For me, July 29, 2010 began like any other day. I had recently completed a quick cross-country trip (that’s “across the U.S.,” to our international readers) and was settling into my early morning ritual of checking email. Little did I know that by the end of the day that the stock price of one preclinical CRO would drop by almost $10 per share while two other preclinical CROs would announce the termination of their planned merger.

Before I proceed, I want to share a cautionary note. Much of what I will share below is old news about three publicly-traded preclinical CROs. This news was widely reported through multiple financial websites. I will review what happened and share my opinions regarding the potential impact for the industry and for the client community. I am not a financial expert so you should not base any investment decisions regarding these companies based on what I share below. While this industry news warrants discussion, financial experts will have dissected its impact, if any, on these companies long before you read this article. Should you desire detailed financial information on the companies mentioned below, I encourage you to visit the investor relations section on each company’s website and/or check them out on your favorite financial website. With that disclaimer out of the way, here’s the news:

What Happened?

After the close of the U.S. stock markets on July 28, Covance announced its second quarter financial results for 2010. This announcement also included a company projection that its third quarter earnings would be significantly below market expectations. Covance also cut its projected earnings for 2010 due to lower demand for early research services. On Thursday, July 29, Covance’s stock plunged nearly 20% as this news percolated through the investment community.

On Thursday, July 29, Charles River Laboratories and WuXi Pharmatech jointly agreed to terminate their planned merger. Charles River agreed to pay WuXi a $30 million break-up fee. This news came after the merger was the target of significant challenges from some Charles River shareholders, including the hedge fund JANA. In its opposition, JANA stated that Charles River had a poor track record integrating previous acquisitions and would face significant challenges merging with WuXi.

On August 2, Charles River announced its 2Q10 financial results, with income plunging due to decreased demand and higher costs. Like Covance, Charles River lowered its projected earnings for 2010, citing decreased demand for preclinical services among the contributing factors.

What’s Going on in the Preclinical CRO Industry?

As we have discussed several times in articles this year, the demand for preclinical outsourcing still has not fully recovered from the slowdown that emerged at the end of 2008. This trend is now seemingly reflected in the financial reports for Covance and Charles River. The additional preclinical capacity that became operational in the industry during 2008 has not been adequately utilized due to this diminished demand. Anecdotal observations from industry veterans would suggest that larger CROs are struggling more to fill capacity than their smaller competitors, but there are no reliable data to support this perception. Some CROs have indicated that there seems to be an improvement in Biopharma outsourcing in 2010 when compared to 2009 but the overall demand for preclinical outsourcing remains subdued. The preclinical CRO industry is in uncharted territory. Where similar slowdowns in the past may have lasted for a quarter or two, this current slowdown in demand has now lasted seven or eight quarters. In my opinion, there are no signs that suggest that the demand for preclinical outsourcing will improve significantly before the end of 2010.

Slowdowns in demand in the past were often the result of diminished spending by sponsors until they got into a new fiscal year and/or work being conducted at a sponsor’s internal facilities rather than being outsourced. What’s different today is that many large pharma companies have experienced significant layoffs and several have diminished their internal capacity for preclinical research. Accordingly, the internal capabilities of Pharma companies are less of a “competitor” to the preclinical CRO industry that in the past. We have also seen at least two new fiscal years start without a substantial increase in outsourcing demand, further suggesting that the current slowdown does not share the characteristics of those in the past. Some have wondered if we are realizing the impact of preclinical CROs in emerging markets. While sponsor companies are testing the capabilities and reliability of these CROs, many believe that this market segment won’t pose a significant threat until the capacity fills up in the North American market. Whether sponsor companies are hoarding cash or have shifted their focus to late-stage development, the bottom line is that many are not spending for preclinical outsourcing at the same level as in the past. Perhaps more of a concern, many preclinical CROs have lost the ability to predict their future workload with any degree of certainty. When sponsors are spending, many times they are doing so with little to no advanced notice. Where CROs in the past were able to schedule for several months at a time, many today struggle to predict reliable work schedules beyond several weeks.

What Should a Preclinical CRO do During Times of Slow Demand?

