Jim Miller is president of PharmSource Information Services, Inc., and publisher of Bio/Pharmaceutical Outsourcing Report.

Jim Miller

Two fundamental cornerstones of the new bio/pharmaceutical business model are the end of the blockbuster product and the need to accumulate and conserve cash. These two realities have major implications for bio/pharmaceutical manufacturing strategies and technologies and create new challenges for CMOs. It is widely understood and accepted that the new products coming out of the bio/pharmaceutical pipeline will be sold in smaller volumes than the products introduced a generation ago (albeit at higher prices). This situation partly reflects the failure of bio/pharmaceutical R&D laboratories to come up with safe and effective drugs suitable for broad populations. More importantly, it also reflects the growing understanding of how drug effectiveness varies within patient groups, the ability to develop biomarkers to identify patients for whom new drugs will work best, and the expectation of regulatory authorities that new drugs will incorporate that knowledge into clinical regimens. The classic example is Roche's/Genentech's Herceptin (trastuzumab), which is highly effectively for the 20% or so of breast-cancer patients that test positive for expressing the HER-2 gene. 

This article was also published in our US sister publication 

Articles

The evolving bio/pharmaceutical business model poses risk for CMOs.

CMOs Face a Kodak Moment

During the past decade, big pharmaceutical companies have been making major efforts to restructure their manufacturing networks. In their haste to shed costs and assets, however, some may be adding risk to their product supply chains.

The number of manufacturing facilities owned and operated by the major pharmaceutical companies mushroomed in the 1980s and 1990s as new blockbuster products were introduced and as companies opened markets globally. In the days before the establishment of regional free trade pacts, such as the EU and the North American Free Trade Agreement (NAFTA), much of the industry viewed having a manufacturing operation in a foreign country as a necessary investment to ensure that country's regulatory approval of their drug product.

In the past decade, however, companies have determined that they do not need to maintain large, farflung and costly manufacturing organizations around the globe. Several factors have contributed to the drive to streamline manufacturing networks, including:					

The establishment of the EU and NAFTA, along with various mutual recognition efforts, which has facilitated the approval and movement of products across borders.

Mergers among major pharmaceutical companies, which left the merged entities with too much capacity.

The decline of blockbuster drug sales and the need for less capacity.

The transition from chemicalbased drugs to biologics, which require different manufacturing assets.

Shedding these redundant assets is not as simple as shutting the doors, however. Transferring products is costly and time consuming under GMP guidelines. In many countries outside the US, labour laws often require long union negotiations and large severance payments to affected workers. In all countries, legacy environmental issues can make it difficult to just walk away from a site.

Under these circumstances, selling a facility to a party that intends to maintain it has obvious appeal; such a sale could help the owner avoid costs incurred in an outright shutdown while maintaining some goodwill with the workers, community and government. It may also generate a little cash.

The availability of redundant facilities has been something of a mixed blessing for the contract manufacturing industry. On one hand, the opportunity has helped some of industry's largest players to quickly and relatively inexpensively build global networks. Major CMOs, including Patheon (Canada), Recipharm (Sweden), Famar (Greece), Haupt (Germany), Piramal Healthcare (India) and DSM (The Netherlands), have acquired redundant manufacturing sites from major pharmaceutical companies to build critical mass; for example, Parisbased Fareva went from zero to E300 million of pharmaceutical manufacturing revenues in just 4 years by acquiring redundant sites in France — principally from Pfizer.

On the other hand, the purchase of these facilities is a bane of the CMO industry because it maintains capacity that the market really doesn't need. Major CMOs have the experience and industry understanding to recognize when an available facility has limited marketability. There have been plenty of potential buyers, however, lured by the chance to get into the business for almost no money down and a cushion of contracts for legacy products. This was particularly true in the easymoney environment of the past decade.

Too often, the groups that take over these facilities have little knowledge or experience of pharmaceutical manufacturing or the contract services business. They are especially naïve about the major investment needed in new business development and the long lead times involved in building market awareness and establishing new client relationships. They may not appreciate just how far behind the state of the art their facilities and equipment are. Also, they learn the hard way that GMP compliance is costly and must be maintained regardless of the level of plant utilization. Their working capital resources to cover these requirements are often inadequate.

