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

Jim Miller

 During the mid-decade drug development boom, some of the biggest winners were those contract service providers that are part of the clinical supply chain. Contract development and manufacturing organizations (CDMOs) especially benefited from the dramatic increase in early-stage compounds, which fed a surge in demand for process development, formulation development, and small-scale manufacturing services.  

The subsequent downturn in development activity, prompted by the drop in the availability of capital, has hit CDMOs particularly hard. Double-digit declines have replaced double-digit increases, and many CDMOs are struggling to stay in business. No longer able to float on a rising tide of predevelopment candidates, CDMOs are fighting for market share and survival. 

In an effort to better understand the dynamics of and outlook for the CDMO industry, PharmSource recently completed a major analysis of the clinical supply-chain market. We modeled the spend for clinical trial material (CTM) development and manufacturing, including process development and manufacturing for active pharmaceutical ingredients (APIs), formulation and manufacturing of dosage forms, and associated analytical activities (we excluded clinical packaging). We conducted extensive interviews with buyers and sellers of clinical supply-chain services to understand the key behaviors and trends driving the industry. The analysis goes into considerable depth on analytical chemistry activities. 

The PharmSource analysis estimates annual spend on CTM development and manufacture at about $9.3 billion, divided almost evenly among process and formulation development, analytical development and testing, and manufacture of CTMs. The biggest bucket of spending is in early development (preclinical and Phase 1), thanks to the large number of projects in the pipeline and the high cost of API characterization and process development, especially for large-molecule compounds. 

The most revealing aspect of the PharmSource analysis is the degree to which contract services have already penetrated the clinical supply chain. We estimate that as much as two-thirds of CTM development and manufacturing expenditures are already outsourced, a much larger proportion than we expected. The principal source for contract services' large share is the small and mid-size biotechnology and pharmaceutical companies, which account for 88% of the outsourced spend. Small and mid-size companies tend to be highly dependent on contract services and account for 75% of the candidates in the new drug development pipeline. By contrast, large global companies, which account for one quarter of total development spending, make up just 12% of outsourced spend. 

The PharmSource model highlights the dilemma faced by CDMOs: they benefited greatly as the number of early development candidates grew to more than 6000, a 55% increase from 1999, and are now suffering as the number of compounds slips back. Faced with a shortage of capital, early-stage companies have been forced to halt work on many candidates and expend funds on remaining candidates more cautiously. Our model projects that a 20% drop in the number of early-development candidates would result in a 10–15% drop in outsourced development spending, which is in line with what we are seeing now throughout the marketplace. 

There is good news, however. The PharmSource model also points to some substantial upside opportunities for the CDMO industry. Most importantly, the continuing shift from small-molecule compounds to large molecules will likely be a significant boon to the contract services. We expect that if large molecules grow to 30% of the pipeline from their current 22%, total outsourced development spend will grow by 15%. Of course, where that spending takes place will shift as well. CDMOs specializing in large-molecule API characterization, process development, and manufacture will increase their market share while small-molecule API manufacturers will lose share. 

The CDMO market is going through a significant restructuring as it adjusts to changing realities in the world of finance and the bio/pharmaceutical industry. There will be significant opportunities for contract service providers as we come out of the restructuring process, but there will definitely be winners and losers.  

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

Articles

A new analysis highlights growth drivers and challenges for clinical supply-chain services.

Sizing Up the CDMO Market

The variables that companies can manipulate to drive revenue growth are pretty straightforward: customers, projects, services, and prices. During the middle part of this decade, those variables were relatively easy to influence, but things are not so easy anymore. 

In the current cost-conscious environment, there are fewer customers and fewer projects, and the surfeit of capacity relative to demand has precipitated major price cutting. Contract service providers are engaged in fierce battles for market share to hold on to what they have and stay in the game until market conditions improve. 

With opportunities limited in their traditional service segments, more service providers are trying to expand their service offerings. Some of this service expansion is tactical—that is, it's aimed at gaining a slightly higher percentage of the clients' development spend or at defending current revenue against more integrated service providers. Tactical expansions bolt on new service offerings contiguous to the contractor's existing offerings. They require a small expenditure for capital investment and staffing, and little additional sales effort because they are targeted at current customers. As a result, they entail limited business risk and limited upside. A common case in point these days is the addition of early-stage formulation services by contract manufacturers that offer process development and small-scale manufacturing service for active pharmaceutical ingredients (APIs).  

