Anticipating Structural Change in the CRO Market
Sponsor crises lead to an unstable landscape
Tufts Center for the Study of Drug Development
The global financial market crisis at the end of 2008, followed by a deep and lengthy recession worldwide, has affected every sector of the economy. The drug development enterprise has been hit particularly hard. Global economic and operating conditions have accelerated the implementation of portfolio diversification and operating strategies put in place prior to the crisis. These conditions have also facilitated the introduction of new — and in many cases reactive — strategies, many of which will result in structural changes in the clinical outsourcing market.
This article explores these structural changes and their implications. Although the short term has been, and will continue to be, a volatile period for both sponsors and CROs, the outsourcing market appears on track to become an even more integrated and collaborative environment in the long term.
Sponsors: Crisis on All Fronts
Over the next several years drug developers face an unprecedented $125 billion in revenue-at-risk due to patent expirations and competition from generic drug equivalents. Many of the largest blockbuster drugs in history — including Lipitor (atorvastatin), Plavix (clopidogrel), and Prevacid (lansoprazole) — are coming off patent with no blockbusters queued-up in the pipeline to replace lost revenue. Instead, pharmaceutical and biotechnology companies are anticipating managing a broader and more active portfolio of investigational treatments for smaller, more targeted illnesses. This ‘patent cliff’ has heightened awareness of the long-term need to contain rising R&D costs and accelerate drug development cycle time.
Weak consumer demand and restrictive price controls have dampened revenue and profitability. Facing far more limited resource availability, sponsors are cutting deeply across multifunctional areas — consolidating head count aggressively. Based on company announcements made between the beginning of 2009 and the first half of 2010, an estimated 100,000 pharmaceutical and biotechnology industry jobs have been eliminated or will not be filled. Of these reductions, approximately 9,000 jobs will be cut directly out of R&D functions.
Poor economic conditions and high market uncertainty have contributed to a major decline in global clinical trial volume. Many companies cancelled and delayed their clinical trials in 2009 through 2010. According to a recent analysis by the Tufts Center for the Study of Drug Development, new clinical trial starts worldwide — as measured by Form 1572s filed by clinical investigators — are down nearly 50% from their peak in 2Q08. Although many observers note that the volume of new clinical trial projects is now picking up, it is doing so sluggishly.
Facing difficult market conditions and the need to diversify their product portfolios, pharmaceutical and biotechnology companies initiated another major wave of mergers and acquisitions in 2009 that will likely continue through 2011. The largest deals: Pfizer’s acquisition of Wyeth for $68 billion, Merck’s purchase of Schering-Plough for $41 billion, and Roche’s completed acquisition of Genentech for $47 billion. Other notable M&A activity during the past 24 months includes Gilead Sciences acquisition of CV Therapeutics, BMS’ purchase of Medarex, Takeda Pharmaceutical’s acquisition of Millennium Pharmaceuticals, Eli Lilly’s acquisition of ImClone Systems, Teva Pharmaceuticals’ acquisition of Barr Pharmaceuticals, and King Pharmaceuticals’ $1.6 billion purchase of Alpharma. In early 2010, Abbot completed its $6.6 billion acquisition of Solvay Pharmaceuticals. And at press time, Sanofi-Aventis is aggressively pursuing the acquisition of Genzyme Corp., and BMS has announced its intent to purchase ZymoGenetics.
An Unstable CRO Market
Faced with an abrupt slowdown in global clinical trial volume and relatively weak sponsor demand, many major CROs struggled in 2009. CSDD’s evaluation of the aggregate performance of six large publicly traded CROs — Covance, Charles River Labs, ICON, Kendle, Parexel, and PPD — found that in the first half of 2010, revenue and earnings growth have slowed down substantially. Growth in the first half of the year between 2009 and 2010 was only 1.8%. This compares to a compound annual growth rate of 12.2% between 2007 and 2009 for large publicly traded CROs.
Operating profitability of major CROs saw an even sharper decline: the aggregate CAGR of those six companies from 2007 to 2009 was 3.1%. In the first half of 2010, operating profit decreased 58.1% in the aggregate compared with the first half of 2009. Individual companies saw their operating profits drop as much as 86%, and only one out of the six public companies evaluated had an increase in profitability in the first half of 2010 over 2009.
Project backlog, although still growing, has slowed down considerably. From the end of 2008 to the end of 2009, the aggregate backlog of the six companies grew 8.9%, but from mid-year 2009 to 2010, backlog grew 2%. Moreover, the aggregate market capitalization of the six companies grew only 4.3% during the first half of 2010.
