Custom Synthesis and Custom Chemicals

The chemical synthesis industry is a dynamic, highly segmented, and growing component of the overall outsourcing business. It has a distinctive service platform and customer base compared with chemical suppliers, thus requiring a clear understanding of key success factors, expectations from pharmaceutical company customers, and changing global economic environments. This article describes the current extent and scope of the chemical synthesis business within the framework of increasing regulatory compliance demands and a growing number of pharmaceutical firms that are requesting contract services for their chemical operations.

Custom synthesis is a business operation conducted by a third-party vendor to build molecules on the behalf of a specific customer that typically has no legal affiliation with the service provider. Custom synthesis is one of the multiple segments within the outsourcing space. Although it is defined as covering only molecule-building activities, custom synthesis represents in of itself a very complex field made by a multitude of segments and subsegments (see Figure 1), which reflect the situations and variants that can be observed, including:

Figure 1: Custom synthesis comprises several subsegments.

• the type of input supplied—namely, either a service (e.g., the development of an optimized process or a technology package ready to be transferred) or a product (e.g., an intermediate or the final molecule);

• the product's life-cycle position (e.g., early- or late-phase development, launch, maturity, or sunset), which has implications for the quantities supplied as well as customer expectations;

• the industry of the end user (e.g., agrochemical, personal care, pharmaceutical, and electronic chemicals) such that regulatory and vendor qualifications hurdles vary greatly depending on the application.

Extent and scope. Both the customer and the vendor slate in custom synthesis are very broad, reflecting the extreme fragmentation of this arena and the number of situations encountered. Similarly, contractual conditions associated with custom synthesis range widely depending on the scope of the vendor–customer agreement. As an example, the agreement can be either restricted to the conversion on a cost-plus basis of a raw material supplied by the customer or it can cover the vendor's development of the technology processes required to effectively produce the end molecule expected by the customer.

It is therefore no surprise that, given this extreme fragmentation, the precise boundaries and size of the custom synthesis space are ill defined. The industry sales range is estimated from more than $50 billion to $6–7 billion when the scope is limited to the life-science outlet.

Some traits clearly differentiate custom synthesis from other segments of the chemicals industry. These include:

• the one-to-one relationship existing between the vendor and its customer. The vendor supplies the product or the service on an exclusive basis to the end user that typically is either the originator or owns the full rights on the molecule;

• the service-type dynamics of the business. The vendor engages in supplying the molecule at the request of its customer. This means that the vendor is entirely dependent on its customer and has either no or limited control on the ultimate fate of the business should the product be withdrawn from the market or should the customer elect to change its supply source;

• the limited transparency of the business. Customers typically insist on maintaining confidential dealings with their vendors, probably as a tactic to increase their leverage.

Although it is often associated with fine chemicals and the life science industry, custom synthesis covers all segments of the chemical industry. Custom-synthesis agreements pertain to both large-volume commodity chemicals, supplied in hundreds or thousands of tons as well as to molecules produced at the microgram scale. The end-user base for custom synthesis also is extremely broad, comprising both integrated end users that have their own chemical production facilities and that elect to outsource part of their requirements as well as virtual companies that have no option but to rely on a third-party supplier for their molecular requirements. Examples include start-ups such as Gilead Sciences (Foster City, CA) or NiCox (Sophia Antipolis, France) as well as established pharmaceutical companies such as Wyeth (Madison, NJ) or Solvay (Brussels, Belgium).

The vendor slate is equally extremely broad. Several thousand companies supply custom-made chemicals, including both large, diversified chemical companies such as Dow Chemical (Midland, MI) or Lanxess (Leverkusen, Germany)—which have developed a base in custom synthesis as a strategy to leverage their technology base to load assets—as well as players for which custom synthesis is their main business, including, for example, Albany Molecular Research (Albany, NY), Proviron (Oostende, Belgium), and Siegfried (Zofingen, Switzerland). Interesting to note, the number of players in custom synthesis has increased over the past five years. As an example, China and India have become increasingly important forces in custom chemicals, particularly in some product groups such as intermediates. Their entry has contributed to exacerbating competitive intensity levels, thereby depressing profit margins in the industry.

Beginnings

The birth date of the outsourcing industry is difficult to pinpoint because outsourcing is viewed as a logical and gradual development. Rather than insisting on full backward integration, end users elect to consider other options for securing access to required inputs (e.g., materials and services), including relying on external vendors for items traditionally produced in-house.

