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. 

The need to accumulate and conserve cash is driven by the imperative that bio/pharmaceutical companies in-license or acquire new development candidates and marketed products rather than depend solely on their in-house R&D operations. One prime target for improving cash position is inventories. Bio/pharmaceutical companies have traditionally held two to four times as much inventory relative to sales as have consumer-products companies. Turning inventories more frequently can release hundreds of millions of dollars in cash for the large bio/pharmaceutical companies. 

The implication of these two realities— smaller volumes and faster inventory turns—is that bio/pharmaceutical companies must manufacture smaller batches more frequently than they have traditionally. This new manufacturing imperative is triggering major changes in manufacturing practices, strategies, and technology. For instance, the CEO of GlaxoSmithKline (GSK) recently talked about how GSK is shortening its supply chain (thereby reducing inventory requirements) by moving manufacturing closer to where the products are being sold rather than concentrating production in very large scale but distant manufacturing sites. 

The new manufacturing paradigm will require facilities that are simultaneously smaller scale, more flexible, and lower cost and will mandate major changes in the design of facilities and equipment. Most of today's bio/pharmaceutical manufacturing facilities were designed 20 or more years ago to accommodate large-scale batch processing operations with separate suites each housing individual pieces of process equipment and complex material flows. Those facilities have very high fixed costs, and equipment often sits unutilized and requires long set-up times.  

Pharmaceutical equipment manufacturers and companies that develop advanced manufacturing technologies have been responding to the new manufacturing requirements for some time. The major advances already being used include:  

Higher-yielding expression and fermentation technologies that reduce the scale of biomanufacturing facilities

Manufacturing equipment for both API and dose manufacturing that incorporate disposable parts for components that come into contact with the product

Microreactors for small-molecule API manufacture, which replace large-scale batch processes with continuous processes conducted in a single, small piece of equipment

Continuous process finishing and dose manufacturing technologies, such as spray drying and equipment that can blend materials and extrude finished tablets

FDA-endorsed methodologies, such  as process analytical technology (PAT) and quality-by-design.

Some of these technologies and practices are not yet in widespread use or fully developed for commercial operation, but they are clearly making their way into the mainstream. For instance, Lonza announced in early February 2012 that it will build a "factory of the future" based on microreactor and continuous flow technology. Major bio/pharmaceutical companies are working with equipment suppliers and engineers to develop proprietary highly-automated and continuous manufacturing systems for their "factories of the future." 

The changing bio/pharmaceutical manufacturing requirements and technologies present a major challenge to CMOs. Much of the manufacturing capacity of the dose CMO industry is compromised of legacy facilities acquired in the past 10 years from global bio/pharmaceutical companies and embodies the large-scale, inflexible, and high-cost batch manufacturing processes that were dominant 20 years ago. As the manufacturing needs of the bio/pharmaceutical industry evolve in the next 5–10 years, CMOs risk being left behind with underutilized facilities that are unsuited for their potential clients' needs. 

Only a few CMOs can be considered innovators in manufacturing technology and practice despite the fact that manufacturing is only the thing they do. To a large degree, the CMO business forces them to focus on their clients' current and near-term needs. CMOs deal with a lot of older products and even with new products, their bio/pharmaceutical  company clients are unwilling to take on the risk of new manufacturing technologies unless they absolutely have to. CMO profit margins generally do not allow much room for investment in innovation, and most innovative technologies housed at CMOs have been developed and paid for by their clients. 

Unless CMOs become more forward-looking about their technology choices and investments, they risk losing out to new entrants and potential clients. The new technologies will often require less investment in facilities and utilities. Because they are smaller and more self-contained, more companies will be tempted to build their own facilities. Because they will operate more-or-less continuously and be highly automated, they will produce drugs less expensively than the older technologies.  

Today, the competitive challenges that CMOs seem most focused on are how to differentiate themselves from their many North American and European competitors while keeping a wary eye on producers in emerging markets. By not appreciating the changing manufacturing requirements of their clients and the related new technologies, they risk being made obsolete.   

This scenario bears a strong resemblance to what happened to Kodak, which recently filed for bankruptcy protection in the US. Because it was focused on preserving its cash cow—the film and photo processing business—the company viewed its primary competitive threats as coming from Fujifilm and other low-cost film manufacturers. As a result, it overlooked the emergence of digital photography, the new technology that ultimately undermined the company. CMOs could now be facing their Kodak moment. 

is president of PharmSource Information Services, Inc., and publisher of Bio/Pharmaceutical Outsourcing Report, tel. 703.383.4903,  

Articles

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

CMOs Face a Kodak Moment

The year 2011 ended with the buyout of the CRO Pharmaceutical Product Development (PPD) by two private-equity firms, the Carlyle Group and Hellman & Friedman. They paid $3.9 billion, a 30% premium over the company's value shortly before the deal was announced, making it the largest private-equity deal for a publicly traded CRO. 

