Much of the media coverage of Europe's debt crisis has focused on the ability of governments in the so-called PIIGS countries—Portugal, Ireland, Italy, Greece, and Spain—to repay or refinance their national debt. It is much more than that, however.
The European debt crisis is potentially a banking crisis as well because the banks hold much of the sovereign debt. If the PIIGS were to default, the banks would be forced to write down the value of their bond holdings, and the resulting losses would reduce their equity and the capital ratios that they must maintain under international and national regulations. That scenario would force the banks to raise more capital and/or reduce their lending to bring assets back in line with their capital. The reduced lending would be felt throughout Europe because the affected institutions, especially the big trans-European banks, such as Deutsche Bank, are major lenders throughout the Euro zone.Another concern is that government austerity programs, combined with reduced bank lending, will severely weaken the already fragile economies of the PIIGS countries. Those economies are already a mess, plagued with low demand, high unemployment, and low tax revenues. Lower government spending, tighter private-sector credit, and higher interest rates will further suppress overall economic activity and household incomes in the coming years.
In fact, the bank pullback already is under way. Recent reports in the financial press (as of the writing of this article in early August) indicate that the European banks are reducing their private-sector lending in the PIIGS countries in an effort to reduce their exposure to the weakening economies.
Implications for CMOs
The deteriorating European financial situation will play out to the detriment of European CMOs in two principal ways: undermining their operating performance and affecting the availability and cost of debt needed to finance their businesses.
Operating performance. The deterioration of the operating performance already is occurring because expenditures on drugs are falling sharply through reduced volumes and lower prices. These lower volumes and prices are especially apparent in countries where the national healthcare systems are primary buyers and distributor of drugs and therefore affected more by reduced government revenues and spending. The deteriorating economies also will impact privately financed spending on drugs.
CMOs are feeling the affect of reduced spending on drugs through lower production and demand from clients for lower prices. Furthermore, many European CMOs also are generic-drug manufacturers that use their excess capacity for contract manufacturing. The reduced spending also is taking a toll on their generic-drug business.
Even before the financial crisis, many European CMOs and generic-drug companies were plagued by low utilization and narrow profit margins. Further deterioration of operating profitability has a range of deleterious implications for the CMOs, ranging from deferred maintenance and capital investment, all the way to receivership. Any sustained deterioration in operating profitability will reduce the credit worthiness of CMOs and threaten their access to bank credit.
Availability of financing. The availability and cost of bank credit could impact a number of CMOs, including those that are owned by private-equity companies. Private-equity firms typically use the debt capacity of the companies they own to reduce the amount of equity they have invested in the companies and even as a means of generating cash that they pay to themselves as a dividend. In the case of European CMOs, even though the owners in most cases didn't pay much or anything for their facilities, the owners could have borrowed against their assets and they could be highly leveraged. Even where companies don't depend on debt for financing assets, any deterioration of operating performance could affect CMOs' ability to get lines of credit for basic operating needs.
The financial crisis will hurt the CMO industry by making it more difficult for their clients to get external financing. Financial crises always make investors more risk averse, and investing in new drug development is inherently risky. Europe has always been a difficult place for early-stage companies to raise venture capital, and the deteriorating economic situation is likely to make it worse.