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).Targeting inventories
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.
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, [email protected]