In response to market conditions, several major CROs have moved to reduce their fixed operating costs and to focus their businesses — through consolidation of manpower, infrastructure and divestiture. Charles River Labs, for example, suspended operations at one of its large preclinical sites. Covance closed a preclinical and a Phase I unit. MDS Pharma Services sold its remaining clinical trial businesses to Ricerca Biosciences. In June 2010, PPD spun off Furiex Pharmaceuticals, its compound partnering division, as an independent company.
The overall CRO market structure is shifting; the 10 largest CROs dominate the market, contributing 75% of total contract clinical CRO revenue (not including pass-through investigator grant fees and central lab fees). In aggregate, these companies have increased their revenues from $5.2 billion in 2005 to $8 billion, a compound annual growth rate of 8.9%. Average revenue per top 10 largest CRO company is $1.3 billion. The next 10 largest CROs grew at a slightly lower rate of 7.2% between 2005 and 2010 (projected). This segment has an 11% share of the overall CRO market at this time. For scale comparisons, the average revenue for each company in the Next-10-Largest CRO segment is $220 million.
The largest surprise in the CRO market comes from the very fragmented, small, niche provider segment. Comprised of hundreds of companies, this segment in the aggregate has been growing by 20.5% each year between 2005 and 2010 (projected). The typical company in this segment is small with average annual revenue of $3.1 million. The niche CRO segment posted slow relative growth (7.6% annually) between 2000 and 2005. Given unusually high growth during the past five years, this segment now generates 14% of the total global market for contract clinical research services.
To what do we attribute such rapid growth among niche providers at a time when most sponsors are looking to consolidate the number of vendors they manage and to establish preferred pricing through longer-term multi-service agreements? Most sponsors and CROs concede that demand for highly specialized niche services and unprecedented access to local markets worldwide has been strong. As such, both sponsors and major CROs have increased their level of partnering with niche providers.
Tomorrow’s Outsourcing Landscape
Several years ago, pharmaceutical and biotechnology companies appeared poised to embrace common integrated alliance-based relationship structures with CROs. In a study conducted by Tufts CSDD in 2008, nearly half of all companies reported that they had entered into typical functional service provider arrangements. Approximately one out of five reported having entered into a strategic alliance. Adoption of these relationship structures, however, has not unfolded in a predictable or uniform manner.
Since the end of 2008, it appears that many sponsor companies have opted to pursue hybrid relationship models based on a wide variety of factors including corporate culture, pipeline characteristics, legacy systems, and internal operating structures and processes. Sponsors are picking and choosing elements from transactional relationships, full service relationships, functional relationships and alliance relationships with two primary objectives in mind:
1) to achieve higher levels of operating efficiency through integration and the transfer of non-core responsibilities, and
2) to lower the overall cost of outsourcing.
Distinctions between various relationship models are blurring. As companies move to mix and match elements, they rely on communication systems and unique governance structures to monitor and manage performance.
Integrated partnerships appear uniquely susceptible to market volatility. Operating challenges have disrupted the adoption and growth of integrated relationships — particularly for those organizations trying to revise their outsourcing strategies and practices. As the industry consolidates through mergers and acquisitions, outsourcing practices favor those organizations driving the transaction. Established sponsor-CRO relationships with those organizations being absorbed simply vanish, as acquiring companies and those directing a merger transaction drive the use of their primary outsourcing practices and partners.
Market volatility and weak demand has distracted CROs and prompted many to reduce their operating costs and capacity. Unless market demand improves markedly, there will be more CRO restructurings — including downsizing and divestiture.
Niche CROs continue to enjoy high relative demand among both sponsors and major CROs. Competitive intensity among the largest CROs is increasing, especially as they strive to win new integrated relationship contracts among a shrinking number of pharmaceutical and biotechnology companies.
Servicing large, integrated relationships, however, is expected to be much more demanding without uniformity in sponsor outsourcing models. Relationships will be more extensive and expensive to operate, involving more elaborate communication and governance. Sponsors will continue to apply downward pressure on margins and to demand a lower tolerance of variance from planned performance. These pressures may spur CROs to further lower their fixed costs and to consolidate their operations. Long term, CROs will be prompted to seek higher margin business opportunities to offset less economically attractive integrated clinical services relationships.
Ultimately, changes in the current landscape will result in a consolidated market with higher levels of collaborative efficiency. Sponsor demand will drive closer, more integrated partnerships between various niche and diversified CROs and between global and local CROs. Getting to this point, however, will no doubt be tumultuous and difficult.
Kenneth Getz is a senior research fellow, and Rachael Zuckerman a research analyst, both at the Tufts Center for the Study of Drug Development (CSDD), Boston, MA. The center can be reached at firstname.lastname@example.org.