Strategic service expansions are far more ambitious. They involve a major investment in a new service area, typically through one or more acquisitions, where the objective is to quickly achieve critical mass in the service sector and have a major impact on the service provider's top and bottom line. Strategic expansions are often undertaken by companies that foresee slower growth in their current core service offerings, perhaps because they already have a substantial share of the market, and see greater returns by investing in new service sectors. Strategic acquirers also have the financial wherewithal to make investments that will have a significant and immediate impact on the company's prospects. 

Drug discovery has been an important target area for strategic expansions lately. The two market leaders in preclinical toxicology, Covance (Princeton, NJ) and Charles River Laboratories (Wilmington, MA), have placed major bets that drug discovery is the next great opportunity for contract services.  

Covance launched its expansion into drug discovery by buying major research operations from large pharmaceutical companies. In August, it acquired Merck's (Whitehouse Station, NJ)  Gene Expression Laboratory, based in Seattle, Washington, which specializes in genomics services such as genotyping, gene sequencing, and gene expression profiling. As part of the deal, Covance received a contract to provide genomic analysis services during the next five years for $145 million. One year ago, Covance acquired the Greenfield, Indiana, research facility of Eli Lilly (Indianapolis). In that deal, Covance obtained a team of scientists experienced in late-phase discovery research as well as advanced imaging technology that has become a major part of the discovery toolkit. 

Charles River Laboratories (CRL)—Covance's principal rival in the preclinical toxicology business—is also expanding its Discovery and Imaging Services business unit. In August, CRL acquired Cerebricon (Kuopio, Finland), a company that provides discovery services for therapies aimed at treating central-nervous-system diseases, for an estimated $9 million. Last year, CRL acquired MIR Preclinical Services (Ann Arbor, MI), a provider of discovery services supported by 

 imaging capabilities, and in April 2009, CRL picked up PPD's (Wilmington, NC) Piedmont Research Center, a provider of preclinical discovery services focused on oncology. 

The discovery-services sector is somewhat unique because it is less penetrated by outsourcing than most development services (with the exception of medicinal chemistry). We expect to see strategic service expansions into sectors where the fragmented market still presents opportunities to gain market share. One such sector is dose manufacturing. In their July conference call announcing first- half financial results, executives of API manufacturer Lonza (Basel, Switzerland) announced that the company has $1 billion available for acquisitions, and has targeted acquisitions in dose manufacturing as its next step in the commercial value chain. We also may see some deals in the analytical chemistry sector, although few target companies there are large enough to make an impact on the performance of a strategic acquirer. 

Contract-service providers are expanding their offerings in this slow-growth environment.

Expansion Plan

Pharmaceutical companies have turned to Asia, Africa, Latin America, and Eastern Europe for their top-line revenue growth and cost-effective clinical trials. The appeal of these emerging markets is well-known: rising healthcare expenditures by an expanding middle class, the large pool of treatment-naïve patients from which to recruit clinical-trial subjects, and the relatively low cost of conducting trials in those countries. 

As sales and research expand in these regions, so do the risks that the biotechnology company, pharmaceutical company, or contract service provider operating in them will face potentially compromising ethical business situations. In many countries, limited institutional and logistical capacity often leads to opportunities for government officials and business executives to demand bribes or engage in other corrupt practices to expedite a transaction like securing permission to conduct a clinical trial or getting clinical trial materials through customs. 

The degree of corruption risk can be estimated based on the Corruption Perceptions Index maintained by Transparency International, a Berlin, Germany-based nonprofit organization dedicated to fighting corruption worldwide. The index ranks countries based on the perceptions of businesspeople and country analysts. In the 2008 edition, China ranked 72nd, Brazil 80th, and India 85th out of 180 countries (by comparison, the United States ranked 18th and the United Kingdom ranked 16th, with the country ranked #1 being the least corrupt). 

