The Future of Pharmaceutical CMOs

Revolution or evolution for the industry?

By Dr. Enrico T. Polastro

Major changes are impacting the pharmaceutical industry. The prestigious aura of a AAA rating — bluest among the blue chips’ image of high margins and predictable growth — is rapidly fading away, at risk of falling to AA status or perhaps even to an agchem-like A rating.

These developments are largely associated with the double-whammy impact of the financial crisis — hitting government finances and health care budgets throughout the world — and the patent cliff effects exacerbated by inadequate R&D productivity levels. These two effects are conspiring together to undermine the traditional business models applied by the pharmaceutical industry, namely increased top and bottom lines through a combination of higher volumes, new product flows and unit prices increases.

To respond to these challenges, pharmaceutical companies — both innovators and generic marketers — are increasingly confronted with the AA paradigm associated with the imperative for maintaining revenues to increase at the same time:

• Access — tapping larger patient populations
• Affordability — acting on the unit price lever, price becoming an increasing important element in the marketing mix

This is epitomized by the thrust of what yesterday were pure innovators in emerging markets as well as in multisource products (witness the example of GSK and Sanofi-Aventis), and an accelerated shift of generic players towards a full commodity approach — phasing out their marketing and sales force, redirecting their promotional efforts towards purchasing economic buyers — namely health insurance bodies — while individual doctors see their role gradually downgraded to executants with curtailed degrees of prescribing freedom.

Within this frame some industry observers are predicting a further downgrading of the pharmaceutical industry to a simple A — A as in agchem — status, characterized by:

• Highly concentrated supply structure, with the top six vendors controlling 65+% of the market.
• Narrowing product line, with smaller volume products being pulled out of the market.
• Only marginal NCE innovation.
• Pricing strictly reflecting value in use as measured by the end user.
• Payer and users as the same individuals.
• Share of generics in excess of 60%, with most “innovators” deriving a substantial share of their sales from “off-patent AI” (Active Ingredients).

Should this be the case, the pharmaceutical industry would undergo a major dramatic reshaping. The developments we’ve witnessed to date would be mere prelude compared to what may lie ahead. In an agchem-type scenario, the pharmaceutical industry would evolve at an accelerated pace towards a model characterized by:

• Massive consolidation of the supply structure
• Downscaling of R&D activities as the emphasis shifts from NCE development to reformulation and product life extension
• Massive surge in the share of generics
• Pruned product lines, with eventually only a couple of APIs in each therapeutic category being maintained

Needless to say such an agchem-like evolution of the pharmaceutical industry would have massive sweeping implications also for the pharma CMO sector. It would inevitably lead to a major consolidation and concentration of the supply structure. Clearly there would not be enough demand to support today’s industry, given a lack of NCE introductions and rationalization of product portfolios with weeding out of marginal molecules.

Also tighter strategic alliances and closer alignment between vendors and customers would become more the rule reflecting mutual overdependence effects. Incestuous relations would also increasingly occur amongst pharmaceutical majors as these engage in various forms of cooperation to complement their own product portfolios — a development driven at least partly by the need and scope for economies of scale.

But is such a scenario credible?

Most probably not, as reflected by several aspects of pharma in contrast to agchem:

• Major unmet needs continue to exist both in the GP (General Practitioner) and specialist segments, as well as for both life-threatening pathologies — cancer being a major example — and lifestyle conditions such as obesity or hair loss.
• NCE innovation efforts are and will continue to be vigorously pursued, driven by unmet needs; however, the focus will be on different therapeutic segments often yielding lower volume products that target smaller patient groups.
• Molecular diversity will remain the rule and is unlikely to decrease anytime soon, reflecting the emergence of niche therapeutic segments as well as the impact of personalized medicine.
• New sets of players continue to emerge, some rising like phoenixes out of the rubble and ashes left by mega-mergers; emerging players are a breed rarely — if at all — seen in the agchem space.
• Volume demand in pharma is poised not to abate given broader access — both in the developed world; witness the expanded health care coverage expected as per the Obama presidency. Also, in emerging regions the rapid graying of the population plays a role in driving pharmaceutical volume demand up!

Within this frame, what we are likely to witness is — rather than a revolution — a gradual evolution scenario for the pharmaceutical industry.

