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

Jim Miller

	While industry participants and observers talk about the “CMO industry,” they know that it is not an undifferentiated mass of manufacturers. The contract and manufacturing organization (CMO) industry can be segmented along obvious lines such as API versus drug product manufacturers, biologics versus small molecule, dose form(s) manufactured, and geographic focus. But none of these designations reflect the strategies that each CMO is pursuing, and without that basic understanding, one cannot fully understand the prospects for the industry. 
	
	In PharmSource’s update of the drug product manufacturing industry’s size and structure (1), the CMO industry was parsed into two strategic segments: innovation-driven CMOs and capacity-driven CMOs.

	Innovation-driven CMOs target higher-value market opportunities including new molecular entities and improved dose forms and formulations of older drugs. Innovation-driven CMOs are distinguished by several key characteristics and capabilities:

		Business strategy based on achieving high margins by providing capabilities that support higher-priced novel products 

		A significant number of new drug application (NDA)/biologic license application (BLA) approvals during the past 10 years, including both new molecular entities and new dosage forms 

		Strong pharmaceutics capabilities to support development and manufacture of novel drugs and formulations

		Strong regulatory and quality assurance (QA) capabilities that support dependable registration and approval of new drugs at FDA and the European Medicines Agency (EMA)

		Capabilities to support clients on a global scale, especially clients in North America, Europe, and Japan.

	Capacity-driven CMOs are focused on filling largely undifferentiated manufacturing capacity primarily by producing generics, undifferentiated over-the-counter (OTC) medications, and late lifecycle branded products. Characteristics of capacity-driven CMOs include:

		Business strategy based on acquiring and/or maintaining capacity for routine manufacturing processes such as direct compression solid dose presentations and injectables packaged in ampules

		Tendency to acquire redundant facilities from bio/pharma companies at relatively low cost and with contracts for legacy products

		Few approvals for NDA/BLAs or new active substances (NAS)

		Focus on regional, national, or local markets with limited experience with major regulatory regimes (FDA, EMA, Japanese Pharmaceuticals and Medical Devices Agency [PMDA]) outside of their home region

		In many cases, entry into CMO business solely to sell excess capacity in facilities manufacturing proprietary products. 

	PharmSource considers only 25 (9%) of the 280 CMOs in the CMO industry to be innovation-focused, but they account for one-third of the dose CMO industry’s revenues. The PharmSource categorization of CMO segments is a function of strategy and track record rather than size. Consider the differences in the top six drug-product CMOs by revenue:

		Famar, Fareva, and Aenova collectively account for more than 10% of total CMO revenue, but between them received only a single new molecular entity (NME) approval in the 2006-2015 period out of 130 outsourced NME approvals, and only 12 NDA/BLA approvals out of 445 outsourced NDA/BLA approvals.  

		By contrast, the three other members of the largest CMO list, Patheon, Catalent, and Vetter, accounted for 18% of industry revenues and 33% of outsourced NDA/BLA approvals.

	Clearly these two groups of companies are addressing different customers and pursuing different strategies. Those strategies are important because individual CMOs cannot depend on general organic market growth alone to propel their own revenue and profitability growth. Having well-thought-out strategies that target more attractive market segments, align capabilities to serve those segments, and capture market share are more crucial than ever for achieving healthy returns and meeting investor expectations.
	 

	The challenges are particularly intense for capacity-driven CMOs, which are dependent on older, often undifferentiated products including generics and branded products in the late phases of their lifecycle. Capacity-driven CMOs face several significant difficulties, notably too much capacity relative to market size and declining prices. 
	
	In Europe, in particular, government efforts to hold the line on healthcare costs have triggered a move away from branded generics to commodity generics that are procured by government tenders. Tendering not only lowers prices, it results in CMOs losing unit volumes when their clients lose tenders. Several CMOs have reported revenue declines resulting from lost tenders in recent years. There is a similar process going on in Japan.