Deciding factors. The drivers behind the decision to outsource are multiple, including:

• a focus on core competencies, often referred to as those operations and processes that allow a company to create value effectively and provide scope for a competitive edge. Manufacturing is rarely considered as one of these operations, contrary to product design, research and development, and marketing;

• the new metrics adopted by management following increasing scrutiny by investors and financial analysts pushing for a more effective use of capital. Options to avoid in-house investments in fixed assets such as production plants are increasingly embraced (e.g., outsourcing to a third party). Interestingly, this drive toward reducing the asset base has prompted some companies to divest part of, if not their entire, manufacturing network;

• the strategy of companies to avoid building up their own fixed cost base and instead electing to outsource some operations. Outsourcing is a convenient tool to shift costs to an external entity, thereby enhancing financial flexibility.

• the desire to tap the best available resources when and if required, thus avoiding building an in-house resource base that would be difficult to maintain fully loaded and alert;

• advances in information technology and communication systems combined with more-sophisticated management tools. These systems enhance the transparency of internal operations, including those pertaining to activity costs, thereby enabling companies to compare these with alternative options such as outsourcing;

• the emergence of viable alternatives to in-house operations. Several vendors focusing their activities around outsourcing services make these their core business (e.g., Lonza [Basel, Switzerland] in fine chemicals molecule building).

Several new entrants are seeking extensive outsourcing of most of their operations, thereby challenging the dominance of traditional fully vertically integrated contract service providers. This action has forced these companies to reassess their mode of operations, including sourcing. Examples include most emerging biotechnology companies that are focusing on discovery and development.

Genesis. It is difficult to pinpoint the origins of custom synthesis to a specific event. The first indications and reports on custom-synthesis activities date to the 1960s and 1970s. At that time, several end users, including some large pharmaceutical companies, saw the demand for their products surge, outstripping their own synthesis capacity. Parallel to this, the paradigm calling for backward integration among several end-user outlets for chemicals such as pharmaceuticals started to become increasingly challenged. This led several chemical users to rely on third-party vendors for not only "standard" catalogue items but also for exclusive products made under custom-synthesis supply contracts.

One of the first documented examples of custom synthesis appeared in the late 1970s and early 1980s with the supply of cimetidine intermediates to SmithKline & French (Philadelphia, PA). At that time, the sales volumes for cimetidine (the first anti-ulcer drug treatment with truly curative effects, thus reducing the need for surgery) exploded, outstripping the most wildly optimistic assumptions. Facing the prospect of losing sales volumes resulting from short product availability given chemical synthesis bottlenecks, Smith Kline & French contacted various fine chemicals vendors including Fine Organics (Seal Sands, UK), Heico Chemicals (Delaware Water Gap, PA), and Lonza, asking them to supply on an exclusive basis selected cimetidine precursors such as the imidazole or the cysteamine intermediate. The overall concept and business model applied was simple. The originator provides the process to the vendor and the vendor applies the process in its own facilities. The vendor took advantage of the infrastructure on hand, and the customer avoided investing in its own capacity while securing immediate access to capacity if and when required—a win-win scheme.

Market expansion. The custom synthesis arena has evolved and grown greatly. Landmarks in this development path include the following:

Leaders. The pioneering efforts of some companies such as Lonza helped to develop the concept of custom synthesis by positioning themselves as credible alternatives to in-house chemical operations ranging from development to full-scale production.

Start-ups. The role played by start-ups in various end-user segments such as pharmaceuticals is growing. For example, although the share of start-ups in total pharmaceutical sales is still modest—not exceeding a few percentage points of the global $500+ billion pharmaceutical turnover—an increasing number of new molecular entities are stemming from this set of players (see Figure 2). Because these companies have no own synthesis capacity, they have no choice but to rely on third-party suppliers for their chemical requirements, thereby providing a new impetus to custom- synthesis demand.

Figure 2: Share of new molecular entities (NMEs) by type of originator.

Changing economic climate. Globalization and increasing transparency of chemical markets have combined with mounting financial pressures faced by chemical companies and chemicals users. These companies are expected to compress their fixed cost base while also reducing outlays in capital expenditures (capex). The industry is gradually starting to pay more attention to concepts such as economic value-added or the ability to ultimately earn acceptable returns on capital invested. End users are electing to source their chemical requirements from third-party vendors rather than continuing to produce in-house. Examples include personal care companies such as Procter & Gamble (Cincinnati, OH) relying on sources such as China for some of their fatty amines requirements as well as DuPont (Wilmington, DE) outsourcing part of its intermediate requirements for various agrochemicals to the Jayhawk fine chemicals business of Degussa (Jayhawk, KS) or the now defunct Hickson & Welch (Castleford, UK). The rationale behind such outsourcing includes access to key technologies, capex reduction, cost structure optimization, and time-to-market imperatives.