Although they grab the headlines, the developments noted in the pharmaceutical industry mainly represent a continuation of a process having started already in the late ’90’s. The economic crisis of the last two years simply acted as a “revelator” rather than a triggering factor per se:

• Consolidation and mergers amongst companies is not a new development in the industry — albeit the focus has shifted from securing access to complementary resources to rather cost synergies as a tactic to protect the bottom line.
• R&D programs are redirected and reassessed — the focus is shifting from the GP and as a corollary the quest for blockbuster products to rather specialist products, companies being also more selective in their development decisions, rationalizing their pipelines while placing increasing emphasis on lifecycle management.
• New organization models are explored in the quest to find a more appropriate balance between growing size prompted by the need for economies of scale and the imperative to maintain entrepreneurial behavior.
• More attention is devoted to costs, leading to downsizing of internal marketing and sales and industrial operations, but few companies appear ready and willing to jettison their traditional business models, instead attempting to adapt the ones currently applied.
• Business development efforts are redirected towards emerging demand areas — namely Asia, Latin America as well as up to a lesser extent Africa — and assembling full product lines to meet the requirements of the therapeutic areas targeted, a move dictated by the need to offer a complete range of solutions to the patient, as opposed to single molecules.

The implications of these developments on the pharmaceutical CMO sector are substantial, resulting in increasing business volatility patterns. In particular CMOs are confronted with:

• Smaller average project size and tighter budgets, combined with unpredictable timelines. Customers, while hesitating until the very last minute to take a decision on what to buy and from whom, expect the vendor to immediately respond to their requests, making capacity available for them — be it human talent or physical assets — at almost zero notice. Of course, they also strongly resist early notice or reservation fees.
• High staff turnover within the customer organization, jeopardizing the value of personal relations, making the creation of goodwill between the vendor and the customer organization a rather elusive concept.
• Customers are increasingly applying leverage as they try to pass the burden down in the value chain, with purchasing behavior being mainly cost driven and tactical decisions being the rule.
• As the flows of new projects dries up, competition and rivalry amongst vendors is the rule, as they all chase the same opportunities. In addition, new sets of players including Chinese and Indian vendors will increasingly step in the traditional turf of Western CMOs, a development actively encouraged by some customers.
• Customer requirements are evolving. As an example, in molecule-building the demand for organic synthesis is stagnating while biomanufacturing is still growing. Parallel to this, product tonnages tend to decrease, mirroring the smaller markets targeted by the NCEs being developed.
• Low delivered prices and value are absolute musts.

These developments are hitting the CMO sector hard. Several players being reported to be struggling; witness the disappointing earnings announced by industry majors like Lonza or Siegfried in molecule-building. The situation for CMOs focusing on dosage form manufacturing is not much better, and CROs focusing on earlier stages of the pharmaceutical product creation process also struggling.

Lonza, to cite one public company in the CMO arena, suffered a major step decline following reports of lower profit margins in late 2009, leading to a drop in share price and market cap. These have been triggered by a combination of project cancellations, postponements and price-volume reductions, leading investors to reassess the prospects of the business. Several other CMOs are in a comparable situation. As a result many are now wondering if the western CMO industry still has a future or if it is doomed and poised for an irreversible decline, to be swept away by Asian competition.

It is important to note that the aggressive behavior of pharmaceutical companies with their contract service providers is nothing new, corresponding to “normal” — albeit not “pleasant” — business practices. The real novel factor is the exacerbated pattern of volatility, to wit:

• The quest for value and drive to squeeze vendors was initiated several years ago. SmithKline Beecham — one of the ancestors of GSK — in 1998 requested to all its “preferred vendors” to enhance the value provided by 9% and a further 7% within a two- or three-year timeframe or else face a reassessment of their preferred supplier status. The vendors were given some degrees of freedom in achieving this value enhancement — longer payment terms or consignment stocks was an alternative to outright price reductions, for example.
• Pharmaceutical companies have been streamlining their supply chains since the early ’90’s, ranking their vendors in a multi-tier structure while at the same time electing to focus on a smaller number of “core” vendors, a thrust largely inspired by the purchasing tactics applied in the automotive industry.
• Asian sources have been developed for many years, particularly by generic marketers. Innovators also increasingly following this path as the risks — either real or perceived — associated with such a move are being reassessed.

Rather than a revolution and a disruption, today’s situation facing the pharma CMO sector appears to represent an intensification and acceleration of trends already observed — albeit at less intense degrees — for 10 if not 20 years. This acceleration results from factors such as globalization, cuts in healthcare budgets (and their domino effects on pharma companies’ bottom lines, forcing them to slash their own fixed costs), and financial turmoil and the attendant scrutiny of the financial community.