The pharmaceutical companies selling these facilities can create a major supply chain headache for themselves if the buyer encounters financial distress. Examples litter the decade. In a somewhat notorious, but illustrative example, sanofi aventis (France) sold a facility in Puerto Rico in 2005 to Inyx, a UKbased company, after several larger and more established CMOs had looked at the facility and passed on it. Inyx's principal owner and executive was known to have some questionable financial dealings and had already led one CMO into bankruptcy earlier in the decade. It should have been no real surprise that 2 years after acquiring the sanofi facility, Inyx filed Chapter 11, ultimately leading to unfilled orders, financial losses and a great deal of litigation. Another prime example is Oread (KS, USA). One of the pioneer providers of analytical and formulation development services, Oread acquired a manufacturing facility in Palo Alto (CA, USA), from Roche (Switzerland) in the late 1990s, and then filed for bankruptcy a few years later because it became over extended. More recently, PharmEng (Canada), an engineering and validation firm whose Keata CMO subsidiary acquired a Pfizer (NY, USA) manufacturing site in Ontario, filed for bankruptcy protection in Canada.

These problems could have been avoided if the selling parties had exerted better due diligence. This is particularly true in cases where the buyers were depending on the divested site to supply product through the transition period.

Concern about the financial viability of divested manufacturing operations has become more relevant because the industry has entered another period of consolidation that will undoubtedly spark another round of manufacturing facility sales. Most industry observers expect that Pfizer, after its acquisition of Wyeth (NJ, USA), and Merck (NJ, USA), after it merges with Schering-Plough (NJ, USA), will have to shed manufacturing facilities to achieve cost savings. Wyeth will bring 33 manufacturing sites with it, adding to the 44 Pfizer will have after it finishes its current 13site divestiture programme. Meanwhile, ScheringPlough has 23 sites to add to Merck's existing network.

The sale of manufacturing sites to investors without the staying power to make them successful doesn't benefit any of the parties involved. Moreover, the resulting financial problems could give the entire CMO industry an undeserved black eye. Let's hope that the next round of plant divestitures is handled with more due diligence and foresight.

Penny-wise, pound-foolish

Is there a point in a CRO's life when contract services begin to look less attractive as a strategic business opportunity? Executives at PPD (NC, USA) seem to think so. In just one day in early April, the CRO announced two moves — an acquisition and a divestiture — that indicate the company is looking in a direction other than contract services for longterm growth.    

The acquisition was Magen BioSciences (MA, USA), a biopharmaceutical company with a pipeline of dermatology candidates it has inlicensed from Eli Lilly and Company (IN, USA). Magen, which PPD acquired for $14.5 million (€10.7 million) in cash, also has discoveryrelated capabilities for screening compounds for efficacy and safety.  

On the same day PPD announced the Magen acquisition, it announced its intention to sell its Piedmont Research Center (PRC) to Charles River Laboratories International (MA, USA) for $46 million (€33.8 million). PRC, which had revenues of $19 million (€14 million) in 2008, provides 

 discoverystage research and evaluation of anticancer agents and therapies.  

Together, the two announcements suggest that PPD executives see bigger longterm opportunities in proprietary drug development than in contract research and development services, despite the higher risk. Although PRC is a tiny player in the discovery and preclinical research sector, PPD could have chosen to acquire a much larger position in that space. There are reportedly several sizeable preclinical CROs for sale, as well as some facilities owned by pharmaceutical companies, and PPD has ample resources to make a sizeable acquisition. At the same time, even a sizeable preclinical acquisition would have left PPD no better than the #3 or #4 player in the global preclinical segment, led by Covance (NJ, USA) and Charles River. PPD management has no intention of being anything less than #1 or #2 in its markets.  

With revenues of $1.5 billion (€1.1 billion) and a position as one of the top two players in Phase II–IV clinical research (along with North Carolina's privatelyheld Quintiles, which doesn't disclose its financials), PPD is challenged to drive the aggressive longterm, topline growth its investors have come to expect from the services business. The company has delivered doubledigit revenue growth throughout this decade by expanding its global network and gaining market share as a preferred provider to major pharmaceutical companies. However, with Big Pharma radically restucturing its pipelines and outsourcing most clinical research, PPD's growth opportunity is probably declining. Further, given PPD's large revenue base, acquisitions in other service areas such as Phase I won't "move the needle" on revenue growth, as company CEO Fred Eshelman often points out. 

