A slow recovery in business activity
The pharmaceutical services industry enters 2010 after enduring one of the most difficult years in its relatively brief history. 2009 was marked by some of the most difficult market conditions ever faced by contract research, development and manufacturing companies (CROs and CDMOs).Unfortunately, the factors that created the problems in 2009 have not fully resolved themselves and there may be new challenges on the horizon. Funding remains uncertain for small and midsize bio/pharmaceutical companies, which account for 35% of all R&D spending and a bigger share of outsourced expenditures. The companies formed by the big mergers of 2009 (Pfizer-Wyeth, Merck-Schering-Plough, Roche-Genentech and Abbott-Solvay) are still sorting out what capacity and capabilities they will keep, and which development candidates they will pursue. The fundamental transformation of the bio/pharmaceutical business model continues, as companies continue to cut overheads, inventories and pipelines in response to the expiration of patents and the new economics of drug development.
CROs and CDMOs are reporting some improvement in requests for proposals and new project awards, but we expect 2010 to start off slow thanks to the factors noted above. By the second half of the year, however, we could see some pick-up in activity as the overall economy improves and the financial sector strengthens. We don't think the turnaround will be robust, but it will at least mark a halt to the revenue declines experienced in 2009.
Big Pharma becomes a competitor to the CDMOs
The major bio/pharmaceutical companies will be a nuisance to CDMOs in 2010. In the commercial manufacturing arena, Pfizer and Abbott are already active sellers of their excess capacity, and we expect at least one more major company to launch a formal effort to establish itself as contract manufacturer. In addition, we continue to see companies sell spare capacity of particular capabilities; for example, biologics manufacturing.
Big Pharma may also be a problem in the market for clinical development and manufacturing services. We think there may be significant overcapacity for manufacturing of clinical trial materials as a result of the trimming of development pipelines and the big mergers. While we don't expect global bio/pharmaceutical companies to start selling clinical manufacturing services, we may see them bring in-house work that they would otherwise outsource, including manufacture of placebos and comparative agents.
We don't foresee this being a longterm problem for the contract services industry. Executives at the giant companies created by last year's megamergers need time to work through the implications of what they have created, and the further rationalization of these development and manufacturing operations will be secondorder considerations. The major bio/pharmaceutical companies are more committed than ever to reducing fixed assets and fixed costs, and they will get around to closing down their redundant capacity and outsourcing more of their development activities during the next few years.
Intensifying competition for development services business
While we expect demand conditions to slowly improve, we expect competition for that business to intensify. Contract service providers are expanding their service offerings to drive their own revenue growth by capturing more of the available expenditures. They are also trying to improve their positioning as potential preferred providers for the major bio/pharmaceutical companies, which tend to favour companies with broader capabilities. So we will see contract analytical laboratories offering formulation and manufacturing services, and providers of API development services adding formulation development and dose manufacturing capabilities. Not all of these companies will be successful, but we expect the effort to negatively impact the smaller service providers that lack specialized expertise.
Acquisitions of contract service providers will increase
Look for acquisitions of contract service providers to pick up in 2010. Acquisition activity almost always picks up as economies come out of a recession as financing becomes more available and companies that survived the downturn seek to exploit their relative strength.
One factor that will drive acquisitions in the services arena will be the effort to increase the breadth of service offerings across both capabilities and geographically. Another factor will be the opportunity to gain economies of scale by increasing company size and generating savings in back office activities, and sales and marketing.
Private equity investors have been active buyers of contract services companies in recent years, and we expect that activity to continue, despite the somewhat diminished attractiveness of the business. One interesting play among some private equity firms is to view formulation development CDMOs as platforms for creating speciality pharmaceutical companies. The rationale is that the formulation and drug development expertise of these companies, combined with the manufacturing capabilities, makes them ideal vehicles for transformation into product development companies. When it comes time to exit, valuations for companies with portfolios of drugs are almost always greater than valuations for service companies, so there is strong incentive for pursuing that strategy.