Every business has to manage its finances. Over the past year we have seen many businesses in the U.S. respond to the slow economy through employee layoffs and other cost reduction initiatives. Charles River, Covance, and many other preclinical CROs have also conducted layoffs during the past 18 months. While layoffs may be necessary to control expenses, periods of slow business demand are an ideal time to optimize CRO operations. When business was robust in 2006 and 2007, CROs were challenged to find experienced workers. Many newer employees were forced into “production mode” to meet growing client needs. Sometimes when the workload slows down in a research operation, more employees are available to conduct studies, and operational quality metrics may actually improve because the workload per employee is more manageable. Over the years, it has been my experience that when a research staff endures a sudden and sustained increase in workload, it is often accompanied by a concurrent increase in quality issues. Given the current state of the business, here are some considerations for management teams at preclinical CROs (or any research operation):

• If you are done with layoffs, keep the remaining staff focused on operational needs. Now is the ideal time to reinforce the attention to detail regarding facility cleanliness and ensure that laboratories are maintained in an orderly manner. I subscribe to the belief that facility appearance is a direct reflection of operational and management effectiveness. If your facility is allowed to remain dirty and unorganized during times of slow business demand, chances are it will never look clean and orderly. That may be acceptable in the company culture but it could wind up costing you the business of those clients that include facility appearance on their CRO qualification criteria. If you don’t care enough to keep your facility clean and orderly, what else don’t you care about?
• Revisit training initiatives at the animal husbandry, technical and supervisory levels of the organization. A fully completed training record doesn’t necessarily mean that employees are proficient in technical procedures. Perhaps more importantly, do employees understand why they do what they do and how that fits into the larger scheme for the successful conduct of a study or the development of a drug? During 2006 and 2007, many employees in CROs were thrust into supervisory or leadership roles due to the rapid increase in the workforce. While training is important, many newer supervisors have not had the life or business experiences critical to leading an effective research operation. If you manage a research operation, are your employees growing or just “doing”? When business demand is slow, it is an ideal time to conduct cross-training initiatives among the technical staff, which will only make the operations more flexible when the workload increases.
• Check the completeness and accuracy of training documentation. A recent GMP (Good Manufacturing Practices) inspection by the FDA at a pharmaceutical operation found employees’ qualifications did not match their job descriptions. If this regulatory focus on training files carries over into the GLP environment, you don’t want your employees scurrying around to achieve compliance when the demand for preclinical outsourcing increases.
• This is an ideal time to ramp up integration efforts at multi-site CROs. This work isn’t very stimulating, but many clients like to see consistency across sites within the same company. When outsourcing demand begins to increase, integration efforts will be among the first operational initiatives to suffer because employees feel that they are just too busy.
• Reassess the effectiveness and the “fit” of your operational leadership. Are your operational leaders spending more time protecting their job or the jobs of their friends rather than seeking to improve operational performance? Does your company culture encourage employees to share their opinions without fear of retribution? As a management team, do you surround yourself with operational leaders who are your favorites or those who have noteworthy performance? Do your operational leaders create a work environment that encourages the growth of the employees or do your leaders manage by fear? Do you know enough about your staff and your operations to know the difference?

What Impact Will Slow Preclinical Demand Have on the Client Community?

• The slow demand for outsourcing should mean that there is ample open capacity for conducting studies, so clients shouldn’t have to wait in a queue to start a study. Many CROs report that when clients do decide to outsource, they give very little notice prior to the study start date. This would suggest that clients are leveraging the open capacity to their benefit, but I must share a word of caution. The less time you give a CRO to prepare for your study, the greater the risk for an operational error. Just because you know that you can schedule a study at the last minute, that doesn’t mean that it is a good business decision.
• We know that CROs have undergone layoffs and cost-cutting initiatives for as long as 18 months. How has this impacted operational performance? Consider the suggestions that were shared above for CROs and perform your own assessment of their operations.
• Although the competitive pricing environment that existed so long in 2009 seems to have ended, continue to seek competitive bids. Understand that many CROs are experiencing financial stress, so make sure the bid price truly encompasses the work that you need to be done and that it isn’t a “teaser” bid designed to acquire your study. It is likely that your own company may be in the midst of cost containment initiatives too, so don’t automatically award your work to the CRO with the lowest bid. Do your due diligence so that you know what you are buying.

On Thursday, July 29, both Covance and Charles River had a bad day. Business had not gone the way they thought it would. In their defense, because both companies are publicly traded, required to report their business performance and activities to the investment community, making it easy to comment on these events. The truth is that many preclinical CROs are subject to the same financial challenges that accompany a slow business environment. As the preclinical outsourcing demand improves, it is likely that the financial well-being of Covance, Charles River, and other preclinical CROs will improve as well. Here is the concern: at a time when preclinical CROs are so desperate to improve their financials, are they so obsessed in looking outward for new business that they are missing a golden opportunity to look inward at their own operations? If so, they risk swapping bad days in the investment community for future bad days in the client community.

Steve Snyder is a consultant with more than 25 years of experience in preclinical toxicology as an outsourcing customer and provider. He can be contacted at info@outsource-support.com.