Looking at the Next Phase in Pharmaceutical Outsourcing

14 April 2003 00:00  [Source: ICB Americas]

The pharmaceutical industry has traditionally been the largest and most profitable market for custom manufacturers. Although it remains the largest customer base for custom suppliers today, profit margins are being squeezed as the market softens. Pharmaceutical companies still rely on outsourced manufacturing and look for qualified, reliable suppliers, but internal financial pressures are reshaping the nature of the outsourcing relationship.  

The market for all of custom manufacturing in 2002 was valued at $8 billion, and it grew between 3 to 4 percent in 2002 over 2001, according to Enrico Polastro, vice president and industry analyst in the Brussels office of Arthur D. Little (ADL). The pharmaceutical market accounted for $6 billion of the total, with agricultural chemicals coming in a very distant second at $1 billion, followed by various other small markets. 

Within pharmaceuticals, the market for early-stage development manufacturing is valued at roughly $500 million, says Dr. Polastro. Custom synthesis of advanced intermediates is estimated at $3 billion, and active pharmaceutical ingredients (APIs)-excluding generics and multi-source pharmaceuticals-account for the remaining $2.5 billion.  

The slowing growth rate for custom synthesis is due to delays in some product launches, less volume than expected for certain drugs, and a less robust pipeline of late-stage drug candidates, explains Dr. Polastro. Moreover, the pharmaceutical industry has undergone a decade-long period of consolidation. The top ten companies now have a combined market share of close to 45 percent, a 50 percent increase over 1990.

The difficulties in realizing organizational synergies in mergers, particularly aligning and prioritizing new product portfolios by the newly merged companies, has also contributed to declining productivity in the pharma industry, says Peter Pollak, a Switzerland-based fine chemicals consultant.

Pharma companies have placed an increasing focus on new, blockbuster drugs, which only represent 2 percent of the total number of drugs on the market, he adds. The increase in resources required to develop drugs for "unprecedented" or new therapeutic categories is another cause of the reduced pipeline. 

In addition, with Indian and Chinese suppliers participating more actively, there is continued pressure to drive prices down, and custom manufacturers have had to make price concessions, says Dr. Polastro. "Traditionally the return on assets for custom pharmaceutical fine chemicals manufacturers was about 15 percent. Companies are now often struggling to reach 10 percent," he says. "Investments required just for maintenance and keeping the assets at par with the evolving technical standards, regulations and customer expectations are 7 to 8 percent of sales, and therefore, free cash flow is limited, if at all positive."  To retain margins, businesses need to squeeze out more dollars per unit of investment and increase their returns by making better use of capacity. Some custom manufacturers are exploring other markets outside of pharmaceuticals in order to maximize use of their facilities.

"We are seeing more vividly that truly strategic outsourcing never really took hold in the industry," says Martin H. (Jay) Joyce, president of the Pharmaceutical Outsourcing Manage-ment Association (POMA), a trade association of drug companies and contract vendors involved in pharmaceutical outsourcing, and  senior purchasing manager, health care global R&D purchases with Procter & Gamble Pharma-ceuticals. The drop-off in outsourced business reflects the failure of certain new drugs to make it through the pipeline, coupled with the decision of some companies to bring outsourced business back in house. "This situation is indicative of a tactical approach to the business. It seems that among top pharma, outsourcing is still a means of gaining additional capacity, or freeing up internal capacity as opposed to a shift to have all (or most) API or drug product manufactured externally."

Jim Miller, president, PharmSource, a provider of strategic information on the pharmaceutical outsourcing industry, adds that despite the growth and maturation of the contract manufacturing industry, big pharma still prefers to tie up capital in manufacturing facilities, rather than take advantage of the capital investment and technology base built up in the manufacturing sector. "Because pharmaceutical companies still earn 80 percent gross margins on product sales, they remain more concerned with controlling supply, rather than making best use of their assets. Big pharma outsourcing now tends to follow a procurement model that puts a lot of emphasis on unit price, but does not necessarily look at cost across an entire supply chain."

Selection Process

While some pharmaceutical companies may have decided to keep projects in-house, for those that outsource, cost, reliability of supply and the quality of the vendor remain deciding factors in the vendor selection process. Roche Pharma follows a standard procedure to evaluate providers of manufacturing services that includes review of products already manufactured, technical capabilities and capacities, explains Albert Kuonen, head of global strategy and supply chain for Roche Pharma. If the provider's cost proposal is in line with Roche's requirements, an audit, which includes evaluation of GMP status and general manufacturing infrastructure/processes, is performed. AstraZeneca uses a supplier evaluation process that includes technical, quality assurance, commercial and risk assessment, says Gunnar Lager, director of outsourcing and procurement for bulk drugs at AstraZeneca.

The Pharmaceutical Research Institute (PRI) at Bristol-Myers Squibb (BMS) evaluates contract services for its research and development needs, covering production of quantities for clinical testing. Once a synthetic route is determined, which can happen when a drug candidate is in Phase I through Phase III, the technical operations development group evaluates custom manufacturers for commercial-scale synthesis projects.

"The decision to select a custom manufacturer is made in a formalized outsourcing project proposal that is approved by the project sponsor," says AstraZeneca's Mr. Lager. "Key elements of the proposal include technical capabilities, speed, commercial terms, good track record from previous outsourcing projects and the supplier's willingness to work with continuous improvements."

Roche Pharma's list of selection criteria includes cost of goods, implementation timelines and earlier experiences with the supplier. It then develops a short list of candidates from which the ultimate manufacturer is chosen, says Mr. Kuonen.

"Key attributes in a custom manufacturer from a pharmaceutical company perspective include trust, adherence to GMP guidelines, technical expertise, partnership skills, reliability and open communication," Mr. Kuonen notes. AstraZeneca's Mr. Lager adds that along with a true dialogue, a mutual understanding of the needs of both customer and supplier are important for success.