Given these circumstances, investing directly in promising new products would seem to be an attractive option with relatively low risk. Begun in 1998, PPD's compound partnering programme largely seeks to inlicense earlystage compounds, take them through proof of concept, and outlicense them to larger partners for late clinical testing and commercialization. PPD absorbs the early development expense and gains revenues generated by licensing fees, milestone payments and commercial royalties. The programme yielded approximately $33 million (€24.3 million) in the past 3 years from dapoxetine, licensed to Johnson & Johnson (NJ, USA) for genitourinary indications, and alogliptin, licensed to Takeda (Japan) for diabetes indications. Dapoxetine received its first approvals in Europe earlier this year and Takeda has filed a new drug application for alogliptin (approval is not expected before 2010). 

PPD's return on its partnering programme has been small thus far, but the filings of dapoxetine and alogliptin promise bigger income streams in the future. If the programme is to really "move the needle," however, PPD needs a larger pipeline. That's where the Magen acquisition comes in. Magen's dermatology compounds (the number hasn't been disclosed) are aimed at psoriasis, acne, dermatitis and more. 

The compound partnering programme hasn't entailed a lot of risk for PPD either. Cost exposure has been relatively small because the costs of early development are relatively low. Writeoffs for failed investments have been small as well. In addition, the company views dermatology as a relatively low-risk indication.  

Although PPD is now betting more on proprietary products, the company is not about to exit the contract research business. PPD is highly profitable, and has a secure market position and a large backlog of work under contract. Still, PPD seems to feel that the contract research market has moved into a very mature phase. 

 is president of PharmSource Information Services, Inc., and publisher of 

. Tel. +1 703 383 4903, Fax +1 703 383 4905, 

Is there a point in a CRO's life when contract services begin to look less attractive as a strategic business opportunity? Executives at PPD (NC, USA) seem to think so.

Limits to CRO growth?

In the business and financial environment we are currently enduring, you wouldn't expect investors to be anxious to buy companies with somewhat uncertain prospects, but this is what is happening in the pharmaceutical services industry. Private equity investors are lining up to own all or a piece of a CRO or CMO business, and the depressed stock market is creating opportunities for them to get in at very attractive valuations. 

The hot interest in pharmaceutical services has some features that make it different from what we saw 2 years ago; for one, the acquisition prices are now a lot lower at the top of the leveraged buyout frenzy. Back then, Blackstone Group (NY, USA) acquired what is now Catalent (NJ, USA) for $3 billion (€2.4 billion) and financed it with $2 billion (€1.6 billion) in debt. The price was 1.6 times sales and 10 times pretax cash flow. Premier Research Group (UK) was taken private by ECI Partners (UK) last year for a similar multiple. By contrast, today's prices are likely to be less than one times revenue with less than half of the purchase price borrowed. 

The lower valuations reflect the restricted availability of debt (when debt was cheap, companies could afford to bid the price up) and the overall uncertain outlook for the bio/pharmaceutical industry. As I've discussed in previous columns, the industry is experiencing a sharp cutback in pipeline development activity as earlystage companies struggle for financing and major companies restructure to improve earnings and cash flow. 

Still, private investors appear confident that the pharmaceutical services business is a longterm winner. Major companies appear committed to outsourcing an ever larger share of their drug development and manufacturing activity. Furthermore, they will increasingly depend on early-stage companies to do the discovery and early development work, and then in-license or acquire the most promising candidates. This means that the earlystage companies will continue to get funding to feed their dependence on contract services. 

The biggest deal to hit the news recently is the acquisition of PharmaNet Development Group (NJ, USA) by JLL Partners (NY, USA), a private equity firm that is also a major investor in CMO Patheon (NC, USA). The total value of the deal will be nearly $250 million (€196 million), comprising $100 million (€78.4 million) for the outstanding PharmaNet stock (valued at $5.00/€3.9per share in the transaction) and $144 million (€112.9 million) to retire PharmaNet's outstanding convertible debt.  

PharmaNet provides Phase I–IV clinical research services, as well as bioanalytical laboratory services. The original PharmaNet Development Group was founded in 1996 by a team that included the founders of what is now Covance, and was acquired by publicly traded SFBC International in late 2004 for $245 million (€192 million). SFBC International changed its name in 2005 to PharmaNet following a scandal surrounding operations at its Phase I operations in Florida (USA). It had revenues of approximately $360 million (€282.1 million) (net of pass throughs) in 2008, putting it among the top 10 clinical CROs by revenue. 