Most Western countries have strict laws prohibiting companies headquartered in them from participating in improper business practices in other countries. In the United States, the applicable law is the Foreign Corrupt Practices Act (FCPA), which prohibits a US company from "directly or indirectly paying or giving a gift of any value to a foreign official in order to obtain or retain business, or secure any improper business advantage." The US and the 29 other member countries of the Organization for Economic Cooperation and Development (OECD) have signed a convention that makes bribery illegal and allows investigators to access bank account and tax records in member countries. 

My colleague at PharmSource, Laurie Pachter, recently wrote a series of articles about the FCPA focusing on government efforts to enforce the FCPA's anticorruption provisions The articles, based on interviews with leading experts in FCPA compliance, discuss the need for compliance efforts, what those compliance efforts should consist of, and the high costs for industry of failing to comply. 

When working in emerging markets, the potential for violating the FCPA and laws of other countries is considerable. Whether a biotechnology or pharmaceutical company is selling products or conducting clinical trials abroad, the risk exposure is substantial. Consider these examples:

1.  Much of the healthcare delivery system, especially hospitals and clinics, is government-owned and operated in emerging markets. Drug sales representatives seeking to place their products in the institutional pharmacy may be expected to provide inducements to procurement and pharmacy staff to make a sale. 

 2. Conducting a clinical trial abroad usually requires permissions from multiple government agencies and officials, including approval of the protocol by the relevant health or drug regulatory agency, permission to import clinical trial materials, and waiver or reimbursement of value-added taxes on clinical trial materials. 

3. Executives of institutions recruiting patients for clinical trials may take advantage of their position to demand special compensation for allowing access to patients. 

FCPA experts advise companies that assessing the risks posed by the number and nature of the interactions their employees have with government and business officials is the first step to establishing an effective compliance program. Key components of any compliance program include a clear corporate ethics policy, regular staff training, documentation of interactions with foreign officials, and regular audits of compliance activities. In many cases, extensive due diligence on the senior government officials with whom the company has regular contacts may be necessary, so that the biopharmaceutical or pharmaceutical company or contract research organization (CRO) fully understands who they are dealing with. Often, other relationships beyond that of the supplier-customer have to be clarified as well. For instance, what if the local CRO office head is married or related to the director of a hospital or a government official? 

Compliance with the FCPA and similar laws in other countries is expensive. It may require the appointment of a compliance officer to oversee the various compliance efforts and of outside auditors to affirm compliance, and compliance efforts are  expensive. An even bigger cost could be the loss of business to less scrupulous or local companies that would result from effective compliance efforts. 

On the other hand, the costs of failing to comply can be high as well. In her articles, Pachter cites a situation where a company was faced with millions of dollars in investigation and remediation costs for mishandling a $70,000 payment. Heavy fines are also a possibility: the US government has collected more than $4 billion in fines for FCPA violations to date. In this time of great pressure to cut costs, companies must be careful not to cut out muscle while trimming the fat in their compliance efforts. 

The risks of violating FCPA and similar laws should loom especially large for CROs and contract manufacturing organizations (CMOs) looking to expand their presence in emerging markets in response to the globalization of their clients' research and marketing strategies. A plan for creating a significant foreign presence must go beyond simply opening or acquiring offices and sites in target countries. Such a plan must include a carefully thought-out and properly funded ethics compliance program. The high cost of establishing and maintaining a program may create a significant barrier to small CROs and CMOs trying to expand their global footprint. 

Biotechnology and pharmaceutical companies need to be thinking about this issue as well. Even if a company is unaware of ethical violations committed by one of its CRO partners, the violations committed by a CRO acting on its behalf could come back to haunt it. At a minimum, it could jeopardize or invalidate trial results if the CRO conducting the trial were to be prosecuted for FCPA ethics violations. The CRO's actions could tarnish the pharmaceutical company's reputation, making it difficult to do business in that country again.  

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

As the pharmaceutical industry looks to emerging markets, corruption becomes an important issue.

Step Carefully into Foreign Affairs

The variables that companies can manipulate to drive revenue growth are pretty straightforward: more customers, more projects, more services and higher prices. During the middle part of this decade, those variables were relatively easy to influence. Demand for contract development services soared as cheap money flowed from venture capitalists and public equity investors into early-stage pharmaceutical companies, and global bio/pharma companies spent lavishly to replenish their pipelines. 