Extension into biologicals. Compared with the scenario in the early days, the custom-synthesis industry has become increasingly segmented. For example, in addition to full-scale production of synthetic molecules (organic or inorganic), the industry now also covers biological products as well as related development services. Examples include:

• mycophenolic acid, an immunosuppresant used in organ grafts originally developed by Syntex (now Roche) and obtained through microbial fermentation. Mycophenolic acid traditionally has been produced on a custom basis by Antibioticos (Settimo Torinese, Italy), a company having a long tradition in fermentation;

• etanercept— the fusion protein making the active ingredient "Enbrel," one of the most innovative treatments for degenerative arthritis. Obtained by cell culture, it has been largely sourced through custom-production agreements between the originator Immunex (Seattle, WA) and Boehringer Ingelheim (Ingelheim, Germany). Amgen (Thousand Oaks, CA) and Wyeth have been marketing the product and have invested in their own capacity over the years. Similarly, UCB (Brussels, Belgium) has entered in a custom production agreement with Lonza for the product "Cimzia" stemming from the former Celltech R&D pipeline.

Although custom synthesis traditionally has been limited to the supply of full-scale volumes, there are increasing activities involving products and services associated with molecules still in early or late development (see sidebar "Outsourcing services for molecule development"). Another important factor in the overall evolution of custom synthesis is the emergence of vendors that provide a full range of outsourcing services, sometimes going beyond molecule building. Examples include vendors in India such as Matrix Laboratories (Hyderabad, India) and Suven Life Sciences (Hyderabad, India), which aim to become full-fledged pharmaceutical custom research and manufacturing (CRAM) partners by providing services in a wide spectrum of molecule-building activities—from microgram up to multiton scale—as well as dosage-form manufacturing. The business rationale is to offer a viable alternative to in-house operations, with the predicament always being the same: Keep in-house only the activities that genuinely contribute to creating value.

Outsourcing services for molecule development

Synthesis by far is not the sole activity outsourced by chemical companies and chemical users. Other activities include distribution and logistics, information technology, and human resource management.

Virtual models. During the past two to three decades, outsourcing in general and custom synthesis in particular has undergone rapid growth. Some industry analysts have envisioned a growing polarization between, at one extreme, virtual companies that outsource their entire chemicals operations and, at the other end, service providers that do not own products but rather supply chemicals to other clusters of companies. This scenario can be legitimately questioned.

Such a model predicated in the 1990s called for a radical departure from the full backward integration that was typical of most chemical companies or large end users such as pharmaceuticals. Rather, it postulated that chemical operations are best left to specialized vendors for whom chemical production is their core business, thereby enabling them to achieve better economics through a combination of experience and enhanced capital efficiency. Within this framework, the paradigm was that the cost of capital for this set of vendors would be lower than for the end users—investor expectations vested in developers and marketers were higher than those of traditional manufacturing companies. On the basis of these postulates, there have been predicaments from the financial community relayed to senior management that several chemical companies and chemical users would be better off entirely farming out their molecule-building activities and divesting or spinning off their chemical assets rather than relying on specialized third-party vendors.

In doing so, companies would embrace a "virtual" model that would delegate to selected vendors major parts of, if not the entire, chemical assets and operations. Barring a handful of exceptions (observed mainly in Japan associated with changes in the Pharmaceutical Affairs Law that provides for the decoupling of the marketing license from manufacturing permits, which has prompted the spin-off of the chemical production arm of various pharma companies such as Fujisawa or Yamanouchi), hardly any player has moved so far as to fully embrace the virtual model. Rather, most chemical companies and chemical users now have adopted the concept of strategic sourcing where all options to secure access to the required chemical input are systematically evaluated on a "which is the best" basis. Within this framework, neither in-house production nor outsourcing custom production are viewed as ends per se. The overall objective is to pursue the most attractive avenue possible to access the required input, be it at the development stage or at full scale. To this end, various considerations are taken into account when formulating the sourcing decision (see sidebar "Decision factors in outsourcing").

Decision factors in outsourcing

Supply structure

The supply structure for custom synthesis or, in general, custom chemicals is extremely broad and heterogeneous. In total, probably several thousand companies provide custom synthesis–related services. These companies include both small family-owned vendors such as Pressure Chemical (Pittsburgh, PA) or ChemShop (Weert, Netherlands) and divisions of diversified chemical groups such as Dow Pharmaceutical Services and Lonza's exclusive synthesis business. Depending on the supplier, custom chemicals can be either the sole business or part of a broader business portfolio.

