Slowing Growth, Accelerating Changes Mark Contract Services Industry

The principal objective of the annual PharmSource–Pharmaceutical Technology outsourcing survey is to gauge overall business trends in the contract manufacturing and research businesses. This year's edition documents an industry that is in good health but facing a new set of dynamics.

A strong, but leveling-off market

This year's survey results indicate that the market remains strong, but signs suggest that demand may be leveling off. Buyers of contract services at bio/pharmaceutical companies report that their spending will be higher in 2006 than it was in 2005, but not as robustly as it was in 2005 (Figure 1). Only 16% of respondents expect their spending on contract services to decline, but just 38% expect spending to increase by 10% or more. This figure is down from nearly 50% in last year's survey. The spending slowdown reflects, in part, a reduction in the growth of spending overall (Figure 2): 43% of respondents report that spending on contract services is growing at the same rate as overall spending in their area of responsibility. Nonetheless, 39% report that their outsourcing spending is growing more slowly than their total spending.

Figure 1

View from the contractors. Contract service providers view the market very much like their bio/pharmaceutical clients (Figure 3). Some 51% expect their revenues to grow by 10% or more in 2006—still a strong showing, but down from 62% in the 2005 survey. More vendors expect to grow by less than 10% this year (39% in 2006 versus 27% in 2005), but only 10% expect revenues to decline.

Figure 2

Contractor optimism over new contract signings also is down somewhat this year. Only 48% of contractors expect new contract signings to increase by 10% or more this year, which is down markedly from 62% in last year's survey. Slightly more contractors expect a net decline in new contract signings this year versus last year.

Figure 3

Somewhat surprisingly, contractors don't seem to be alarmed by the slower pace of new contract signings, which should be a bellwether for revenue in the coming months and years. Fifty-five percent of contractors expect business opportunities in 2007 to be "somewhat better" or "much better" than they have been in 2006 (Figure 4). Nonetheless, bio/pharmaceutical respondents indicate that contractors shouldn't be too sure: 48% expect contract spending to grow by less than 10% next year, and only 10% expect spending to grow by 20%, which is almost half as many as those who predicted a 20% spending increase last year (Figure 5).

Figure 4

Contractors aren't resting on their laurels. Bio/pharma buyers report that contractors are aggressively seeking new business. That desire for new business is not necessarily at the expense of price, however. Only a third of respondents indicated that vendors have been willing to cut prices to get their business. Just more than half said that vendors have been asking for new business, but have not been willing to cut price to get it.

Figure 5

One check on price cutting—and a brake on growth—may be that contractor capacity is growing tighter. The percentage of contractors reporting that they are facing capacity constraints is up to 43% in our 2006 survey versus 35% last year. Finding staff has been the greatest challenge for service providers battling to grow faster, followed by their ability to find capital for investment. The availability of new equipment is less of a problem in 2006 than it was in 2005.

Procurement practices

In our 2006 survey, we continue to track the evolution of procurement practices, which we believe are undergoing fundamental shifts that will impact the contract services industry significantly. Price pressures on the pharmaceutical industry have forced drug companies to take greater control of their costs, and procurement groups are on the front lines of those efforts.

Respondents profile

A major component of this trend is the shift of decision-making power and influence from scientific and technical professionals to sourcing professionals. Service providers are certainly experiencing the growing power of procurement operations: the number of contractor respondents who report that sourcing and procurement groups "control the decision" nearly doubled in 2006, to 22% from 12% in 2005. The portion of respondents that expect sourcing and procurement groups eventually to control decision making grew to 30% from 26% (Figure 6).

Figure 6

Shrinking supplier base. Procurement and sourcing groups are driving the consolidation of the supplier base that most major pharmaceutical companies have made a critical component of their cost-reduction strategy. Shrinking the supplier base enables companies to reduce vendor management and overhead costs, negotiate better pricing based on the higher volume of purchases, and improve coordination and communication mechanisms.

Our 2006 survey indicates that vendor consolidation efforts are well underway (Figure 7). Among bio/pharmaceutical company respondents, 29% indicated that they already have begun reducing the number of suppliers they work with, and another 15% expect to begin the process within the next year or so. Nearly half of those client-side respondents report that they consider using new vendors only when they need specialized capabilities or services not currently available to them, and 13% said that they are using only current or recent vendors.

Figure 7

Contractors are beginning to feel the effect of supply-base consolidation efforts. Among contractor respondents, 20% say that they are gaining business, while 16% report that they are losing business as result of supplier consolidation programs. Nearly half of respondents do not expect consolidation to have much effect on their revenues, which we think is a naïve position for them to take.

Service providers willing to be proactive and keep knocking on doors should do well, however, because plenty of opportunities still remain. Almost a quarter of respondents report that they are looking to expand their supplier base and are continually identifying and testing new vendors.

Slow evolution in sourcing from Asia

We continue to track bio/pharmaceutical company interest in sourcing from Asia, especially contractors in India and China. Our survey results show a slowly-but-steadily growing interest in sourcing from Asian supplies, but the pace is not yet alarming to Western service providers.

In this year's survey, 20% of bio/pharma company respondents report that they are actively sourcing now from suppliers in India and China versus 16% in 2005. Slightly more companies aren't sourcing from Asia yet, but are preparing to do so. Thirty-one percent indicated they are either searching for vendors or developing a strategy versus 29% last year.

Nearly a quarter of bio/pharma respondents expect 5–10% of their external spending to be with Asian suppliers in two years, a big jump from the 15% reported in the 2005 survey. The share of respondents expecting to spend more than 10% of their budgets in India and China in 2 years was flat at 18% (Figure 8).

Figure 8

Western contract service providers are not panicking over Asian competitors yet, but most know that they will feel an effect sooner rather than later. In this year's survey, 27% of contractors say they expect to feel a "considerable" impact from Indian and Chinese competitors within two years. That is up from just 15% of respondents in last year's survey and is consistent with the bio/pharmaceutical company findings cited above. Twenty-nine percent of contractors expect to feel a "considerable" impact in five years, again up sharply from 2005.

Conclusions

This year's PharmSource–Pharmaceutical Technology outsourcing survey has documented a slowdown in the growth of demand for contract services, but the revenue and spending projections certainly don't portend an overall decline in the market. The year 2005 represented a significant rebound from the early part of this decade, when a thinning pipeline, funding constraints, and Big Pharma restructuring combined to slow the pace of drug development. The industry has moved well beyond those constraining factors, and new drug development is booming. In addition, Big Pharma is increasingly inclined toward outsourcing as companies seek to reduce costs and free up cash for investments in new products.

Nevertheless, this year's survey predicts substantial changes in the outsourcing environment, especially for contract services providers. We have confirmed the trends toward consolidated supplier bases, procurement-driven processes, and the opportunities to reduce costs via offshore sourcing. My conversations with industry participants have convinced me that nonclinical development and manufacturing service providers have not fully grasped the implications of these trends and have failed to react adequately to their implications.

CRO and CMO executives need only look at the restructuring of the pharmaceutical chemical industry in recent years to see what awaits them if they don't respond to the new realities of their industry.