However, things are not so easy anymore. In the current tight money and cost-conscious environment, there are fewer customers and fewer projects, and the surfeit of capacity relative to demand has precipitated a lot of price cutting. Service providers are engaged in fierce battles for market share to hold on to what they have and stay in the game until market conditions improve. 

With opportunities limited in their traditional service segments, more service providers are trying to expand their service offerings. Some of this service expansion is tactical; that is, aimed at gaining a few more percent of the clients' development spend or at defending current revenue against more integrated service providers. Tactical expansions bolt on new service offerings contiguous to the contractor's existing offerings. They require a small expenditure for capital investment and staffing, and little additional sales effort because they are targeted at current customers. As a result, they entail limited business risk and limited upside. A common case in point these days is the addition of early-stage formulation services by contract manufacturers that offer process development and small-scale manufacturing service for APIs.  

Strategic service expansions are far more ambitious. They involve a major investment in a new service area, typically through one or more acquisitions, where the objective is to quickly achieve critical mass in the service sector and have a major impact on the service provider's top and bottom line. Strategic expansions are often undertaken by companies that foresee slower growth in their current core service offerings, perhaps because they already have a substantial share of the market and see greater returns by investing in new service sectors. Strategic acquirers also have the financial wherewithal to make investments that will have a significant immediate impact on the company's prospects. 

An important target area for strategic expansions of late has been drug discovery. The two market leaders in preclinical toxicology, Covance (NJ, USA) and Charles River Laboratories (CRL [MA, USA]), have placed major bets that drug discovery is the next great opportunity for contract services. 

Covance has launched its expansion into drug discovery by buying major research operations from major pharmaceutical companies. In August, it acquired Merck's Gene Expression Laboratory, based in Seattle (WA, USA), which specializes in genomics services such as genotyping, gene sequencing and gene expression profiling. As part of the deal, Covance received a contract to provide genomic analysis services during the next 5 years for a total of $145 million. A year ago, Covance acquired the Greenfield (IN, USA) research facility of Eli Lilly. In that deal, Covance received a team of scientists experienced in late-phase discovery research, as well as advanced imaging technology that has become a major part of the discovery tool kit. 

Covance's principal rival in the preclinical toxicology business, CRL is also expanding its discovery and imaging services business unit. In August, CRL acquired Cerebricon (Finland), a company that provides discovery services for therapies aimed at treating central nervous system diseases, for an estimated $9 million. Last year, CRL acquired MIR Preclinical Services (MI, USA), a provider of discovery services supported by 

 imaging capabilities, and in April 2009 it picked up PPD's Piedmont Research Center, a provider of preclinical discovery services focused on oncology. 

The discovery services sector is somewhat unique because it is less penetrated by outsourcing than most development services (with the exception of medicinal chemistry). As we look ahead, we expect to see strategic service expansions into sectors where the fragmented market still presents opportunities to gain market share. One such sector is dose manufacturing: in a July conference call announcing its first half financial results, executives of API manufacturer Lonza (Switzerland) announced that the company has $1 billion available for acquisitions, and has targeted acquisitions in dose manufacturing as the next step in the commercial value chain. We may also see some deals in the analytical chemistry sector — although few companies there are large enough to make an impact on the performance of a strategic acquirer.  

In the current slow growth environment, service providers are looking to tactical expansions, as well as more ambitious strategic service expansions.

Expansion plan

My colleague at PharmSource, Laurie Pachter, recently wrote a series of articles about the FCPA focusing on government efforts to enforce the FCPA's anticorruption provisions (see 

). The articles, based on interviews with leading experts in FCPA compliance, discuss the need for compliance efforts, what those compliance efforts should consist of, and the high costs for industry of failing to comply. 

When working in emerging markets, the potential for violating the FCPA and laws of other countries is considerable. Whether a biotechnology or pharmaceutical company is selling products or conducting clinical trials abroad, the risk exposure is substantial. Consider these examples:  

Much of the healthcare delivery system, especially hospitals and clinics, is government-owned and operated in emerging markets. Drug sales representatives seeking to place their products in the institutional pharmacy may be expected to provide inducements to procurement and pharmacy staff to make a sale. 

Conducting a clinical trial abroad usually requires permissions from multiple government agencies and officials, including approval of the protocol by the relevant health or drug regulatory agency, permission to import clinical trial materials, and waiver or reimbursement of value-added taxes on clinical trial materials. 