An evolving industry. The emergence of companies specializing in supplying custom chemical-related inputs should be viewed within the broader context of the reshaping of the chemical industry (see Figure 3). This reshaping has been prompted by:

Figure 3: Four models of outsourcing providers, including chemical service providers.

• increasing shareholder activism;

• chronic inability of most chemical companies to recover their cost of capital over a full economic cycle;

• surging operating hurdles;

• emergence of new sets of competitors;

• evolving expectations from customers or stakeholders;

Focused business models. As a result, the chemical industry has undergone major changes and consolidation leading to the emergence of focused models.

For example, chemical utilities, often referred to as "commodity chemical companies," are focusing on large-volume products obtained directly out of basic feedstocks. Their value proposition revolves around low-cost positions, reflecting economies of scale and superior access to key feedstocks. Examples of such players include Methanex (Vancouver, Canada), SQM (Santiago, Chile), and Sabic (Riyadh, Saudi Arabia).

As another example, product and technology specialists are centering their activities around selected product trees and technology know-how such as fluorination, nitration, or oxo condensations. Their product range largely revolves around forward commodities and value-added intermediates. Levers for value creation are represented by distinctive technology capabilities and focus. Examples of such players include the polymer intermediates business of Lonza, the building blocks group of Degussa (Düsseldorf, Germany), and the diphenols activities of Rhodia (Paris, France).

In addition, application specialists are emphasizing formulated products sold on a performance basis. Key success factors among these players largely revolve around application know-how and technical services. Examples of such companies include life science groups and suppliers of coatings and functional food additives.

Chemical solution providers whose business is to offer to customers an alternative to in-house chemical production or formulation activities are another focused model. Rather than supplying molecules on a specification basis, they provide customized services to their customers. In doing so, they leverage superior operation management and production economics. Examples of companies in this area include in molecule builders ChemShop and Lonza's exclusive synthesis business, GE Water and Process Technologies (Trevose, PA), and PPG Industries (Pittsburgh, PA), which provide, respectively, turnkey chemical solutions in industrial water treatment and automotive coatings. Industrial gas companies such as Air Liquide (Paris, France), Linde (Wiesbaden, Germany), or BOC (London, UK) that operate gas production units on the behalf of customers also represent notable examples of solution providers.

Globalization. In addition to Western third-party vendors, an increasing number of companies located in China, India, and other emerging regions such as the Commonwealth of Independent States (CIS) are active in the broadly defined custom-chemicals space. Their entry corresponds to the increasing globalization of the chemical industry as well as the quest among customers for the most competitive source.

In this respect, it is worth noting that the CIS has emerged as one of the most important sources of custom-made chemical libraries and early-phase custom-synthesis services. This region has access to a large molecular diversity pool as well as to substantial synthesis talent. Examples of service providers finding their roots in the CIS include ChemBridge (San Diego, CA) and Chemical Diversity (San Diego, CA).

India is increasingly being considered for the supply of custom-made intermediates. A growing number of chemical companies are trying to build a base in custom chemicals, with their value proposition revolving around low labor costs, limited labor and environmental hurdles, and access to an ample chemically trained workforce. For example, Dishman Pharmaceuticals & Chemicals (Ahmedabad, India) supplies part of the eprosartan bulk requirements for Solvay.

China also is taking an increasing role as a manufacturing hub for the global chemical industry. While its focus has been traditionally on standard catalogue products, more Chinese companies are starting to offer custom-chemical production services. Wuxi Pharmaceuticals (Wuxi, China), for example, has made this its core activity. By and large, the main attractiveness of Chinese and Indian vendors revolves around lower perceived unit prices largely reflecting a combination of cheap labor costs and limited capex outlays compared with their Western counterparts (see Figure 4).

Figure 4: Labor costs in India and China are a fraction of those noted in the West.

The supplier slate in custom chemicals comprises both large competitors that have custom-chemicals sales in excess of $300 million such as DSM Pharmaceutical Products (Heerlen, Netherlands) or Lonza as well as smaller firms with a turnover of less than $10 million such as ChemCon (Freiburg, Germany). Most often, small competitors tend to focus on niches of selected products or technologies, while large companies offer a broader range of services and sometimes position themselves as full molecule-building service providers.

Customer base

The customer slate for custom synthesis ranges from major multinational companies such as Procter & Gamble and DuPont to start-up companies such as NiCox and Vertex Pharmaceuticals (Cambridge, MA). The custom-synthesis requirements of these companies range widely as well, including:

• back-up supply agreements in which a customer seeks to secure access to a second source to ensure continuous access to his chemical input requirements;

• the full outsourcing of chemical input requirements from selected third-party vendors. In this case, the customer has no option but to rely on external sources for its chemical needs. Examples include Wyeth and Gilead Sciences.