PharmaNet's stock price dropped from more than $40(€31.3) per share in March 2008 to less than $1.00 (0.78) by December 2008. That cataclysmic price drop reflected several factors, including the overall decline in CRO stock prices (Covance dropped from more than $90 (€70.5) a share to less than $35 (€27.4) per share during the period), and a sharp drop in revenues and backlog during the second half of 2008. A complicating factor was the company's inability to get holders of the senior convertible debt to agree to redeem those notes for debt with new terms; under the terms of the notes, the debt holders could force redemption in August 2009 at face value and were in a position to take control of the company if it could not redeem them. 

In a sense, PharmaNet is a victim of the altered financial environment, which starved many of its customers of capital while cutting off its own ability to refinance its debt. At the same time, however, it is a victim of its own problems: the convertible debt was originally issued in 2004 to allow SFBC to acquire PharmaNet, and the subsequent legal problems surrounding the Florida Phase I sites probably distracted management attention from creating a more sustainable business model the way competitors such as Covance and PPD have done.  

The sale to JLL will allow PharmaNet's management team, which is well respected in the industry, to focus on improving the company's operations and, possibly, expand its capabilities through selected acquisitions. In the time it has been an investor at Patheon, JLL has shown itself to be a patient and long-term investor, helping Patheon management complete a necessary, but painful restructuring. JLL has also offered to buy more of the outstanding shares of Patheon, but at a price that may not be attractive to existing shareholders. 

Private equity investors may get another bite of the Top 10 CRO apple in coming months if the directors of MDS Inc. (ON, Canada), parent of MDS Pharmaceutical Services (MDSPS), decide to test the market. MDS announced that it has formed a committee of independent directors to review alternative ways to improve shareholder value. The committee will work with outside advisors to review a broad range of options, from doing nothing to sale of business units or the entire company. The company says there is no timetable for the review to be completed. 

As with PharmaNet, MDSPS, which had revenues of $482 million (€377.7 million) in 2008, has faced some particular challenges. Its early development business has been hurt by the reputational and operational implications of quality problems at its Montréal (Canada) bioanalytical lab, which was cited by FDA in 2004 for inadequate investigation of contaminated samples. Management reports that the problems are largely behind it and that it is attracting clients back to the bioanalytical business. In the Phase II–IV segment, MDSPS continues to lose market share to larger competitors, including Quintiles, PPD, Icon and Parexel (NC, USA). It suffers from smaller scale and a more limited global footprint, even though its revenues place it among the Top 10 CROs. 

MDS has ample cash and little longterm debt, so it is not compelled to sell. However, the company's board and management have been under investor pressure for some time to consider strategic alternatives. With three distinct businesses in its portfolio (MDS also has business units that make analytical instruments and radiopharmaceuticals), the company would seem to have some interesting options, including selling one or more of the business units to either strategic or private equity buyers. However, as one analyst told me, the board could find that what buyers are willing to pay for the businesses in the current financial environment is well below what they believe they are worth.  

While publicly held CROs represent the highest profile targets, we are aware of several wellknown privately held CMOs whose owners have put them on the block and which are attracting considerable interest from investors. Private investors aren't the only buyers either: publicly held CROs such as PPD (NC, USA), which recently acquired the Eastern Europe CRO AbCRO (Bulgaria), are also taking the opportunity to make deals that help flesh out their capabilities. 

This doesn't mean that investors aren't being picky, however. Investors are focusing on CROs with strong market positions and viable business models, mindful that the services industry will experience a shake out in coming months. We know of several highprofile companies that have been unsuccessful at finding private investors in the last year. 

The lesson is that despite the doom and gloom in the financial media, there are still good businesses to invest in and institutions with money to invest in them. The smart money seems to be saying that pharmaceutical services will be a great business well into the future. 

Despite the market downturn and financial meltdown, private equity investors are lining up for pharmaceutical services businesses.

Pharma's silver lining

The global economic crisis has not spared the pharmaceutical industry and, by extension, the pharmaceutical contract services industry. The financial prospects for 2009 of CROs and CMOs have dimmed significantly in recent months.  

