and, if so, they may not be apparent to sponsors until significant changes occur.
Industry Impact?
Given the current economy, the preclinical CRO industry will be further challenged to execute business strategies and maintain quality operations. Every business has to exercise fiscal responsibility but sponsors won’t want to hear about poor quality due to cost-cutting initiatives. Therein lies the problem. If a sponsor encountered quality issues at a CRO, no CRO employee would ever admit that the root cause was cost-cutting. Again, it is incumbent on sponsors to do their due diligence in selecting a CRO and in monitoring ongoing studies, because CROs will be increasingly challenged to police their own operations. Here are some of the challenges that specific companies will face in 2009:
Covance: With the purchase of Lilly’s Greenfield toxicology facility and opening a new toxicology facility in Chandler, AZ, Covance will be challenged to manage its growing operations and fill its commercial capacity. Covance will need to do this without impacting the operations at its other preclinical sites. Sponsor demand was much greater when the Greenfield and Chandler strategies were developed, so it follows that it could be difficult to bring new capacity on-line during tough economic times.
WIL Research and Charles River: Both companies made management changes at the end of 2008. At a preclinical CRO, management sets the tone for organizational effectiveness. Just as shareholders should be alert when a veteran manager of a mutual fund departs, sponsors should pay attention when there are management changes at a CRO. Does the new management understand preclinical CRO operations or is it merely someone with impressive paper credentials? Will new management be so focused on revenue growth that it will ignore quality initiatives and customer service? At least in the case of WIL Research, the management changes simply reflect new levels of responsibility for the remaining senior staff.
MPI Research: As mentioned earlier, the company has a lot of capacity and now fewer employees. Will it be able to deliver on quality and customer service? Will it be able to generate revenue out of all of this existing capacity? Will pressures from external investors impact operational effectiveness? These challenges are now greater because sponsor demand is lower.
Smaller CROs: With a lower demand for preclinical services, will smaller CROs be able to compete with larger providers? At the beginning of 2008, sponsor demand was so great that smaller CROs did a robust business. Those with an excellent reputation for quality and customer service will likely continue to do well as long as they are competitive on pricing. CROs that don’t enjoy excellent reputations for quality could see business lag as sponsors seek out quality organizations.
Emerging Markets: Although the financial end of sponsor companies will continue to push to identify preclinical providers in lower cost emerging markets, one has to wonder if the open capacity in the North American market will adversely impact the flow of business to CROs in India and China. Why would sponsors want to manage logistics in emerging markets when space and competitive pricing is available in North America? Although some claim that there will be no effect, the impact of the recent terrorism activity in Mumbai still needs to be determined, as it relates to preclinical outsourcing in India.
What Does All This Mean for Preclinical Customers?
More choices: With open capacity in the industry and new capacity coming on-line with Covance’s Arizona facility, sponsors can be more selective on where to place their work. In early 2008, sponsors almost had to select CROs based on which had capacity available the soonest. For now, sponsors can be more selective, but don’t expect this abundance of capacity to be a long-term phenomenon. Although sponsor companies curtailed their outsourcing at the end of 2008, they need to continue to develop potential new drugs if they want to stay in business. Watch for available capacity to shrink by 3Q09 unless the economy has not begun to improve by that time.
Better prices: Good deals can be had if sponsors are willing to seek competitive bids but sponsors should be wary of selecting the lowest bid. CROs are under pressure to fill capacity and generate revenue. The lowest bid may not translate to work of acceptable quality.
More worries: The economy is impacting everyone. We have seen that it is impacting CROs. CROs always face operational challenges and now these challenges could be exacerbated by the economic factors. Sponsors need to scrutinize CRO operations before awarding new work and that scrutiny needs to continue once the work is ongoing. Are the operations under control? Is management involved? Has revenue growth been put ahead of a commitment to quality? This last point may sound ludicrous but financial expectations from Wall Street or private investors can cause shifting priorities.
Sponsors need to be wary of CROs that have undergone layoffs or management changes. What is the morale of the staff? Are people worried about their job security? Is the new management effective and does it understand the business, or is it a corporate figurehead?
Finally, although travel budgets are the first to be cut, this is not the time to cut back on study monitoring. CROs are quietly going through their own rounds of cost-cutting, which could mean that the CRO staffs are not watching your studies as closely or that less experienced staff is conducting your research. Based on what I shared above, sponsors should be increasing their scrutiny of CRO operations, not decreasing it. Travel budget savings will seem minuscule if the development of a key drug is delayed due to quality issues at a CRO.
I entitled this article “The Perfect Storm” because many of the preclinical CROs were impacted by economic and (seemingly) operational challenges within a short period of time at the end of 2008. In my opinion, the current economy has highlighted the challenges that face CRO management teams. Managing a CRO growth strategy is challenging but managing preclinical operations is even more of a challenge. Industry folklore is full of stories where management teams ran (or are running) perfectly good preclinical CROs into the ground because of their inability to effectively manage operations.
The good news is that this storm will pass and the economy will eventually improve. Sponsor demand will return and capacity will eventually be in short supply again. In time, everyone will forget these recent industry events.
The bad news is that everyone will forget these recent industry events. The understanding of the need for effective operational management will be lost as revenues grow. Eventually, we’ll experience another “perfect storm.” It will happen but for now, let me share the following advice to start 2009: “Winter Storm Warning — Buyer Beware!”
