Investors are betting on the current growth of CDMOs; but history reminds us that extrapolating today’s market well into the future is dangerous.
Mergers and acquisitions (M&A) are a central feature of the contract development and manufacturing (CDMO) industry today. Several new deals are being announced every month, some of them quite substantial, and these deals are reshaping the industry.
CDMOs are in great demand by both strategic buyers (i.e., companies in the CDMO business or a related business) and financial buyers (i.e., private equity firms). Valuations of companies acquired in M&A deals are reaching high levels as buyers compete to win the prize. While private equity investors typically use a “rule of thumb” to value businesses at 10 times earnings before interest, taxes, depreciation, and amortization (EBITDA), some deals have gone as high as 20x EBITDA. One small CDMO that recently went through a process reported that they had received nearly 10 offers from potential investors.
The interest in CDMOs as acquisition targets is driven in large part by the demand for contract development and manufacturing services from emerging bio/pharmaceutical companies. Those companies generally lack internal development capabilities and are highly dependent on CDMOs and contract research organizations (CROs). Emerging bio/pharma companies themselves have attracted large amounts of investor capital as they have become a major source of new product candidates for global bio/pharma companies. Thanks to growing demand from emerging bio/pharma companies, CDMOs have enjoyed high double-digit growth rates in recent years, and investors in CDMOs are betting that those rates of growth will continue into the next five years at least.
Therein lies the rub: today’s high valuations are based on current market conditions, but history tells us that extrapolating today’s market well into the future is dangerous. External financing for emerging bio/pharma companies is notoriously cyclical: a boom in the late 1990s collapsed along with the bursting of the dotcom bubble in 2000. After several poor years, the market rekindled again in 2004 but collapsed with the global financial crisis in 2008. Public financial markets did not really open again for emerging bio/pharma companies until 2012-2013, and the industry is now four years into the current financing rebound. While an imminent collapse in bio/pharma funding is not predicted, history suggests that caution is warranted. The challenge for the industry is illustrated in Figure 1.
R&D spending by publicly-traded emerging bio/pharma companies has risen rapidly since the beginning of 2015, although it has been flat in the first few quarters (blue columns). However, most of those companies have cash on hand equivalent to just over four quarters’ of R&D spending (red line). If external financing becomes more difficult to raise, as it did in 2016, companies will slow their rate of spending in order to conserve their cash until they can raise more. With just four quarters’ of cash on hand, spending could slow quickly if conditions worsen.
The implications of making acquisitions in an overheated market will differ depending on the motivations of the buyer, and the way the buyer finances the deal. Strategic buyers have a long-term perspective, and measure success in terms of market share, revenue growth, and enterprise value. The motivations of financial buyers, however, are often more complicated. They typically make acquisitions with defined investment horizons of about five years, and their focus is on how to optimize their cash return on investment over that period. While concerned with enterprise value at the end of the holding period, private equity investors may also seek a faster return by using the company’s cash flow and debt capacity to finance dividends. Their take on what makes an acquisition attractive is often different from that of the strategic buyer.
The conflict between near-term cash returns and long-term investments can be particularly severe in the case of pharmaceutical manufacturing and development. A substantial capacity investment can take two-to-three years to design, construct, and validate, and ramping up utilization of that capacity increment will take several more years after that. For a financial investor with a five-year horizon, an investment that is cash-negative for most of that period may not be attractive, even if it enhances the long-term value of the business.
This is not to suggest that private equity firms are not welcome buyers of CDMOs. Often the businesses private equity buyers invest in are short on the capital, know-how, financial discipline, and executive skills necessary to take their businesses to the next level. The best private equity firms are very good at providing the resources to enable business growth and maturation. In an environment of frothy valuations, however, investors in debt-financed acquisitions may be challenged to feed businesses all the resources they need to grow.
But using a lot of debt to buy a business at the top of a cycle can be dangerous. As revenues flatten out or fall on the downside of the cycle, debt-laden businesses will struggle to make the necessary investments as well as service their debt. A number of CDMOs experienced financial challenges in the wake of the downturn in the late 2000s and were forced to restructure or close down altogether. Bio/pharma companies should do careful financial due diligence when qualifying CDMOs, especially for commercial requirements.
Another concern is the impact that M&A activity has on customer perceptions, especially global bio/pharma companies. On the one hand, M&A creates companies with broader capabilities and scope, which enables bio/pharma companies of all sizes to simplify their supply chains.
However, the M&A activity also creates uncertainty around the supply chain. Given the current rate of activity, there is no assurance that the CDMO a biopharma company contracts with today will be the same company that is fulfilling its order two years from now. The business model, objectives, culture, and operating skills of a new owner may be different from the owner the CDMO originally contracted with.
Global bio/pharma companies may be particularly concerned about changes in ownership. Already reluctant to outsource and keenly attuned to supply chain security issues, too much churn in the supply base can make those companies wary about working with CDMOs.
Overall M&A is a positive for the CDMO industry. The current activity attests to the industry’s robustness and long-term prospects, and rewards the entrepreneurs who have built admirable businesses. But buyers and sellers need to be wary of the downsides of the overheated market.