There are two principal culprits for this downturn. The first is the efforts of major pharmaceutical companies to reduce their costs even as they outsource more. Big Pharma is even exiting entire therapeutic areas and halting early stage projects in those areas. For continuing programmes, they are aggressively looking for ways to cut development expenditures prior to demonstrating proof of concept. 

Further, most major pharmaceutical companies have established global sourcing units that are pursuing strategies to reduce outsourcing costs by standardizing processes and reducing the number of vendors that must be qualified, audited and managed. These programmes started 5 years ago in the clinical CRO realm and resulted in companies reducing the number of CROs they work with by as much as 80%. These practices have spread to the preclinical area, and we expect to see a similar pattern for outsourced formulation and manufacturing services. 

The second factor undermining CRO and CMO industries is the uncertainty of funding for early stage companies. Traditional funding sources, such as initial public offerings, follow-on stock offerings and debt, have all but dried up. Venture capital flows have held steady, but investors are funnelling their money to companies in which they already have investments rather than spreading it around. This is because they want to ensure that the most promising candidates in their portfolio companies continue to progress, and because new investors would insist on terms that would greatly dilute the equity positions of the early investors. The problem is particularly acute in Europe where venture capital support for early stage bio/pharma companies has always been weaker than in the US. 

To conserve funds, early stage companies with multiple candidates are being forced to shelve less developed candidates to concentrate on those with the nearest and best prospects for commercial approval or out-licensing — while start-ups are having a difficult time getting funding at all. 

Service providers that offer early R&D services are being especially hurt by the downturn because there are fewer candidates and less money to spend on them. These include CROs offering discovery, preclinical toxicology, process development and Phase I clinical supplies manufacture. These companies are reporting steep downturns in business activity, and a sharp increase in project cancellations and delays. 

Late stage development has not been affected too much yet as candidates closest to commercial approval are being advanced. Contract backlogs at clinical CROs continue to rise despite the general downturn although the timing of projects may suffer. 

How long will this difficult environment last? It's hard to say because no one really knows how the financial and economic crisis will evolve and when the funding situation for early pharma will improve. Executives at Covance (NJ, USA), a market leader in the preclinical and Phase I services areas, said in December that they expect market trends to turn positive in mid-year. Many companies were blind-sided by the downturn and don't know what to expect. 

The impact on the product pipeline is likely to be long term, however. When the financial markets were flush with cash, many companies and projects received funding they wouldn't have if proper due diligence had been conducted; they got the green light because venture capital investors had to put their large pools of money to work. Now, products and companies with marginal chances of success (and many that may be promising, as well) are not getting funded, meaning the decline in early stage compounds could be sustained for several years. 

With less money, fewer compounds and continuing efforts at major pharmaceutical companies to consolidate the vendor base, the number of CROs and CMOs is expected to shrink considerably. Companies that have depended largely on the venture capital-backed companies will have a particularly hard time as their customers seldom have more than one or two candidates in need of services at any one time so they must continually replace their customers with new ones. However, those candidates won't be there. 

The survivors will have a strong track record of servicing companies with multiproduct pipelines that can offer repeat business. They will have profitable operations, strong financial positions (little or no debt and positive cash flow) and savvy business development skills. Increasingly, those that serve the largest bio/pharmaceutical companies will have a global network of operations that can support their clients' global ambitions. 

Companies looking for vendors are advised to do careful due diligence on those they seek to do business with. Financial condition, including profitability, cash position and debt service requirements, should be a paramount consideration; clients should insist on full financial disclosure, even from privately held companies (of course, contractors should demand the same of their venture-backed clients). Further, some strategic due diligence will be important to make sure the parent company or investor group is committed to the business. 

One part of the industry that is already showing significant signs of consolidation is the European dose manufacturing segment. PharmSource estimates the size of the market at $5.75 billion (€4.29 billion), representing approximately 55% of the global contract dose manufacturing market. Our contractor database counts more than 160 dose manufacturers in Europe. Most impressively, 10 of the largest dose CMOs operate almost entirely from an European network of facilities.

