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Survival of the Fittest Companies
The industry outlook has changed from rosy to glum in a remarkably short period of time. Less than six months ago, we reported that the respondents to the 2008 PharmSource–Pharmaceutical Technology Outsourcing Survey were optimistic about their 2009 prospects. Nearly 70% of participants from contract services companies expected 2009 to be better than 2008, and a similar share of biopharmaceutical and pharmaceutical company respondents expected their outsourced expenditures to grow in 2009.
The financial crisis is putting an end to those expectations. Service providers that offer early research and development services, including discovery, preclinical toxicology, process development, and clinical-supplies manufacture, are reporting steep downturns in business activity, and a sharp increase in project cancellations and delays.
The primary culprit behind this gloomy picture is the uncertainty of funding for early-stage companies. Traditional funding sources such as initial public offerings (IPOs), follow-on stock offerings, and debt have nearly dried up. Venture capital flows have held steady at about $1 billion per quarter, but investors are funneling money to companies in which they already have investments rather than spreading it around. That's because they want to ensure that the most promising candidates in their portfolio companies continue to progress, and because new investors would insist on terms that would greatly dilute the equity positions of the early investors.
To conserve funds, early-stage companies with multiple product candidates are being forced to shelve less developed candidates. They are focusing instead on candidates with the nearest and best prospects for commercial approval or out-licensing. Start-up projects are having a difficult time finding any funding.
The demand downturn has been compounded by major pharmaceutical companies' efforts to reduce costs even as they increase outsourcing. Big Pharma is exiting entire therapeutic areas and halting early-stage projects in those areas. For continuing programs, they are aggressively looking for ways to cut development expenditures before demonstrating proof of concept.
Further, most major pharmaceutical companies have established global sourcing units that are pursuing strategies to reduce outsourcing costs by standardizing processes and reducing the number of vendors that must be qualified, audited, and managed. These programs started five years ago in the clinical CRO realm and resulted in companies reducing the number of CROs they work with by as much as 80%. We expect to see a similar pattern for outsourced formulation and manufacturing services. This changing environment is hitting especially hard those CROs and CMOs that focus on early development because there are fewer candidates and less money to spend. Late-stage development has not been affected as much and contract backlogs at clinical CROs continue to rise.
It's hard to say how long this environment may last. No one knows how the financial and economic crisis will evolve and when the funding situation for early pharma will improve. The impact on the product pipeline is likely to be longterm, however. When the financial markets were flush with cash, many companies and projects received funding that would not have if proper due diligence had been carried out. They got the green light because venture capital investors had to put their large pools of money to work. Now, products and companies with marginal chances of success (and many that may be promising, as well) are not being funded. Thus, the decline in early-stage compounds could be sustained for several years.
Moreover, a higher percentage of remaining development candidates will be placed in the hands of major biopharmaceutical and pharmaceutical companies. Most of the largest companies have substantial caches of cash (Pfizer alone has more than $26 billion in the bank). These companies have been eager buyers of promising early-stage companies and licensees of promising products and technologies. They have bid up valuations to historic levels. Now, with early-stage companies desperate for funding and their valuations collapsing, the cash-rich major pharmaceutical companies are widely expected to step up their acquisitions.
With less money, fewer compounds, and continuing efforts by major pharmaceutical companies to consolidate the vendor base, we expect the number of CROs and CMOs to shrink considerably. Companies that have depended largely on the venture capital-backed companies will have an especially hard time. Their customers seldom have more than one or two candidates in need of services at any one time, so they must continually replace their customers with new ones. However, those candidates won't be there.
The survivors will have a strong track record of servicing companies with multiproduct pipelines that can offer repeat business. They will have profitable operations, strong financial positions, and savvy business development skills. Increasingly, those that serve the largest companies will have a global network of operations to support their clients' global ambitions.
While we don't wish ill on any contract service provider, a shakeout of weaker companies would probably benefit the industry. The CRO–CMO industry has too many participants; lots of new entrants have been attracted in recent years by the growing pipeline and ample funding. In the manufacturing sector, entry has been eased by the willingness of pharmaceutical companies to sell redundant facilities at bargain prices to get assets and employees off of their books. Many of these companies have minimal experience in business development and marketing, no brand equity, and few long-term relationships with better-funded companies. In addition, they are not well-capitalized. We expect a number of them to disappear in the downturn.
Pharmaceutical companies looking for vendors are advised to carry out careful due diligence on the companies with which they seek to work. Financial condition such as profitability, cash position, and debt-service requirements should be a paramount consideration. Clients should insist on full financial disclosure, even from privately-held companies (contractors should demand the same of venture-backed clients). Strategic due diligence will be important to ensure that the parent company or investor group is committed to the business. The CRO–CMO industry will come out of this stronger in the long run, but it will be painful getting there.