	There are two areas where capacity-driven CMOs have promising opportunities. One is generic injectables, where product shortages owing to capacity exits and compliance problems at both domestic and offshore suppliers continue to plague the market. The other promising area, in North America at least, is generic semisolid topical products, for which sharp price increases have drawn competitors to the market; however, most generic-drug companies lack formulation capability or manufacturing capacity for semisolids. 
	 

	Innovation-driven CMOs are focused on developing, manufacturing, and supporting truly new products, including NMEs and novel formulations of older products. Innovation-driven strategies should produce faster growth and better profit margins than the strategies pursued by capacity-driven CMOs. The key to their success is a combination of technical expertise, operational dependability, and regulatory savvy that ensures a new product application will navigate the approval process in multiple jurisdictions with few problems.
	
	The current bio/pharma industry environment is a positive one for the innovation-driven CMOs. New product approvals have surged in recent years, while the convergence of new technologies and a generous financing environment has swelled the pipeline of new product candidates and seemingly assures a continued flow of new opportunities and approvals.

	Nevertheless, innovation-driven CMOs face some significant challenges. Perhaps the biggest is the reduced propensity of global bio/pharma companies to outsource manufacture of their newest products, especially biopharmaceuticals. New product approvals earned by global bio/pharma companies (i.e., the 25 largest companies by revenues) have more than doubled in recent years, thanks in part to in-licensing and acquisition of candidates from smaller companies. At the same time, they have substantially increased their investment in new in-house manufacturing facilities, especially for biopharmaceuticals. That combination of a greater share of approvals and reduced propensity to outsource creates a significant headwind for innovation-driven CMOs.

	CMOs are also contending with smaller unit volumes per product as new drugs are better targeted than previous generations. To some degree, the smaller volumes will be offset by higher unit prices reflecting more complex processing requirements as well as smaller batch sizes, but CMOs may need more products to generate a given volume of new growth.

	The segmentation between innovation-driven and capacity-driven CMOs is not hard and fast; innovation-driven CMOs, in particular, have the ability to pursue the kind of opportunities that capacity-driven CMOs would typically target, although their higher cost structure will reduce the profitability of those deals. Capacity-driven CMOs, however, are much more constrained in their strategic options, in particular by their meager track records of NDA and NME approvals. For a company bringing an innovative product to market, the risk of working with a CMO that has gained only one or two NDA approvals in a 10-year period is great relative to working with a CMO that gets two-to-five NDA approvals annually. Track record is a huge barrier that protects innovation-driven CMOs from their capacity-driven competitors, and the height of that barrier will only increase over time.

Contract Dose Manufacturing Industry by the Numbers: Composition, Size, Market Share and Outlook-2016 Edition

Articles

CMOs chose innovation vs. capacity paths to compete in the pharma market.

Contract Manufacturers Match Capabilities to Market Needs


	Vol. 40, No. 9
	September 2016
	Pages: 86 and 96

	When referring to this article, please cite it as J. Miller, "Efforts Accelerate to Streamline Postapproval Change Process," 

The strategies of a innovation-driven CMO may be different than a capacity-driven CMO.

Innovation vs. Capacity:  How CMOs Compete

	Contract research organizations (CROs) and contract development and manufacturing organizations (CDMOs) may not be feeling it yet, but the downturn in external financing for early stage bio/pharma companies is real. The impact on CDMOs and CROs will be delayed, but there is no doubt that service providers will be feeling it in coming months.
	
	Two recent articles in the financial press underscore what has been happening. An item on 

 chronicled the challenges early-stage public companies are facing as they go out for further funding beyond their initial public offerings (IPOs) (1). The article highlights the plight of two bio/pharma companies, Aldeyra Therapeutics and Ovascience, whose stock prices took big hits when they floated secondary public offerings of their stock on May 26th.  The shares of Ovascience went down 30% on the day of the offering while those of Aldeyra fell 10%.

	The Bloomberg article noted that Aldeyra and Ovascience’s experiences are reflective of what has been happening to many bio/pharma companies trying to tap public markets. According to the article, the number of secondary offerings from bio/pharma companies is down 40% in 2016, with 64 offerings vs. 106 in 2015; but the amount raised is down 70% from $9 billion to $2.6 billion. So it’s not just the decline in the number of offerings that is hurting early-stage bio/pharma; they are also raising fewer dollars per offering.

