We have reached the edge of the great pharmaceutical patent cliff—those years when a large number of blockbuster drugs lose
patent protection and are open to generic competition. Right on schedule, the major biotechnology and pharmaceutical companies
are making the big strategic and financial moves that the industry has been expecting: large mergers, massive staff reductions
(especially in sales and marketing), and an intensified focus on in-licensing and acquisition of promising drug candidates
from smaller companies.
While preparing for the looming loss of blockbuster products, the big companies also have had to contend with the implications
of the global financial crisis. The near meltdown of the financial system has heightened respect for risk and created a sense
that a company can never have too much cash. Cash flow has not been a problem for major biotechnology and pharmaceutical companies
for decades, giving them ready access to capital markets. In fact, five of the largest companies have raised more than $80
billion this year to fund acquisitions and other corporate activities.
Still, the major firms are focusing on cash-flow management as never before. Working capital (i.e., cash used to finance current
assets such as inventory and accounts receivable) has been a principal target in these efforts and is negatively affecting
contract manufacturing organizations (CMOs).
A primary concern for CMOs has been inventory levels. Major biotechnology and pharmaceutical companies are trying to turn
their inventories more quickly (i.e., reduce the amount of inventory they carry relative to sales volume). Back when good
cash management wasn't such a big concern, the major companies would carry inventory equivalent to as much as nine months
of product sales. Things have improved somewhat since then, but major firms are still carrying more than four months' worth
of sales in inventories, despite working all year to reduce that volume. Consumer-products powerhouse Procter & Gamble (P&G)
, by contrast, carries just two months' worth of inventory in its warehouses.
There was a time when the major biotechnology and pharmaceutical companies could unload inventories by selling products at
a significant discount to drug wholesalers such as Cardinal Health and AmerisourceBergen. However, after some of them got
into legal troubles for this practice, the major companies switched to paying the wholesalers a fee for their distribution
services. The change forced them to carry the entire inventory on their own balance sheets.
With wholesalers out of the picture, major biotechnology and pharmaceutical firms are now cutting back on purchases from suppliers
and curtailing their own manufacturing activities to reduce inventory. This practice is wreaking havoc on CMOs, which are
experiencing unprecedented delays and canceled orders, as well as smaller orders.
The problem has been noted by several CMOs during the past year, but the issue came into dramatic relief at the end of October
when Lonza (Basel, Switzerland) warned of a substantial shortfall in expected revenues and earnings. The warning was brought
on by a cascade of order cancellations and delays that started in late September and continued through October in both its
biopharmaceutical and small-molecule active pharmaceutical ingredient businesses. Lonza CEO Stefan Borgas blamed the cancellations
largely on working capital-management efforts by Lonza customers. The reduced volumes forced Lonza to reduce its projected
year-end profits (as measured by earnings before interest and taxes, or EBIT) by more than CHF 200 million ($202 million).
Lonza said in an Oct. 29 company press release that, "This environment of high volatility is expected to continue for the
next few years." As a result, it launched an aggressive program to counter the negative developments, including reductions
in operating costs that it said would save CHF 60–80 million ($61–81 million) over two years and cutbacks in capital expenditures
of more than CHF 100 million ($101 million) annually.
CMOs are likely to face other challenges from these efforts to manage working capital, including having to wait longer to
get their invoices paid. However, the impact of the inventory reduction drive is potentially catastrophic. As Figure 1 indicates,
the major biotechnology and pharmaceutical companies would have to reduce their inventories by another 50% in order to match
the efficiency of P&G.
Figure 1: A comparison of Big Pharma inventory turns with those of Procter & Gamble (P&G). An inventory turn is the ratio
of of cost of goods sold (CGS) to inventory. (FIGURE 1 IS COURTESY OF AUTHOR; DATA FROM COMPANY INFORMATION.)
It is unlikely that things will get quite that bad for CMOs. At most major firms, more product is produced in-house than at
CMOs, so in-house manufacturing operations should absorb more of the impact, along with raw-materials suppliers. However,
as the Lonza announcement demonstrates, the transition period is likely to be painful for CMOs.
In fact, working capital is likely to create opportunities for some of the most capable and savvy CMOs. Inventory-control
efforts include initiatives to producing in response to demand rather than producing for inventory. CMOs that demonstrate
the flexibility to respond to short-term ebbs and flows in product demand, rather than insisting on the traditional 90-day
lock-in of orders, will prove themselves capable partners for the major industry firms. These efforts by CMOs can lead to
even more business opportunities with clients. Should the biotechnology and pharmaceutical companies decide to close facilities
as part of their ongoing restructuring efforts, those CMOs that have been able to deliver product on short notice will benefit.
Some of the best opportunities in business have come about as a result of extreme adversity. The inventory challenge is likely
to provide such an opportunity for CMOs.
Jim Miller is president of PharmSource Information Services, Inc., and publisher of Bio/Pharmaceutical Outsourcing Report, tel. 703.383.4903, fax 703.383.4905, firstname.lastname@example.org