One of the distinguishing characteristics of the European CMO industry of late has been the level of merger and acquisition activity. Major players have been adding facilities or combining operations at a rapid pace, propelled by private sources of financing (either private equity funds or private family ownership) with a long-term commitment to the CMO business. Major developments in the past year include:  

Fareva (France) recently acquired the Farmaclair semisolid and liquid manufacturing facility in Herouville (France) from GSK and the Feucht (Germany) operations of Pfizer. Fareva has shot from almost no pharmaceutical manufacturing revenues 3 years ago to approximately $300 million (€224 million) today thanks to the acquisition of redundant facilities, mostly from Pfizer.

AENOVA (Germany) was created through the merger of SwissCaps (Switzerland), a softgel manufacturer, and Dragenopharm (Germany), which produces solid dose forms. The merger was driven by Bridgepoint, the private equity firm that owns both companies.

Haupt Pharma (Germany) recently became a $250 million (€187 million) company after two other German CMOs, Amareg and Wulfing, were merged into it by their common private equity investor.

Recipharm (Sweden) acquired injectables facilities in France, the UK and Switzerland to complement its solid dose operations in Sweden. In 2007, the company sold off its proprietary product line to focus on contract manufacturing.

As these companies grow, they are looking to become more global. Notably, several that lacked FDA compliance standing have gained or are anticipating their first FDA approvals. Vetter and Haupt have established a sales presence in the US. Nextpharma (UK) made its first US acquisition in 2007 (Bioserv in San Diego), and European CMOs are expected to be among the bidders for the parental facility in North Carolina (USA) that Catalent has announced it may sell. Japan is another target; Haupt has acquired a parenteral facility, Catalent has operated a softgel facility for some time and others, including Vetter and Patheon, have a sales presence in the country. 

The major European CMOs have succeeded for a variety of reasons. The major success factors include:  

Long-term relationships with global pharmaceutical companies, often as a result of acquiring a redundant facility from a major company, and getting a multi-year contract to manufacture the legacy products.

Specialty capabilities, including the ability to handle compounds that require segregation, such as cytotoxics, hormones and cephalosporins.

Efficiency; that is, the ability to achieve greater output from a given level of investment and staffing than competing operations elsewhere. 

The European dose CMO sector appears to be very vibrant, probably more so than the market in the US. The big question for European CMOs is whether they can stay on this role. Companies such as Fareva and Recipharm must replace the legacy business they gained when they acquired their facilities; challenges from Eastern Europe and Asia are growing; and the competition from companies selling excess capacity isn't abating. The difficult global financial environment will only increase the challenges for these market leaders.

The European dose CMO sector appears to be very vibrant, probably more so than the market in the US.

Consolidation play

Different arms of the pharmaceutical contract services market have been evolving in very different ways. In the clinical and preclinical research sectors, large CROs have experienced annual growth rates of 15–20% during the past 3 years, more than double the rate of European and North American contract manufacturers. Furthermore, this rapid growth has been accompanied by consolidation of these service sectors, resulting in the 10 largest CROs accounting for approximately 75% of the clinical and preclinical markets. 

The large clinical CROs benefited from a number of favourable trends, including growth in the drug development pipeline and efforts by major pharmaceutical companies to reduce the number of vendors they work with. At the same time, however, the big CROs have been making important strategic moves and investments that have enabled them to consolidate their market domination, including investment in electronic data capture and other information technologies, as well as expanding their geographic scope to include the emerging markets in Asia and Latin America.  

Major preclinical CROs are consolidating their market positions by building very large research facilities (30000 m

  or larger) and entering into long-term contracts with major pharmaceutical companies for use of that space; for example, Eli Lilly and Company (IN, USA) recently outsourced all of its GLP-compliant toxicology testing to Covance (NJ, USA), one of the two largest preclinical CROs. In addition, major CROs are entering into joint ventures to service large pharmaceutical companies' expanding base of R&D operations in China. 

CMOs have not enjoyed nearly the success CROs have. The formulation manufacturing and small molecule API segments have experienced overall growth of less than 5%. CMOs have been hurt by a number of factors, including the shrinking number of new product approvals by European regulators and FDA; declining sales for key client products; clients repatriating products to underutilized in-house manufacturing facilities; and overcapacity that has fuelled price competition. The two bright spots in the manufacturing universe have been biomanufacturing (especially mammalian cell culture) and manufacturing of clinical trial supplies. 

Immediate prospects for CMOs could change for the better if their clients can get more products approved in the next year or so. However, CMOs may be in trouble in the long term as most of them continue to operate with business models and strategies based on old perceptions that don't reflect the current realities of the pharmaceutical industry. This is particularly true in several key areas. 