Differentiation Is Key

As custom manufacturers wait out the downturn in drug output, industry observers point to the ongoing need to provide differentiated capabilities, particularly in process development. "To a certain extent, manufacturers have little choice but to wait out this down period and hope that more opportunities will be forthcoming in the near future," notes PharmaSource's Mr. Miller. "If there aren't enough new products in the pipeline, there won't be enough demand for contractor services." He adds that contract manufacturers with truly proprietary, performance-enhancing capabilities can do better than others with more generic capabilities.

A large toolbox of chemistries and technologies is already almost ubiquitous in the industry, says Dr. Pollak. "In sharp contrast, process development offers a valuable opportunity for differentiation among fine chemical companies. It both covers a key need of the customers and in many instances there still is large room for improvement," he notes. "In order to create a distinct competitive advantage, process development must not be geared at gaining a few percentage points of yield here and there, or improving on the recovery rate of solvents. The prime targets must rather be to cut significantly the number of steps required to make a given API, to switch to more readily available raw materials, and to have a close look at the work-up process," he says.

Mr. Miller also believes that contract manufacturers need to relearn how to do business development and customer service. "These skill sets were allowed to atrophy in the boom times of the late 1990s. In addition, contractors should examine their value propositions more critically as they have a tendency to overrate how much value they are really adding to their clients' enterprises."

In order to retain margins successfully, custom manufacturers will need to differentiate themselves by offering total quality, responsiveness to customer requirements-both stated and unstated-and understanding and acting upon the importance of the people side of the relationship between the two firms, POMA's Mr. Joyce adds.

On the emergence of lower-cost providers in Asia (primarily India and China), Mr. Joyce notes that there are important issues to be addressed in this region with regard to good manufacturing practices (cGMP) and intellectual property (IP) compliance. However, he is confident that resolving these issues is a matter of how soon, not if. "Well-established Western Hemisphere firms that can develop sound partnerships with firms based in these areas will offer pharma companies an easy way into this market that benefits all parties. Those that either ignore such growth or view it as purely competitive (rather than potentially collaborative), will suffer in the long run," he says.

Recovery Expected In Two to Three Years

ADL's Dr. Polastro says the market will see a recovery in the longer term (two to three years) in response to the pharmaceutical industry's restructuring of its asset base. However, the size and extent of the recovery remain a big question mark.

In the view of PharmSource's Mr. Miller, the most interesting scenario would find the increasingly difficult pharmaceutical industry environment lead major pharmaceutical companies to reconsider their entire business model. "In other words, faced with downward pressure on prices, generic substitution and weak pipelines, senior pharma executives decide that they can no longer afford to be so vertically integrated, and that they need to utilize more of their assets for in-licensing and alliances for new products," he explains. The major pharmaceutical companies can release billions of dollars currently tied up in inventories and manufacturing plants and put that cash to work in revenue-generating ventures, Mr. Miller adds. "The volume of outsourcing that would result from such a sea change in the business model would create unprecedented opportunities for the contract manufacturing industry."

Despite the dominance that pharmaceutical companies wield in the outsourcing relationship, some observers caution that exercising too much purchasing power may not prove beneficial in the long term. "With custom manufacturing, to ensure a strong position, pharma companies need to have full confidence between the customer and the supplier," says ADL's Dr. Polastro. "By squeezing the custom manufacturers so hard for cost savings, they are putting that relationship in jeopardy. Without a full dialogue between the customer and supplier, the pharma firms will potentially have problems in the future."

POMA's Mr. Joyce says there is significant opportunity for custom manufacturers to provide an improved level of effective and comprehensive project management. This approach includes understanding all facets of the work required by the pharmaceutical company and managing not only the technical scope of the project, but also the budget and other issues, such as quality and regulatory strategy. "Those that succeed at doing this well will earn repeat business and be able to charge a fair price at a reasonable margin," he says. "This doesn't mean lowest price. Within reason, customers are willing to pay for never having to worry about rework, having a provider who anticipates their requirements and who is easy to work with. These latter two qualities particularly don't cost much to cultivate in terms of out-of-pocket dollars and can reap ongoing business at a higher price," Mr. Joyce explains.

However, broadening the relationship by, for example, offering early-stage development services, may not prove fruitful for the custom manufacturer in securing the coveted bulk manufacturing contract. "There are no guarantees that if a custom manufacturer provides early stage development services that pharma customers will stay with that supplier for commercial production of the API," says Dr. Polastro. Pharmaceutical companies will continue to shop for the lowest cost suppliers and will increasingly rely on in-sourcing to maximize their own capacities, he explains.

True "risk-sharing" is only beginning to be discussed, and it represents an opportunity for the future, according to Mr. Joyce. Historically, the approach by providers to their customers in the development stage has been to expect to have costs and some reasonable profit covered, even when a new drug has not been commercialized. "True risk-sharing means 'If you win, I win commensurately; if you lose, I also lose.'," says Mr. Joyce, who adds that a new paradigm of risk-sharing that works both ways may help cultivate strategic outsourcing relationships.

The biopharmaceutical capacity crunch may cause change and be one area in which that model of risk-sharing could be developed. "It provides a chance for real strategic outsourcing to grow through mutual dependence," says Mr. Joyce. The "one-stop shop" paradigm continues to be discussed. "One of these days someone is going to figure out how to offer pharma companies a value-added, cross-functional service at no added cost, and they'll have a competitive advantage in the market," Mr. Joyce says. "The value to the customer is not likely to be out-of-pocket cost savings, but rather the ability to leverage resources and gain speed and efficiency in the process."

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