The situation of flux that CMOs and CROs are facing is not very different from what had been seen 10 years ago at the time of the internet bubble (and the CMO bubble). At that time a rush of new entrants scrambled to take a position in the pharmaceutical CMO /CRO space, viewed by some as a harbinger of prosperity and continuing growth. Some financial analysts did not hesitate to declare it as “one of the most attractive segments of the industry,” poised to continuing profitable growth prompted by the momentum of the pharmaceutical industry, which was expected to increasingly embrace a virtual R&D and supply chain mode of operations, relying extensively on strategic vendors.

These prospects lured many new entrants, acquiring capabilities often at premium prices to set up a base in this field. Examples include AlliedSignal, Honeywell, Clariant, PPG, Rhodia, to name just a few.

However, many — if not all — of these players, invariably jockeying to reach a $500+ million in size — the benchmark of success given perceived critical mass as well as credibility considerations — have had to exit the scene, often after suffering major losses.

With hindsight, it can be said that these setbacks have been largely self inflicted, as many of these new entrants failed to properly understand the dynamics of the industry, including its intrinsic lumpiness and the client base’s continuing quest for value (unwilling to share its comfortable margins with its vendors).

It is also interesting to see how various CMO and CROs are trying to adapt their business models, very often with the same recipes applied with uneven success a few years ago. These include:

• Quest for “magic” size
• Positioning as unavoidable service provider
• Searching for new sources of traction: “the grass is always greener”
• Investing in new technologies
• Jettisoning costs

CMOs are taking an active part in the industry consolidation, a larger size often being associated with increasing resilience as well as enhanced bargaining power vis-à-vis ever larger pharmaceutical giants — the benefits of such a move being all but clear, as size tends to go in parallel with:

• Loss of efficiency and of responsiveness: one of the pitfalls often encountered by mega-pharmaceutical groups resulting from their own mergers, and
• Failure to diversify risks, instead creating increasing dependence on key products and customers.

Some broaden the range of services offered to the pharmaceutical industry — for example, combining capabilities in molecule building with formulation or developing full-service research and development platforms — with the idea of becoming the unavoidable partner of pharmaceutical companies. However, it is important to note that the appeal to the customer — if not even the very viability of such a model — is yet to be tested. It remains a major issue to master under one roof the breadth and diversity of skills.

Some players in the quest of new sources of traction are considering a move outside their traditional home turfs — examples including for API producers moving into dosage form generics or setting a base in Asia. Here too benefits — if any — will depend on the companies’ abilities to leverage synergies and adjacencies, while avoiding moving in untested waters — a surefire recipe for disaster.

The key for success is rather to be found in gaining insights in what it will take for vendors to be successful in the evolving environment. We can envision various futures, including:

• Back to the Good Old Days: Return to the AAA status as health care budgets are restored and R&D productivity returns
• More of the Same: Continuing restructuring with growing convergence between innovators and generic marketers, volume but not necessarily value growth, and modest albeit steady flow of NCEs
• Breakthrough: where scientific advances and/or new organization models — including virtual operations — lead to a sweeping reconfiguration of the industry
• Agchem-like A rating: Drift towards a commodity-status comparable to Agchem, with consolidation among providers

Barring a surprise, only blue-eyed dreamers can realistically believe that the good old days will be back, with money freely flowing to the pharma sector and continued, extended growth.

As we already discussed, an agchem-like A-rating course — in which the pharmaceutical industry shifts to a pure commodity status — does not appear to be realistic. Meanwhile, a breakthrough scenario in which pharma companies massively embrace a virtual mode of operations also appears rather unlikely.

Instead, the most likely outcome is that the pharmaceutical industry will continue to evolve with:

• Continuing volume but not necessarily value growth
• Growing convergence between innovators and generic marketers as the boundaries between the two become more diffuse
• Pharmaceutical companies continuing to insist on maintaining firm control as overall project managers and supply chain orchestrators

For vendors, this will imply:

• Fewer but more sophisticated and more complex vendors to serve customers. Only a few — if any — will be likely and willing to move to a virtual mode of operations for R&D or supply chain. All, however, will continue to have multiple sourcing requirements
• Continuing unpredictable product life cycles
• Diminishing turnover and volumes associated with any given contract

To prosper, vendors will not focus on size and a quest for greener pastures. Rather, they must hew to the following goals:

• Large enough to matter, but small enough to care . . . and easy to manage
• Diversified — yet coherent — business base with no critical dependency
• Ability to do business with all cultures and in all parts of the world
• No-nonsense approach to business
• Unitary approach
• Focus on customer and internal operations
• Agility to seize emerging opportunities.

Dr. Enrico T. Polastro is a vice president and senior industry specialist of the European Pharmaceutical and Fine Chemicals practice of Arthur D. Little. He can be reached at polastro.e@adlittle.com.