	The market has also not been friendly to young bio/pharma companies trying to tap public markets for the first time. There have been half the number of IPOs, 8 in 2016 vs. 17 in 2015, but the amount raised, just $483 million by Bloomberg’s count, is down 75%.

	Data compiled from the PharmSource Lead Sheet (

) confirms the Bloomberg analysis and also shows that venture capital (VC) investment has held up well despite the public market travails. Nevertheless, an article in the 

 described how the balance of power has shifted from entrepreneurs to investors in the venture capital world (2). According to the article, VC firms have been able to demand much tougher terms from companies they are investing in, including lower valuations and the hiring of more experienced executives. The article focuses on Internet companies, but the pinch is being felt across the start-up spectrum.


	It’s not surprising that CROs and CDMOs may not be feeling the impact of the funding downturn quite yet. After the 2008 global financial crisis, it took two years for investigational new drug (IND) filings and Phase I clinical trial starts to reflect the funding decline (

). That’s because early-stage companies focused their remaining cash on getting their lead candidates into the clinic as quickly as possible in hopes of demonstrating proof of concept (POC). POC is typically the prerequisite for licensing deals and other partnering arrangements from larger bio/pharma as well as funding from public sources. Funding from partnering arrangements is probably the most secure funding source because large bio/pharma companies now depend on in-licensed and acquired candidates for at least half of the products they ultimately take to commercial markets.

	Early-stage companies trying to get into the clinic are an important source of business for CDMOs because most are dependent on service providers to manufacture APIs and formulated dose forms. Those companies represent the majority of customers at most CDMOs, but they typically have just a small number of new drug candidates, so CDMOs need to constantly replenish their customer portfolios to thrive. That replenishment is highly dependent on a rebound in public bio/pharma equity markets: venture capital might get candidates through discovery and into preclinical but emerging bio/pharma companies need the larger tranches of public funding to sustain a clinical development program.


	The most recent downturn in external financing is barely a year old, so CROs and CDMOs aren’t yet feeling the pinch. Emerging bio/pharma companies are using the funds they have to get their candidates into the clinic, as in past funding cycles, which is good for CDMO business in the near term. But without public markets, the industry could see a sharp drop in IND filings, and in the demand for CDMO services, as it did in 2010.

	One way for CDMOs and CROs to prepare themselves for the worst case is to focus on resurrecting their business development skills. After several years of just answering unsolicited external inquiries, they will soon have to be prospecting for new business and selling the customer on why they should use them rather than a competitor. As they were in the last downturn, new business development skills will be a key to sustained success.

“Biotech’s Vicious Secondary Cycle,”

“Start-Ups Once Showered With Cash Now Have to Work for It,”

Unfavorable public investment markets could put emerging bio/pharma growth and CDMO spending at risk in 2017

Slower Bio/Pharma Investment Could Hurt CDMOs in 2017

Contract manufacturing and contract development and manufacturing organizations (CMOs and CDMOs) are an entrenched and critical component of the bio/pharmaceutical industry, but they have proven to be more important to some segments of the industry than others. A bio/pharma company’s relationship with its CMOs depends a lot on its size and product portfolio.	 	Not surprisingly, CMOs have been most successful meeting the needs of small- and mid-size bio/pharma companies. Nearly 80% of the products approved by FDA on behalf of small bio/pharma companies (companies with just one or few products) are contract manufactured, while 50% of the products sponsored by mid-size companies ($500 million to $5 billion in revenues) use a CMO. Small- and mid-size companies typically lack the cash needed to build a modern bio/pharmaceutical manufacturing facility and cannot bear the financial risks in the event their products don’t succeed commercially. CMOs are crucial to the existence of small and mid-size bio/pharma companies, and the converse is almost equally true.	 	The CMO industry, however, has been challenged in overcoming the insistence of global bio/pharma companies that manufacturing of their newest, highest-value products be kept in-house. Analysis by PharmSource has shown the outsourcing of drug-product manufacture for new molecular entities (NMEs) by global bio/pharma companies has dropped sharply during the past 10 years, from 60% of new NME approvals in 2006 to 20% in 2015 (	