The type of product and input outsourced also spans a wide spectrum covering:

• the supply of early-phase lots or research quantities as an example of screening libraries;

• intermediates as well as the final molecule ready to undergo the formulation and physical processing step, without further molecule-building transformation.

High expectations. Depending on the type of inputs required, companies have various expectations of custom-synthesis vendors. Most often, low prices on delivered units are the overriding factor for noncritical items such as mature to aging end products where the emphasis is on cost minimization rather than differentiation. On the contrary, for products in the development phase, a vendor's timely availability, responsiveness, and flexibility are critical factors.

Similarly, the mode of interaction between customers and vendors varies widely. Three main models are emerging. First is the traditional "you-against-me" type of interaction in which the customer systematically requests bids for every product outsourced from a large number of vendors. The overall goal is to extract all possible price concessions by skillfully playing one vendor against the other.

Second is the partnership setup in which customers enter into preferential dealings with one or two main lead vendors (Tier 1), who act as extensions of their customers' own operations. In such a setup, a customer delegates entire parts of its chemical development and full-scale supply requirements to these vendors. This model implies that the retained vendors are granted the right of first refusal on all (or most) new chemical requirements of the customer. In turn, they are asked to provide preferential treatment to the customer as well as to pledge continuous cost reduction targets to be shared with the customer. It is interesting to note that although they are widely advertised in the industry, examples of genuine strategic partnership agreements between end users and vendors are relatively rare in custom synthesis. For example, the strategic partnership for synthesis announced in the late 1990s between SmithKline Beecham and Lonza is reported to have been short lived. Both parties eventually elected to revert to more traditional-type of agreements. The customer feared that a strategic partnership may dull the incentive for the vendor to remain competitive, and the vendor saw no benefits nor preferential treatment granted to it compared with other suppliers.

The third model is "à-la-carte" dealings in which a customer defines and selects a short list of vendors (e.g., 5–10) and prequalifies them in terms of their range of capabilities, compatibility with the customer's systems and procedures, and the ability to effectively interface with the customer's staff. The customer asks for offers from two or three vendors, selecting these on a "which is best" basis. The underlying customer philosophy in the à-la-carte type of dealings is to compress overall vendor selection lead times and to avoid becoming overly dependent on one given source. The industry seems to be increasingly active in this à-la-carte mode of interaction.

Contractual relationships

Custom synthesis often is a business in which the prices of the products and services provided are set on a cost-plus basis. The profit margins that are eventually achieved depend on the overall competitive position (including a customer's own in-house capabilities) and the ability of the vendor to efficiently manage its own cost base.

Maximizing returns. Typically the custom-synthesis customer has a good understanding of the costs involved to produce the inputs it requires. These insights reflect either its own experience or the price offers received from other vendors. This obviously limits the returns ultimately achievable by the service supplier. In fact, the custom-synthesis business is sometimes defined as a "controlled competitive utility," namely a cap on margins in a highly competitive environment. Nonetheless, levers are available to vendors to achieve above-average returns, including:

• proprietary technologies or intellectual property position, making them the obliged partner to the customer. Lonza with its "Glutamine Synthetase" cell-culture expression system in custom biopharmaceuticals is a notable example;

• short capacity availability, thereby restricting customer freedom in exerting price leverage;

Various pricing schemes also are present in the custom synthesis space, including:

• fixed-price contracts, which reflect both a vendor's own cost structure as well as its customer's ability and willingness to pay;

• cost plus, in which a vendor is granted a preagreed markup over and above its own costs;

• profit sharing, in which a vendor receives a fraction of the sales (or profit) associated with the end product it is dealing with (i.e., a profit–sales royalty-related scheme).

The terms of the agreement can vary from monthly agreements, to multiyear agreements (e.g., three to five years), or to "evergreen" agreements. Depending on the contract, the customer can provide for just indicative volume targets (e.g., 80–120% of a certain predefined, nonbinding target) or settle for firm take-or-pay provisions in which the vendor is guaranteed a certain revenue stream irrespective of the quantities of inputs actually supplied. Examples of such take-or-pay agreements include the reservation fees paid by pharmaceutical customers to secure access to biopharmaceutical production capacity following the aftermath of the Enbrel (etanercept) case in which supply had been inadequate to meet demand—a situation that reflected short availability of capacity.