 Most CMO strategies were established in the early part of this decade when new product approvals were expected to be plentiful, and drug prices and unit volumes were rising. The assumption was that growth would continue, meaning there would always be a need for capacity and that CMOs could expect annual price increases. This led CMOs to invest in substantial capacity expansions and acquisitions of redundant facilities from major pharmaceutical companies. It was also a time when it was assumed that "price doesn't matter" as drug sales were so high and profitable that pharmaceutical companies were more concerned about assuring a dependable supply than they were about cost of goods. 

However, the pharmaceutical industry's growth prospects have changed considerably since then. New product approvals have continued a 10-year decline, governments and private insurers have fought back against drug price increases, and safety concerns and utilization guidelines are limiting the growth of blockbuster drugs, especially biologics. 

 Five years ago, CMOs geared their strategies to the North American and European markets, where prices were highest and usage was growing the most rapidly. CMOs geared their facility design and quality assurance practices to meet FDA and EMEA standards of compliance.  

Today, market focus of the major pharmaceutical companies is turning to the emerging economies of Brazil, Russia, India and China. Serving these countries is an entirely different challenge: they either have their own vigilant regulatory agencies, as in the case of Brazil and China; or lower compliance standards that make the costs of maintaining FDA and EMEA compliance uneconomic. In many cases, laws and/or regulatory practices require local manufacture and discourage imports, and most Western CMOs lack facilities in the emerging economies to take advantage of these expanding opportunities. 

 While many major pharmaceutical companies have announced their intentions to outsource more, they have also continued to invest heavily in new facilities and equipment, particularly for development and manufacturing of large molecule products. Capital investment by the fifteen largest pharmaceutical companies grew 16% in 2007 to approximately $22 billion (€15.6 billion). With the pharmaceutical companies on a spree to acquire or in-license large molecule candidates, the high-value opportunities CMOs were counting on will likely remain in-house. 

CMOs are also being hurt by increasingly global sourcing strategies. Global sourcing has introduced new low-cost competitors in countries such as India and China, and greatly extended the pharmaceutical supply chain, meaning that dose CMOs must often deal with the inability of clients to ship adequate API supplies, resulting in schedule disruptions and revenue shortfalls. 

The CMO industry is facing an overcapacity problem that is becoming increasingly worse: CMOs are building new capacity, Indian and Chinese companies are entering the market, and new companies are entering the industry by purchasing old facilities from Big Pharma. In the absence of other differentiating elements, overcapacity will drive down prices.

The CMO business model is still based on selling capacity, but manufacturing capacity is really an undifferentiated commodity. CMOs must find new business models and strategies that reflect the many dimensions of the industry's realities, such as Big Pharma's growing emphasis on reducing costs and making costs more flexible, and the globalization of the industry from both the end-user market and sourcing perspectives. These models and strategies need to do a better job of differentiating CMOs to prevent price competition. There should be multiple models targeting different customer groups and needs.

One option being used by some companies is the integrated service offering provider. These organizations are especially suited to small and mid-size bio/pharmaceutical companies, as they provide a complete suite of physical product services from early process development through to commercial manufacture. The main value of these companies is their ability to move products through development and commercialization quickly and cost effectively because of their skills in product development, regulatory strategy and project management.

For CMOs targeting major pharmaceutical companies, I expect manufacturing and supply chain management excellence to be the hallmark of the emerging strategies. Those CMOs will seek to bring manufacturing practice to a level still unknown in pharmaceuticals but common in most of the industrial economy. Characteristics of these best-in-class manufacturers will include:					

A focus on reducing manufacturing costs through continuous improvement activities and optimizing plant utilization.

Manufacturing in a more 'just-in-time' environment to prevent companies from carrying large inventories of raw materials and finished product. 

Operating global plant networks, including operations in emerging markets such as India and China, to achieve lower costs and improved access to these markets.

The 'manufacturing excellence' business model will be the real game changer for the CMO industry. It is the one strategy that offers major pharmaceutical companies the ability to completely alter their business models by addressing costs and globalization without sacrificing security of supply. CMOS that can deliver this will be big players and big winners in the contract manufacturing stakes.

CMOs must find new business models and strategies that reflect the many dimensions of the industry's realities...