	 	It would appear that the manufacturing networks of the global bio/pharma companies have finally caught up with their pipelines. When the wave of new biologics approvals hit, global bio/pharma companies were not prepared, and they depended more heavily on major CMOs to launch their products. In the past 10 years, however, they have invested heavily in manufacturing facilities to accommodate this transition from an organic chemistry-focused platform to a multi-technology platform incorporating cell biology and even more novel technologies. Global bio/pharma companies have spent nearly $100 billion in just the past five years to build up their biopharmaceutical manufacturing base, including very large-scale facilities to house mammalian cell culture, microbial fermentation, and filling of vials and prefilled syringes.

	These developments point to two realities that face the CMO industry: global bio/pharma companies prefer to keep manufacturing in-house, and only they have the resources to bring about a large-scale transformation of the industry’s manufacturing base in a relatively short amount of time. The reasons are easy to understand.	 	Bio/pharmaceuticals are a product business. While the industry press often focuses on intellectual property creation, and licensing fees are important to emerging bio/pharma companies, the bulk of industry revenues are generated from sales of the actual products themselves.  So, far from being a “non-core competency” as some contract manufacturing proponents tell themselves, manufacturing is crucial to the existence of the bio/pharmaceutical industry. It should come as no surprise that companies would want to maintain control of their main revenue generators by manufacturing them in-house. 	 	Further, capital investments of the magnitude needed to manufacture the rapidly-expanding portfolio of biologics can only be supported by the kind of profit margins and cash flows that biopharmaceutical product companies can generate. The bio/pharmaceutical industry has gone through a technology revolution as biologics capture a growing share of revenues and product pipelines, and a whole new manufacturing infrastructure has been required to make those new products. To create that infrastructure, capital spending by the 25 largest bio/pharmaceutical companies in each of the past three years has exceeded the revenues of the entire drug-product manufacturing sector. So while CMOs have been critical for helping global bio/pharma companies make the transition to biologics, they don’t have the resources to provide all of the manufacturing capacity the industry needs.	 

	CMOs can’t compete with captive capacity on scale. If they are going to capture a meaningful share of global bio/pharma manufacturing expenditures, they need to do two things effectively: position their offerings toward those activities for which they can compete effectively, and innovate their business models to address the broad range of objectives that global bio/pharma companies seek to achieve in their manufacturing arrangements.	 	Global bio/pharma companies have shown a clear propensity to outsource certain categories of activities (

). Activities that involve seldom-used technologies and capabilities, are highly novel, or are high risk, are likely to be conducted at a CMO. For instance, global bio/pharma companies frequently turn to contract manufacturers of highly potent APIs (HPAPI) and dosage forms incorporating HPAPI, because they require very specialized capabilities that CMOs can amortize across multiple clients. CMOs have manufactured the first antibody-drug conjugates (ADCs), which similarly require very specialized facilities and which are still unproven commercially. CMOs have also been leaders in investing emerging technologies such as cell and gene therapy, being among the first companies to establish facilities and improve the technology. Other specialized requirements that are often outsourced include drug delivery and clinical packaging.	 	

	 	Global bio/pharma companies are also more likely to outsource requirements that involve mature technologies or that involve highly routine activities. Global bio/pharma companies are increasingly using CMOs to manufacture their small-molecule APIs, even for new molecular entities; the double-digit growth rates in recent years of CMOs manufacturing small-molecule APIs bear testament to the increased willingness to outsource those requirements. Routine analytical testing, including testing products using validated methods and raw materials testing, has long been outsourced.	 	By contrast, global bio/pharma companies continue to invest heavily in technologies and capabilities that are fundamental to their long-term strategies, notably biologics manufacturing and manufacturing of key dosage forms including injectables and inhalation. They also tend to hold on to activities that generate knowledge about their molecules and which supports their strategies as it accumulates, such as knowledge gained in characterizing molecules and developing analytical methods and formulations.	 	Where CMOs have been successful in winning manufacturing business from global bio/pharma companies, it is often because they have addressed the broader considerations involved in making manufacturing decisions. Traditionally, CMOs have focused on addressing the basic supply concerns of security of supply and unit cost, which mostly come down to matters of price and capacity. But, as illustrated in 

, global bio/pharma companies have a much broader array of objectives and options to consider when determining how to design their supply chains and whether to manufacture in-house or outsource, as follows:	

		Financial considerations can often skew the decision. Generous tax incentives and subsidies and lower tax rates may drive companies to construct a facility in a country, while balancing exchange rate exposures may also drive decisions on where costs are incurred.