Executives of institutions recruiting patients for clinical trials may take advantage of their position to demand special compensation for allowing access to patients. 

FCPA experts advise companies that assessing the risks posed by the number and nature of the interactions their employees have with government and business officials is the first step to establishing an effective compliance program. 

Key components of any compliance program include a clear corporate ethics policy, regular staff training, documentation of interactions with foreign officials, and regular audits of compliance activities. In many cases, extensive due diligence on the senior government officials with whom the company has regular contacts may be necessary, so that the biopharmaceutical or pharmaceutical company or contract research organization (CRO) fully understands who they are dealing with. Often, other relationships beyond that of the supplier-customer have to be clarified as well. For instance, what if the local CRO office head is married or related to the director of a hospital or a government official? 

The risks of violating FCPA and similar laws should loom especially large for CROs and contract manufacturing organizations (CMOs)s looking to expand their presence in emerging markets in response to the globalization of their clients' research and marketing strategies. A plan for creating a significant foreign presence must go beyond simply opening or acquiring offices and sites in target countries. Such a plan must include a carefully thought-out and properly funded ethics compliance program. The high cost of establishing and maintaining a program may create a significant barrier to small CROs and CMOs trying to expand their global footprint. 

There has been an atmosphere of doom and gloom over much of the contract services industry this year. Early development outsourcing has been hit hard by funding cuts to small biopharmaceutical and pharmaceutical companies and restructuring at the major companies. Late-stage development has maintained some momentum, but a feeling of uncertainty has overtaken the confident swagger of contract services providers.    

 ILLUSTRATION BY M. MCEVOY. IMAGES: DON FARRALL, CREATIV STUDIO HEINEMANN/GETTY IMAGES			

 Outsourcing Survey suggests that the sense of gloom is overblown. Although the positive responses are somewhat fewer and the negative responses somewhat greater compared with previous surveys, the overall picture is still one of a healthy level of activity at contract manufacturing, contract development and manufacturing, and contract research organizations (CMOs, CDMOs, and CROs). Competition has intensified at the margins, but there is a core level of activity sustaining the industry. 

The healthy image of the industry is reflected in the spending patterns reported by respondents from biopharmaceutical and pharmaceutical companies (i.e., the "buy side" of the outsourcing equation). The number of respondents reporting double-digit increases in outsourcing spend dropped sharply, while the number reporting an absolute decrease in spending more than doubled (see Figure 1). Responses from contractors mirrored these results, with a sharp drop in those expecting 2009 to be "very good" and a quadrupling of those expecting the year to be "not very good" (see Figure 2). 

Still, more than 50% of biopharmaceutical and pharmaceutical respondents expect at least some growth in their spending this year, and another 28% expect it to remain level. Among contractors, nearly 75% expect business to be "good" or "very good" in 2009. These responses indicate a slow growth year, but certainly not a disaster. 

Other survey questions illustrated just how different the current market is from the recent past. The number of contractors pointing to large biopharmaceutical and pharmaceutical companies as their best-performing customer segment has jumped sharply, while the number singling out small firms fell sharply (see Figure 3). This change reflects the reduced means of early-stage companies that depend on the crippled financial markets for capital to fund their development activities. It suggests that companies that have been disproportionately dependent on small biopharmaceutical and pharmaceutical companies have been disproportionately hurt by the downturn. 

Another big difference in this year's survey is that, for the first time in three years, more respondents report that outsourced spending is growing more slowly than total spending (see Figure 4). Con-tractor respondents also noticed this development. This may reflect efforts by major pharmaceutical companies to use internal capacity freed by the cancellation of many development programs, as well as the reduced funding available at many small companies. 

As expected in the soft business environment, competition for new business has intensified. The clearest indicator of this move is the big jump in the number of biopharmaceutical and pharmaceutical respondents claiming that contractors are willing to cut prices to get business: 52% of biopharmaceutical and pharmaceutical respondents indicated that contractors are willing to cut prices, versus 42% last year, and just 34% as recently as 2006 (see Figure 5). 

Competition has been intensified by companies' ongoing efforts to consolidate the number of contractors they use. Respondents indicating that they are reducing their vendor base increased slightly, from 27% in 2008 to 31% this year, while the number of respondents with plans to expand their vendor base continued a two-year decline (see Figure 6). 

There are still new opportunities, however, for contractors with biopharmaceutical and pharmaceutical companies: nearly half of the survey respondents indicate that they continually identify and test new vendors, while most others are looking for contractors to fill special needs or replace poor performers. Getting on the "short list" of bidders for a project, though, is becoming more difficult according to our survey. Both the number of bidders per project and the share of bids accepted from new vendors declined somewhat over past years. 

One trend that seems to have slowed slightly is sourcing from India and China. The share of biopharmaceutical and pharmaceutical respondents indicating that they have no plans to source from India and China rose from 45% last year to 51% in 2009 (see Figure 7). This minor growth does not necessarily imply a lessening of interest in sourcing from Asia, but rather a lull reflecting the overall uncertainty in companies' development programs. 

Clients and contractors continue to view contractor performance differently. Contractor respondents are downright immodest in judging their own performance: more than 90% rated their technical and operational performance as "excellent" or "good," and 88% gave themselves "excellent" or "good" ratings on customer service (see Figure 8). 

Clients graded contractor performance on a much tougher curve. Only 57% of biopharmaceutical and pharmaceutical respondents rated contractors' customer service as "excellent" or "good," and only 53% think contractors' project management skills are "excellent" or "good." Contractors fare better on technical and operational performance with 67% of respondents considering them to be "excellent" or "good." On the bright side, only 8–10% of biopharmaceutical and pharmaceutical respondents grade contractors as "poor" or "fair" in these performance categories. 

Perhaps the biggest sign of the changing times revealed by the 2009 PharmSource–

 Outsourcing Survey is the change in which market factors worry service providers the most. In past years, service providers were most concerned about competition from CROs and CMOs in India and China, and about too much capacity in the industry. In 2009, their concerns are more fundamental: they worry about whether the biopharmaceutical and pharmaceutical industries will be able to maintain their historic levels of research and development (R&D) expenditures (see Figure 9). In light of the business-model changes occurring among major companies and the pullback of venture capital, these are very valid and real concerns. 

Despite that uncertainty, respondents to this year's survey are signaling that 2010 could still be a good year. Spending growth is likely to be slower than in past years, but half of biopharmaceutical and pharmaceutical respondents expect increases in their outsourcing expenditures in 2010 (see Figure 10).  Among the ever-optimistic contractor respondents, more than half expect 2010 to be somewhat better, and relatively few are expecting a bad year. 

Although the 2009 survey paints a picture of an overall  healthy industry, contract services providers are right to be concerned about future levels of R&D spending. These concerns reflect fundamental changes taking place in the biopharmaceutical and pharmaceutical industry as the increasing challenges of commercial success are reflected in the level and nature of new drug development. 

For providers of formulation and manufacturing services, the silver lining is that there is still plenty of opportunity for growth—outsourcing has not penetrated as deeply into physical product development as it has into clinical research. Clinical CROs have already grabbed as much as 70% of the clinical research spend available to be outsourced, and that segment's growth curve is likely to flatten. Formulation and manufacturing service providers have achieved about half of that level of penetration, so there appears to be additional opportunity to grab more of that spend. 

The opportunity will not be an equal one for all participants in the business, however. CDMOs can no longer depend on a rising tide to lift industry participants. The increase in outsourcing penetration in the clinical segment has been accompanied by a sharp consolidation of business among a relative few CROs that offer global scope, economies of scale, financial stability, and management maturity. The same is likely to be true for formulation and manufacturing services. The highly fragmented nature of the industry will change, and many smaller CDMOs will fall by the wayside as larger participants consolidate their market shares. 

The key to capturing the opportunity will be performance—that is, the ability to deliver products and services dependably and at lower costs. The gap between how buyers and sellers view CDMO performance continues to be one of the more striking findings of the PharmSource–

Service providers must improve their understanding of client needs and expectations and figure out how to provide the levels of service clients expect. The 2009 survey suggests they aren't doing a terrible job now, but the CDMOs that can close the gap will capture the lion's share of the business in coming years.   

The contract services industry may not be as robust in 2009 as it has been in previous years, but it's not as bad as many people think.