Clinical CROs such as PPD have proven to be popular takeover targets for private-equity firms: PharmSource counts at least eight publicly owned CROs that have been taken private by private-equity firms since 2003 (see Table I). One CRO, PRA International, had a roundtrip. It was founded as a private company, taken public by its private-equity investor, Genstar Capital, in an initial public offering in 2005, and then taken private again by Genstar in 2007.  

Table I:  Publicly traded CROs acquired in private-equity deals.  

Private-equity buyouts are usually quite attractive to the current shareholders of the company because they offer a significant premium over what the company's stock was selling for shortly before the deal was announced. These deals are usually even more enticing to the senior executives who run the acquired company for two big reasons. Going private allows executives to pursue long-term growth strategies away from the oversight of public shareholders and Wall Street analysts, both of which may be more interested in short-term results than initiatives that promise longer-term, but more uncertain, payoffs. As importantly, the private-equity buyers usually offer the senior executives increased equity stakes in the company that can deliver great riches if those executives are successful in substantially increasing the value of the company through the successful implementation of those long-term strategies. 

The PPD deal illustrates how senior management's frustrations with the public market can drive a company's board to pursue a private-equity buyout. In the past decade, the company had pursued a strategy it called "compound partnering" under which it would acquire or invest in promising early-stage drug candidates. PPD would undertake the early-development efforts to establish proof-of-concept, then out-license or sell the candidate to a drug company for late development and commercialization. Despite some early successes, the stock market and analysts following the company were uncomfortable with this strategy because it introduced a level of risk and uncertainty into a valuation model that expected steady financial performance that was easy to forecast. As a result of the uncertainty, the market discounted the value of the company's stock. A similar problem had been a major reason for another CRO, Quintiles, to undertake a management-led buyout in 2003. 

PPD's board tried to improve its stock's performance by making its compound-partnering business into a separate company, which it spun off to shareholders in 2010. That move, however, did not help the stock's valuation as much as had been hoped. Part of the problem had been the underperformance of PPD's laboratory services business, whose disappointing profitability in recent years has been blamed for depressing the company's stock price.  

Private ownership may enable PPD management to address the laboratory businesses' problems with a long-term view while shielding it from second-guessing by public investors. That was the story at 

PharmaNet Development, which was bought by a private-equity firm after it was cited for noncompliant behavior in running some of its clinical trials. 

The aim of private-equity investors is simple: make a large cash return on the cash invested. This goal is accomplished in two ways: by taking advantage of the acquired company's cash-generating capability and by making the company worth more when it is sold than when it was bought. 

Most private-equity deals take advantage of the acquired company's ability to support a significant debt burden. By using the target's debt capacity, the private firm is able to borrow much of the purchase price and limit the amount of cash it must put up to make the acquisition in the first place. Current interest rates make borrowing especially attractive. 

Clinical CROs are an attractive vehicle for leveraged buyouts. Their capital-

investment requirements are usually small in comparison with manufacturing businesses, so they can throw off a lot of cash. Further, those cashflows are highly predictable because clinical CROs tend to have highly diversified multiyear project backlogs. A growing CRO is likely to be able to pay out substantial dividends to its owners as well as carry a substantial debt burden. 

Enhancing the value of the acquired company may just be a matter of timing, such as by buying the company at a low point in the market cycle and going public when market multiples are high again. The private-equity firm also can improve the value of its target through further acquisitions, expansions of offerings, or restructuring to improve profits. Stock analysts who were following PPD before the acquisition speculated that PPD's laboratory businesses might be in for restructuring.  

Buyouts by private-equity companies are not without risk as such moves are subject to not fully understanding the prospects of the business or changing market conditions. Both of these things appeared to happen to the buyers of the European CMO Nextpharma, whose Belgian injectables manufacturing business was recently forced to file for bankruptcy protection, as well as to the French CMO Osny Pharma, which filed for bankruptcy protection in early 2011 and was absorbed by another CMO, Cenexi. 

While PPD's track record of profitability and market position (it is thought to be the second largest for Phase I–IV clinical research after Quintiles) would seem to guarantee a strong performance  over the typical private-equity holding period of five years, the changing CRO and bio/pharmaceutical research environment could present challenges. As global bio/pharmaceutical companies reduce their CRO relationships to a few preferred providers, competition for those relationships has become intense. There reportedly has been aggressive price cutting in the industry to get those deals, thereby leaving "winners" saddled with lower profit margins but losers shut out altogether.  

Investors have been attracted to the CRO industry because the ongoing reinvention of the bio/pharma business model has outsourcing as a core strategy. The ultimate form of that business model is still being evolved and tested, and there is no guarantee that it will ultimately look like what it looks like today. Buyers of PPD bought one of the crown jewels of the industry. The greater risk is probably faced not by them, but the private-equity firms that bought PPD's small and mid-size competitors.  

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

Some recent private-equity buyouts of CROs show both the upside and downside for investors.

