20 October 2003 00:00 [Source: ICB]
Fine chemicals in general, and more particularly pharmaceutical custom manufacturing, were once viewed as the most attractive segment of the chemical industry. But not anymore.
Over the past 12 months a string of bad news and flood of red ink has hit the fine chemicals sector. Some industry observers have facetiously, albeit rather appropriately, indicated 'the fine mess' that has developed. The bad news is reflected in the disappointing results reported by several players, including DSM and Lonza which have engaged in major cost cutting initiatives. Some new entrants, such as Clariant, have been rumoured to be considering divesting their fine chemicals activities.
The downturn appears to have been particularly severe in the pharmaceutical custom synthesis segment, witness:
- Collapsing Ebitda levels having reduced free cash flows to a trickle;
- Growth remaining sluggish;
- Unit prices becoming increasingly under pressure reflecting both the leverage exerted by customers and rivalry among competitors. Many vendors have engaged in price discounting to keep their capacity loaded.
This downturn is far from over. In fact, the predictions of a recovery formulated at the beginning of 2003 are far from materialising. Many fine chemicals companies openly recognise that even matching 2002 results may well be a major challenge. Hopes of a recovery are now postponed to 2005, reflecting the uncertainties facing the business and its largest end user outlet - the pharma industry. As a result, several companies are preparing themselves for a tougher competitive environment and are engaging in cost pruning and staff lay-offs.
In fact no segment of the fine chemicals industry appears to be immune from this downturn. Even the much touted custom biopharmaceutical manufacturing sector has been hit by delays and project cancellations.
It appears that the industry has lost its allure. Far from representing the predicted safe harbour, fine chemicals now appears to be no different to a commodity business with sluggish, cyclical growth rates, limited differentiation, price competition and fluctuating returns.
How was the lustre lost?
Most probably, the supply side is the main culprit and root cause behind the current blues in fine chemicals. It has disrupted traditional equilibria and accelerated the sector's move towards commodity status.
Until recently, fine chemicals in general and custom synthesis in particular, have been largely immune from the boom-and-bust cycles so typical of most commodity-based industries. Built-in performance stabilisers, such as broad product portfolios and diversified customer slates, limited dependence on any given product or account. Moreover, until recently, the strategies of fine chemicals suppliers differed from each other. Most players focused on select areas that corresponded to distinct niches or at least to different oligopolies, which left few players in direct head-to-head competition.
This situation was clearly in sharp contrast to commodity chemicals, where fortunes typically depend on a single product sold to a few end-use outlets. Also, a feature of commodity business is the tendency of all players to invest in a synchronised way, contributing to boom-and-bust roller-coaster performance patterns.
A number of developments have contributed to the disruption of the built-in stabilisers and diversity so typical of the fine chemicals space. Substantial capacity both in terms of reactor volumes and development muscle has been brought onstream over the past few years, with several players adding capacity at the same time. Such a situation is in sharp contrast to what had typically been observed in the past, when the timing of investment decisions tended to differ between the various individual players, with hardly any synchronisation. This has rapidly resulted in a self-amplifying emergence of overcapacity with all players facing the challenge of loading their newly installed capacities.
Several vendors, including both new entrants and established players, have elected to focus on the custom synthesis segment, particularly targeting pharmaceuticals. However, this increased focus on the pharmaceutical custom synthesis segment has altered the traditional balance of power between vendors and customers as more suppliers dilute the selling power of vendors, particularly as a number of Chinese and Indian suppliers have joined the fray.
The strategies of most players have converged in both targets pursued and market approaches taken. Invariably, every move by a main player is soon imitated by the competition. As a result, the 'unique selling propositions' of vendors became increasingly similar, if not identical.
Most vendors have overestimated the degree of control they could have on the business by failing to realise that their technologies provide only limited scope for competitive edge - the customer being clearly in the driving seat. These elements have combined to drive competitive intensity and, when coupled with soft demand, have created the current woes of the industry.
Could this have been avoided?
With the benefit of hindsight, it is safe to say the intrinsic dynamics of the fine chemicals business were misinterpreted as several assumptions and beliefs were eventually challenged by facts. The sector's perceived intrinsic attractiveness was based on assumptions such as expectations of continuing double-digit growth in demand, fuelled by projections of greater outsourcing by pharma companies, coupled with projections of unabated pharmaceutical demand and of an untarnished flow of new molecular entities (NMEs) reaching the market, and predictions of growing opportunities to premium price fine chemicals offerings.
However, the current reality is a far cry from these original predictions and assumptions. The 'even-keel' scenario predicted for the pharmaceutical industry appears to be now superceded by a 'cataclysm' vision. In such an environment, both established pharmaceutical companies or emerging pharma start-ups worry for their future and their ultimate ability to meet growth and profitability targets.
Following the burst of the dot.com bubble, financial investors have become increasingly cautious as their appetite for risk is superceded by a quest for safe havens and capital preservation. This has meant a de-facto shut-off of financial markets for most pharma start-ups, which are viewed as too risky given long lead development times. At the same time, established pharma, which until recently had provided another major source of financing for start-ups through licensing deals or direct investments, also turned cautious. This has forced most emerging pharma companies to reduce their cash burn rates by pruning their development programmes and focusing only on the most promising drug candidates.
Established pharma is faced with the prospect of sagging sales and cut-throat competition as the flow of NMEs reaching the market appears to be woefully inadequate to support growth, unleashing fears that many players would soon be left dramatically exposed to generic competition.
The woes of the pharmaceutical industry are obviously hurting its vendors, including fine chemicals suppliers which are confronted with a wave of cancelled, postponed or downscaled contracts. As typical in most other industrial sectors, players active in the upstream end of the activity chain are the first hit in case of a downturn. Fine chemicals are no exception as customers reduce the amount of work outsourced to keep their own capacity loaded while also applying leverage on vendors.
What future for fine chemicals?
The current mood in fine chemicals is undoubtedly downbeat. Does this mean that the party is over and that the fine chemicals sector has irremediably reached commodity status and will have to wait for the next upturn of the economy?
The solution to the current industry woes and the root causes behind the downturn will be found on the inside. As companies increasingly realise the new competitive environment, actions, such as streamlining the cost structure, which includes reducing headcount and retiring capacity, are being taken. Our industry surveys suggest that installed reactor volumes may have peaked in 2002 while staff productivity is increasing.
For the first time in the recent past, companies collectively reduced their investment outlays in 2002 - a trend expected to continue. The emphasis of investments is also shifting towards capacity and infrastructure upgrades as opposed to expansions. Players are also increasingly evaluating opportunities to broaden their activities to other fine chemicals segments such as generics or selected niches, perceived to offer better return opportunities.
However, will this be sufficient to restore the health of the industry by acting mainly on the supply side? The answer is probably not. The trend towards maturity and increased commodity status of fine chemicals is probably difficult if not impossible to revert. However, mature and commoditised industries are not necessarily synonyms for misery and low returns. Success, rather than coming from esoteric receipts or business models, will stem from understanding and mastering the key success factors better than the competition. These critical success factors are:
- Gain a deep understanding of the customer's true requirements;
- