Pharmaceutical companies outsource well and often, there is no doubt. Site and shared services, clinical support, so-called 'non-inventory,' temporary labor and other activities are now routinely outsourced on an increasing and more sophisticated basis. The procurement of outsourced services has become a science, an outcome of a more formalized and professional corporate mandate. But it is my opinion that drug product outsourcing still has a long way to go in our industry. What will the right balance look like in our industry? Can CMOs deliver the goods? What implications will it have for pharma? Let's explore these important questions.
The Case for Change
Gross margins in pharmaceuticals are among the highest of any industry. However, as the economy tightens up and new products fail to materialize, the cost of goods becomes an obvious financial lever to pull. Procurement organizations are being challenged to find more savings, which has translated to corresponding pressure on the supply base. It is certainly reasonable to ask suppliers to concede price as a way to cut costs, but this can only go so far. Capacity must come out of the system, and the capacity that remains must become more efficient.
There are far too many pharmaceutical plants and most are considerably under-utilized. Reliable data are scarce in this industry, but consider Puerto Rico, still a major manufacturing center for the industry and a good marker for this discussion. Today, 25 of the 68 plants on the island are for sale and many of them exist in a mothballed state1. It is reasonable to assume that capacity utilization across the industry is considerably less than 50%2. (Albeit with some successful CMOs working at a much higher rate than that.)
To compound the problem of over-capacity, more of our new drugs are highly potent, aimed at smaller patient segments and delivered in more differentiated dose forms. This leads to smaller volumes and a reliance on specialized plants, putting much of our traditional capacity at risk.
These pressures, and the actions that result, will ultimately lead the industry to find an appropriate balance between in-sourcing and outsourcing.
Leadership Needed To Get the Balance Right
Drug product outsourcing strategies are evolving, and will become more strategic over time. The right balance will be difficult to achieve, given the overcapacity issue noted above, the risk in transferring drugs from one site to another, and a natural reluctance to allow others to do what we think we can do ourselves. It is going to take persistence, leadership, patience and trust to get this balance right.
Both sides have work to do. Rather than transactional, product-by-product contracting, pharma will do more 'bundling' of products and more strategic partnerships will be formed. Over time, CMOs will bring utilization rates up to where they can finally deliver true cost savings to the industry and better margins for their owners.
In making decisions, pharma companies must refine their 'make vs. buy' models so they reflect the true costs of doing business internally. Idle capacity is a real cost and should not be excluded from overheads when evaluating supply strategy. Marginal cost analyses are interesting, but they often hide the true costs of maintaining so much capacity. Pharma must assume that any plant in a company's network is vulnerable and perhaps should compete with an increasingly sophisticated outsourcing alternative. With the right data and an open mind, a proper sourcing strategy will evolve.
Some pharma companies are making good progress, but even the most proactive of the major companies are only outsourcing 15-20% of total drug product manufacture3. (Small and mid-tier are outsourcing a much higher percentage.) Most are still hanging on to too much capacity and assuming that their internal pipelines will fill the gap. Others are themselves becoming CMOs by selling their 'idle capacity' as a means to absorb overhead. But is this the best way for our industry to deal with overcapacity? Are we just prolonging the inevitable?
CMOs Still Have Work To Do
It takes two to tango. The CMO industry, for its part, needs to mature and consolidate. Many of today's CMOs are mere shadows of their former selves, created from previously divested pharma plants. In many cases, these plants are still managed by the same staff and under the same operating procedures handed down from their previous owners. Rather than filling orders and maintaining inventory for their parent companies, these same plant managers are now learning how to run businesses of their own. But capacity utilization is still low in the CMO industry, arguably below 50%4. EBITDA margins in the industry are typically 7-14%5 and, in the opinion of this author, barely sufficient to maintain their annual CAPEX requirements.
In this relatively flat 'buyer's market,' CMOs are doing what they can to win new business, usually with price concessions. This recent trend puts additional pressure on margins, which in turn forces management to cut costs. Thin margins force management to contain investment; small CAPEX budgets prohibit CMOs from installing the latest automation and equipment needed to operate more efficiently. Many have not yet embraced operational excellence or lean six sigma methods as a core competency and do not have the tools to eliminate the waste and variability embedded in their plants. These trends will need to change if CMOs are to survive.
CMOs also need to embrace Key Performance Indicators (KPIs), improve delivery service and keep up with an increasingly active FDA, while delivering the low-cost solution that the industry expects.
What Do Other Industries Do?
One only needs to look outside to see what the right balance could look like. Consider Nike, the world's leading manufacturer of sporting goods. Nike is a $19 billion business, employs 30,000 people, and outsources 100% of its product6. Nike owns no plants of its own.
The best companies strategically manage their sourcing so carefully that nearly every technical improvement originates from their suppliers, which must differentiate themselves to maintain the relationship. Nokia outsourced its R&D and was the first to offer a camera phone, a development that bought them 20%+ market share in the '90's7. The list of industries and companies whose outsourcing strategies are well advanced is too long for this article.
The CRO Industry as a Leading Indicator
The pharmaceutical industry itself has already embraced outsourcing in clinical operations. What started as a small niche in the late '90's has grown to a $20 billion market, with more than 1,000 companies. Nearly one-third of the industry's R&D budgets are spent on outsourced services. Although the CRO industry is still relatively fragmented, it has matured and consolidated and today the top 10 CROs account for more than 50% of the market8. Many are publicly traded. New benchmarks have been established. KPIs are well established and visible to the public, which has further established the CRO market as a stable and mature industry.
The CMO industry, on the other hand, is far less visible. Very few are publicly traded and details are scarce. Benchmarks are hard to find and performance claims hard to substantiate. This lack of visibility has forced CMOs to look to the CRO industry as a leading indicator. But this can only be a temporary phenomenon. The CMO industry, their margins and their performance indicators will ultimately become more visible, better measured and more accountable to their clients. I'll explore this in a future column.
The Outsourcing Department
Nearly all large pharma companies have established new, free-standing divisions or departments to manage the outsourcing of drug manufacture. In some cases, these departments exist within the procurement function. In others, they are independent departments which report directly to the head of manufacturing. This trend is encouraging. Outsourcing of drug product is becoming more structured and accepted. Internal manufacturing networks are being pitted against their external counterparts. KPIs are beginning to emerge. Technical transfers are becoming more routine, almost standardized processes. But there are still issues of trust, reliability and the ever-present problem of over-capacity that are impeding more breakthrough progress.
Ultimately, the right balance between in-sourcing and outsourcing must be achieved.Both sides have a lot of work to do, but we must continue the journey. Pharma needs to continue to embrace outsourcing as a natural order of things. Sponsors need to be honest with their 'make versus buy' analyses and consider every plant an expiring and vulnerable asset. They must decide what is 'core,' how many plants they need to support their 'core,' and ultimately shed capacity.
CMOs, for their part, also have much to do before they can be rewarded with more business. They need to embrace service, invest in new technology, develop new ways to differentiate, keep up with the compliance requirements, and deliver a cost efficient service - all at the same time. It will not be easy.
We have a long way to go, but finding the right balance of what is in-sourced versus what is outsourced is a necessary and important step in the evolution of our industry. Next time, we will explore how the emerging markets may impact the outsourcing industry.
References
1 CBRE Data on file, Cinteger
2 PharmSource, Author estimate
3 PharmSource, Author estimate
4 Based on theoretical 6x3 shift schedule, Author estimate
5 Patheon 2010 results, Catalent data, PharmSource,Author estimates
6 Nike Annual Report, 10-K 2009
7 International Association of Outsourcing Professionals Body of Knowledge 2006 issuance
8 Wikipedia 2011
Wes Wheeler is a 32-year operations veteran, with the past 20 years in pharmaceuticals. He was most recently president and chief executive officer of Patheon. Previously, he was president of Valeant Pharmaceuticals (2003-2007) and chief executive officer of DSM Pharmaceuticals (2002-2003). Prior to DSM, he had a 13-year career at GlaxoSmithKline, where he held senior positions in logistics, manufacturing, marketing, marketing services and engineering. He left GSK as a senior vice president, Global Logistics & Strategy. Mr. Wheeler is currently consulting with his own company, WPWheelerLLC, and can be reached at wes@wpwheeler.com.