Labor and capacity costs. Very often, a key pricing determinant in custom chemicals is the unit labor and capacity costs incurred by the vendor. Either implicitly or explicitly, these costs are used in a vendor's pricing offer provided to its customer. For example, in development work, a key driver of pricing is the so-called full-time-equivalent (FTE), which is defined as the price at which the vendor is offering a unit of time (e.g., one hour, one day, a week, or a year) for a staff member. Rates applied vary widely. In 2005, for example, the FTE observed for process-development work spanned from $50,000 p/y (person per year) to more than $250,000 p/y. These rates depended on:

• the location of the vendor. The lowest rates tended to be applied by vendors located in China or India, while North American–based companies were among the highest;

• reputation of the vendor and its track record;

• the range of services included. Some vendors excluded from the supply of raw materials and reagents from FTE quotations, while such costs were included in the offers of other suppliers;

• qualification of the personnel. Some vendors apply identical rates for all their staff, while others differentiate between the rates applied for staff holding PhDs and staff without academic degrees.

Similarly for pilot- and full-scale production, a key parameter is the equipment hours, namely, the cost per unit of time associated with operating a piece of equipment. Here too, the pricing offer of a vendor can be either fully transparent—by explicitly reporting the estimated hours of use for each piece of equipment multiplied by the associated unit costs—or rather "flat-inclusive," which provides no details.

Pricing. During the past few years, the trend among customers has been to increasingly request custom-chemicals vendors to provide detailed pricing offers in which all assumptions such as unit inputs and unit costs are clearly explicated. Through such transparency, these customers hope to improve their leverage and extract better conditions from their vendors. In turn, vendors try to leverage this transparency to their advantage by systematically pricing as "extra" whatever additional service is provided to the customer that is not explicitly included in the original offer.

Customer demands. In terms of contractual conditions, chemical-synthesis customers typically insist that vendors provide full confidentiality. Customers prefer to keep supply relations secret, mainly because of fears of intellectual property and data leakage. Customers tend to trust less the confidentially of external staff. Another reason is a customer's desire to keep the supply structure opaque to enhance its bargaining position vis-à-vis vendors.

Customers typically insist on complete control and ownership of all intellectual property that may be developed by the vendor as part of the custom-chemical supply relationship. In this respect, the customer usually demands being granted automatic licensing rights on all know-how and inventions that may be brought by the vendor. In addition, often a customer will request its vendors refrain from using this know-how for products or accounts that may be in direct or indirect competition.

Customers also may insist that vendors share all cost savings resulting from "learning-curve effects" or improvements brought by the vendor.

Finally, chemical synthesis customers will also require that the vendor diligently apply the processes specified in the custom-synthesis contract. Any change should be properly documented, reported, and approved by the customer before implementation. The adherence to such standard operating procedures is particularly critical for chemicals going to applications characterized by extensive regulatory hurdles (e.g., pharmaceutical fine chemicals).

Depending on the contractual agreement, raw materials can be supplied either by the customer to the vendor or sourced directly by the vendor following the specification set by the customer.

Other details. The duration of the contract also is extremely variable, ranging from a few months to multiyear agreements. Shorter contracts tend to be typical for relatively simple processes that can be easily transferred from one source to the other, (e.g., banal chemical transformations), particularly for nonpharmaceutical applications where regulatory hurdles are limited. For more complex processes or cases in which the production site must be inspected by regulatory authorities, longer contracts may be needed. The costs and lead times associated with the shifting of supply source typically deter a change of suppliers.

Depending on the product, associated volumes, and the customer, the number of custom-synthesis vendors retained for a given molecule may differ. Often small-volume products are outsourced from just one vendor. The security of supply is managed by maintaining adequate backup inventories calculated on the basis of the lead time for developing an alternative source. Multiple sources are established for large-volume products as well as molecules generating large sales. For example, a lead source providing for 70–80% of total volumes may be complemented by a back-up vendor, thus allowing optimal flexibility and supply reliability.

The custom-synthesis contract can cover either the end molecule or related intermediates with the customer performing the last synthesis step in-house. The latter setup is typical of several pharmaceutical companies that most often keep in-house these parts of the synthesis process described in the drug master file for both quality and tax optimization considerations.

As an example, a leading US pharmaceutical company contracts three vendors to supply the intermediate requirements associated with one of its top-selling molecules, the last couple of synthesis steps are performed in its Puerto Rico plant. Such a setup is believed to provide:

• optimal efficiency, extracting the best possible price concessions from the three vendors, systematically putting these in direct competition;

• outstanding capital efficiency; the investment in a customer's own synthesis capacity is limited to a bare minimum;

• superior tax efficiency; performing the last synthesis steps in Puerto Rico, for example, allows a company to capture substantial tax concessions.