		Regulatory factors will play heavily into sourcing decisions. Regulatory regimes in many countries favor local manufacture over imports, as do reimbursement policies. Local labor laws may make it difficult or expensive to close a manufacturing facility even if outsourcing the products made in it would be more cost effective.

	 	With the increased use of in-licensing and acquisitions to build product pipelines, manufacturing plans must be able to accommodate products that are not currently in their pipelines and have not yet been identified. That may mean maintaining unutilized capacity to handle unexpected demands.	 	To address these broader considerations, leading CMOs are reconsidering their value propositions to develop innovative service offerings. In particular, they are realizing that they can disaggregate the range of activities they perform in order to manufacture a product, and repackage them into offerings that create more flexible solutions for their global bio/pharma clients. 	 	The primary example of that new thinking to date is the growing number of deals in which CMOs are hosting and operating dedicated manufacturing operations for clients. Typically, these arrangements involve the client funding, and some cases operating, dedicated equipment in a leased suite at a CMO facility. The client enjoys the flexibility and security of having its own dedicated manufacturing operation but at much lower cost, because it can share fixed and operating facility costs like warehousing, air and water systems, and site security.	 

	The history of the contract manufacturing business has generally been one of CMOs acquiring outmoded legacy facilities from pharmaceutical companies to manufacture late lifecycle and generic products. Few CMOs have participated in the innovator drug portion of the industry: from 2006-2015, more than 150 CMOs got at least one new drug application (NDA) approval but just 10 account for more than 50% of those approvals, and most only got one NDA approval in 10 years. 	 	In the next five years, most CMOs will remain mired in the commodity capacity CMO model, stymied by a lack of strategic vision or limited capital. However, based on recent industry developments, a handful of CMOs will offer a more innovative CMO model that will be truly service-oriented and innovative, and will be more appealing to global bio/pharma companies. Those are the companies that will dominate the industry and inspire customers and investors. 	 

	Supplement	Vol. 40, No. 8	Pages: 6–10	 

	When referring to this article, please cite as J. Miller, "What’s Next for 	the CMO Industry?," Outsourcing Resources Supplement to Pharmaceutical Technology 40 (8) 2016.

CMOs that offer an innovative service-oriented model will dominate the industry.

What’s Next for  the CMO Industry?

	Merger and acquisition (M&A) activity remains robust across all industries, including contract pharmaceutical services, as low interest rates and slow organic growth create both the opportunity and the rationale for doing deals. Recent events suggest that the world may have reached the boundaries of what is doable, however, as some large deals, such as the proposed combination of Pfizer and Allergan in pharma and Halliburton and Baker-Hughes in petroleum, have fallen apart over issues of tax policy, antitrust, and global commodity prices. Volatility in the world’s stock markets is also making it more difficult to do deals where payment is to be made in shares rather than cash.
	
	Deals in the contract manufacturing organization (CMO) world aren’t likely to be affected by those macro-economy issues because of their relatively small size and scope, and it is expected that a number of them will be announced in the later part of 2016. A number of factors will continue to drive M&A in the CMO sector including a difficult initial public offering (IPO) market, the scramble for strategic assets, facility divestments by global bio/pharma companies, and a number of private equity-owned companies reaching the point, typically five years or so after their initial acquisition, when the owners are looking to sell.
	