Contract Services in 2012

This year has been a good one for development-services providers, especially those that support late development (i.e., Phase II–III). CMOs and CDMOs report strong demand for late-stage clinical-trial materials and clinical-development services, and our PharmSource surveys indicate that the industry could experience growth of 5–10% this year. 

The buoyant conditions for late-development services may not last much longer, however, as there is growing evidence that discovery and early- development activity may be declining. CROs offering preclinical-development services, such as animal toxicology testing, have reported soft market conditions and weak revenues throughout the year. CMOs specializing in process development for small-molecule APIs note that demand for process development and early-stage clinical supplies remains weak even as late-development demand has been strong. This situation is a big concern for late-development services, of course, because a weak early-development pipeline means fewer Phase II and Phase III candidates in coming years.  

Much of the blame for this state of affairs can be placed on the highly uncertain and volatile global financial environment. Investors remain risk-averse and are less likely to embrace investments that require long gestation periods and have a low probability of positive outcomes. Late-stage development candidates have a greater probability of success than candidates in discovery or early development and are closer to a payoff in the form of licensing or outright sale to a global bio/pharmaceutical company.  

This state of affairs is reflected in venture-capital activity in the bio/pharmaceutical industry. According to US data provided by the National Venture Capital Association, the number of venture-capital investments in the bio/pharmaceutical sector is down 15% through the first nine months of 2011 compared with venture-capital investments in 2010. The actual dollar value of investments is up, but that is because of some large deals that supported companies with strong late-development prospects, such as the $300 million raised by Reata Pharmaceuticals from a single investor. Venture-capital support is crucial to early-stage companies, and the decline in funding is a clear warning sign for the industry. 

The European financial crisis is another cloud on the bio/pharmaceutical R&D horizon. As part of austerity measures required to get their sovereign debt situation under control, many European governments are slashing expenditures on drugs. In countries such as Greece and Spain, governments have cut the prices they will pay for drugs by as much as 25% or more and are forcing a conversion to generic drugs from branded drugs. (The southern-tier countries that have the greatest debt problems have lower generic-drug penetration than northern European countries).  

According to a report by the investment firm Jefferies and Company, the top-line squeeze is likely to force small and mid-size companies in Europe to cut their R&D expenditures as part of overall cost-cutting measures. A recent article in the 

 cites Spain's Almirall and Greece's Alapis as mid-size companies that are facing R&D cuts as revenues fall (1).  

If European revenues are severely affected, even the global bio/pharmaceutical companies could end up reducing their R&D spending in Europe. Although those companies try to maintain global R&D networks to tap into the broadest array of opportunities, their R&D activities have typically been matched to the regions with the greatest revenue and profit potential. Over the past 10-plus years, the locus has been in North America, where the high prices and margins in the US market have funded most of the R&D budgets at global bio/pharmaceutical companies. More recently, the focus has been shifting to the high-growth emerging markets. Even though some of the largest global bio/pharmaceutical companies are headquartered in Europe, continuing sales and profit pressures could force them to move more R&D activity to other locales. 

The global financial outlook is not likely to improve in the foreseeable future. The outlook in Europe remains highly uncertain, with further cuts in government expenditures likely and the survival of the euro zone at risk. Deep budget cuts are coming in the United States, where the aging population and the need to cut budget deficits will put severe pressure on Medicare, the large government-sponsored healthcare program. 

These macro environmental challenges and uncertainties compound the bio/pharmaceutical industry's internal challenges, most notably the decline in revenues resulting from patent expiries. Under these circumstances, the outlook for bio/pharmaceutical R&D spending would seem to indicate  little or no growth in coming years.  

The difficult R&D environment will have a mixed impact on the bio/pharmaceutical services industry. Bio/pharmaceutical company efforts to control R&D costs have helped the contract-services industry, and the penetration of outsourcing is likely to grow, especially in the nonclinical-development segment. However, those benefits will not be equally shared among all industry participants. Thanks largely to the efforts of the global bio/pharmaceutical companies to reduce the number of vendors they work with, a select number of preferred providers is benefiting disproportionately from the outsourcing trend. The clinical-development services segment has already consolidated into a handful of major CROs with large market shares, and we are seeing evidence of a similar consolidation in the nonclinical-development segment although the pace is slower. CROs and CDMOs that don't achieve preferred-provider status will be left to fight over limited opportunities among small- and mid-size bio/pharmaceutical companies. 

The pharmaceutical services industry has traditionally risen and fallen with the R&D spending tide. When the tide has been high, most of the companies in the industry have prospered, but when the tide has gone out, all the participants have suffered more or less equally. If we are going into another period of industry weakness, the pain is not so likely to be shared this time around. 

 1. J. Whalen, "Europe's Smaller Drug Firms Feeling Pain," 

A dearth of late-stage candidates could hurt the pharmaceutical services market in the future.

Troublesome Signs for Bio/Pharmaceutical R&D

Table I:  Publicly traded CROs acquired in private-equity deals. 			