Key success factors

Expectations vested by customers in their custom chemicals vendors vary depending on the position of the product in its life cycle and the complexity of the product in terms of the length of the synthesis, the type of technologies involved in the production process, and any technical hurdles. End-product application also is a major factor. It is a key determinant of purity requirements, the ultimate influence of the chemical input on the end-user price structure (and hence at least indirectly the scope for value pricing available to the custom chemicals vendor), the regulatory hurdles associated with changes in the production process or in the production site, and the ultimate tonnages achievable.

Selecting a vendor: important considerations for customers of custom chemicals

Custom-synthesis customers take several considerations into account when deciding to contract with a vendor (see sidebar "Selecting a vendor: important considerations for customers of custom chemicals "). Consequently, these expectations translate into key success factors that custom chemicals vendors have to meet to effectively compete (see sidebar, "Key success factors for vendors of custom chemicals ").

Key success factors for vendors of custom chemicals

The role of size as a key success factor in custom chemicals is a highly controversial topic. At least until recently, some industry analysts have been considering size as important, and several companies have openly stated that sales of at least $500 million would be needed to continue to effectively compete. Such views were based on the assumption that through a larger size, a vendor would be able to increase its standing vis-à-vis customers reducing scale, thereby allowing a vendor to exert leverage. Similarly, size has been associated with the ability to afford a larger range of resources as well as to better diversify the product portfolio, thereby ensuring more resilience against business vagaries. Another school of thought views size more as a facilitator or an obstacle, in parallel with increasing organizational complexity and as a corollary loss of flexibility, lower responsiveness, and higher fixed costs.

Only time will validate one of these two opposite theses. Empirical evidence suggests that an optimum probably exists in terms of size in custom synthesis. At least in Western countries, this optimum is in the range of $100–200 million. Below such turnover, vendors are typically hard pressed to effectively cover their fixed costs and to assemble a well-diversified product portfolio. If over the threshold of $200 million or so, efficiency and responsiveness tend to decrease, thus often nullifying possible benefits resulting from a larger scale. Similarly, there is no evidence that larger sales necessarily go in parallel with a better product-portfolio diversification.

Industry size and growth

No reliable data exist on the size of the custom-chemicals space. Estimates range widely from less than $10 billion to more than $50 billion. This wide range reflects the extreme fragmentation and ill-defined boundaries of custom chemicals. Even at the individual segment level—defined as covering selected types of products or customers such as custom-made microbial-derived biopharmaceuticals or custom-made libraries of screening compounds for the pharmaceutical industry—it is difficult to precisely estimate the size of the demand. This situation stems from the dynamics intrinsic to the custom synthesis business in which:

• Transparency is limited. The type of product outsourced as well as the source retained are typically kept confidential.

• Only a fraction of the customer's product requirements are often outsourced to third-party vendors.

• Unit prices paid to the vendor for volumes outsourced are rarely publicly available.

As a result, market estimates most often are based on several assumptions, some extremely difficult to validate, including:

• the value of the chemical as a percent of the end-product sales price. As an example, a frequently applied rule of thumb is to put the value of the drug substance and of the agrochemical active at 6–8% and 20–25% of the end-product price, respectively. The robustness of such estimates are all but established, however.

• the share of outsourcing as a percentage of total requirements. Here too, only rough estimates are available at least at the consolidated level.

It is therefore no surprise that given the number of hypotheses and assumptions, only rough estimates can be provided. As an example, the total custom biopharmaceutical market in 2004 is tentatively estimated between $1.0 billion and $1.7 billion (estimates by Arthur D. Little, Brussels, Belgium). This broad range reflects at least partly different definitions. The lower estimate excludes products supplied under licensing agreements.

Similarly, the size of demand for custom-chemicals in some applications may be difficult to estimate because some supply agreements call for the customer to provide the raw materials. This situation is in sharp contrast with constructs applied by other companies that rely on the vendor to source the required inputs on its own, clearly providing a major source of distortion.

Growth in custom chemicals is equally difficult to precisely assess precisely. Overall growth of custom chemicals is projected to outpace the corresponding chemical demand across most segments. This situation reflects the trend toward increasing outsourcing of chemical operations, as noted among several end-user groups. These operations include not only agrochemical and pharmaceutical companies but also firms that focus on performance applications such detergent formulations. Often these companies elect to produce in-house all their chemicals requirements rather than rely on third-party vendors, although some custom chemicals may be outsourced. The drivers behind this trend include:

• end users are focusing on key competencies and activities to truly create value;

• customers' attempts to reduce their own capacity and to inflate the fixed-cost base;

• the emergence of a reliable set of suppliers.