	


	However, flurries of acquisition activity, such as those seen in the past few years, invariably lead to hangovers that can impact the operations and even the viability of the buyers. In times of strong end-market demand, such as the contract services industry has been enjoying, there is intense desire to close deals to broaden capabilities and build market share. In the rush to do deals while financial markets are accommodating, companies can outrun their operating and financial capabilities. The following are some potential pitfalls that bio/pharma companies need to watch out for when doing their due diligence on service providers that have been active acquirers.
	
	

 Putting manufacturing, sales, human resources, and accounting operations on the same platform is a big, expensive undertaking that companies may fail to anticipate. Integration often requires investments in new software platforms, additional senior executive leadership, intensive staffing retraining, and ultimately the creation of a new corporate culture that can take years and a lot of cash. Companies pushed to show profits that justify the deal may not be willing or able to make the investments necessary for successful integration. The resulting complexity can have negative implications ranging from delayed financial reports (which can violate loan covenants) to high staff turnover to, in extreme cases, compliance issues because facilities operate under different quality and standard operating procedure (SOP) regimes.
	
	

 Some acquirers are piling on debt in order to fund their acquisitions. In the current financial environment, interest rates are low, but interest, principal repayment, and loan covenants may limit cash available for investment in new plant and equipment. Further, as noted above, integration may require investment in new information technology and other capabilities that compete with the need for new or replacement manufacturing equipment. Customers can be persuaded to pay for some new investment, but that is usually for specialized dedicated equipment, not basic capabilities.

 Acquisition-driven companies can be susceptible when the underlying strategy proves to be inappropriate or difficult to execute. For instance, the full service CMO model looks to be an appropriate response to the efforts by bio/pharma companies to consolidate their supplier base. But just as a chain is only as strong as its weakest link, a CMO’s reputation can suffer badly if any part of the full service offering falls below acceptable standards of performance.

 Given the high prices paid for acquisitions and the use of debt to fund them, acquirers may be especially susceptible to any downturns in demand for contract services. Especially in a fixed-cost business such as manufacturing, small declines in demand can lead to disproportionately large declines in profitability, and any profit declines put debt servicing and loan covenant compliance at risk.

	External funding for early stage bio/pharma companies has always been cyclical, and there was a sharp drop-off in external funding in the first quarter of 2016 as valuations of early stage bio/pharma companies came down sharply. While there may not be an immediate negative impact on the CMO industry, the funding slowdown could impact the industry in 2017–2018 if it continues.


	While acquisitions are an important and legitimate avenue for companies to broaden their capabilities and gain market share, it’s important to remember that such strategic considerations aren’t always what is driving deal activity. Often acquisitions are sought as a remedy for slow organic growth (i.e., the inability of the current core business to grow as quickly as the owners would like). Also, it should be noted that private equity firms are paid to put capital to work and may be driven to do deals in part to demonstrate to investors that they are doing just that.

	While Valeant Pharmaceuticals is not a CMO, its recent travails are a close-to-home illustration of what can happen when the assumptions underlying an acquisition-driven strategy prove to be unrealistic. Contract development and manufacturing organization (CDMO) industry veterans may also recall what happened to AAIPharma 10 years ago when it tried to transition from a CDMO to a pharmaceutical company. Corporate executives may challenge the boundaries of ethical and legal practices when their market and business assumptions prove unrealistic.

	Most of the major players in the CDMO industry are well-managed and conduct careful due diligence when carrying out their acquisition strategies. But bio/pharma companies that depend on CDMOs for product development and in-market supply owe it to themselves to be especially diligent when qualifying suppliers that have been actively acquiring new businesses. Inquiring about integration activities and capital structure may not be part of the usual due diligence questionnaire but the answers could be crucial to the success of the relationship. Even if the survival of the supplier is not immediately threatened, clients need to be aware of potential disruptions to the business.

Bio/pharma companies that are qualifying potential contract service providers should investigate post-merger integration activities and capital structure as part of the due diligence.

Potential Consequences of the CDMO Acquisition Binge


	When referring to this article, please cite it as J. Miller, “Bio/Pharma Funding Challenges Could Hurt CDMOs in 2017," 

CDMOs need to be aware that unfavorable public markets put emerging bio/pharma R&D spending at risk in 2017.