These factors are expected to favor a steady growth of outsourcing. It is important, however, to recognize that an upper boundary is unlikely to be exceeded in terms of share of outsourcing because it is not credible to expect that all users will ever entirely embrace a virtual model of chemical operations in which they would entirely rely on third-party vendors.

Moreover, although the growth outlook for custom chemicals is positive in terms of volume, unit prices tend to be increasingly under pressure. This reflects leverage applied by customers to their vendors, intense competition between vendors (the custom chemicals space being characterized by an overcapacity situation), and inroads of new sets of vendors, including Chinese and Indian companies. These companies from China and India may offer their services at highly competitive rates, reflecting both lower labor costs as well as less-sophisticated pricing policies (sometimes failing to take into account the cost of capital).

As a result, it is common for unit prices associated with the supply of a given custom chemical to decline a few percentage points every year. This unit-price erosion is at least partly offsetting volume growth, thereby resulting in growth that is flat or below growth in gross domestic product for at least some segments of the custom-chemicals space.

Additional resources

Concluding remarks

Custom synthesis has more to do with a service industry than the supply of products. Probably, it is the German language and terminology designating custom synthesis as "Lohn Synthese," namely "synthesis-at-a-fee," which best captures the essence of the business: the vendor is compensated for its molecule-building activities performed at the request of a customer having retained its services.

The custom-synthesis business is characterized by highly distinctive dynamics compared with the supply of standard chemicals. These distinctive traits include:

• a substantial interdependence between the vendor and the customer, with the vendor being entirely dependent on the customer for each specific product. This dependence link is typically less for the customer.

• an extreme fragmentation reflecting the multitude of products, customers, and range of contractual relations existing between the customer and the vendor. This fragmentation provides rich opportunities for small players to successfully compete in the custom chemical space as the scope and need for economies of scale is all but certain.

• typical service dynamics, with the vendor retained to provide its services on the basis of its capabilities such as research and development muscle and reactor volumes in view of eventually supplying a chemical-related output that is custom made at the request of a given customer.

In terms of attractiveness levels—namely, the combination of growth and profit potential—that characterize the custom synthesis space, much has been written, and it remains a highly controversial topic.

According to some observers, custom chemicals are a highly attractive space, given the predictions of continuous growth fueled by expanding outsourcing of molecule-building activities by end users such as specialty chemicals companies that focus on areas of core competence and strive to reduce capex outlays rather than relying on third-party vendors. Furthermore, industry analysts expect improving profitability for custom chemicals vendors. This trend is driven by an accelerating supply structure consolidation as small players are squeezed out of the market and customers increasingly rely on their custom vendors for critical inputs. This in turn provides scope for value pricing and results in lower rivalry between vendors, which combined with lesser customer bargaining power, should ultimately translate into expanded profit margins.

These views are strongly challenged by other analysts who point out the limited scope for economies of scale among vendors, which fails to support the thesis calling for an overdue supply structure consolidation. Another element appearing to plead against this consolidation is the growing inroads of Chinese and Indian suppliers, thereby suggesting that at least in some segments entry barriers are limited. Analysts also point out the intrinsic disequilibrium in the customer–vendor balance of power. The extreme dependence of the vendor on its customer cannot be overemphasized. The vendor has at its disposal very few levers to control its own fate, at least for each individual product. This dependence can be illustrated by the setbacks suffered in the early 1990s by Hickson, which produced on a custom basis a detergent component for Unilever (Rotterdam, Netherlands). This product was eventually withdrawn from the market, leading to far reaching implications for Hickson, which saw its capacity utilization and revenue stream dramatically fall. The successor of Hickson, C6 Solutions, eventually went out of business following the termination of a custom supply agreement for an agrochemical intermediate for DuPont.

Most likely, reality lies somewhere between these extreme views. Custom synthesis, like most other businesses, can be attractive, subject to clearly understanding its dynamics and managing these activities accordingly. Most important, it is critical for vendors already active in this field or planning to enter it to vest realistic expectations on the ultimate profit and growth potential achievable. Within this frame, it will be important for these vendors to strive for a diversified product and customer portfolio to avoid possible risks associated with overdependence.

Enrico T. Polastro, PhD, is the vice-president and a senior industry specialist at Arthur D. Little Benelux S.A./N.V. Avenue de Tervurenlaan 270, B-1150 Brussels, Belgium, tel. +32 2 761 7219, polastro.enrico@adlittle.com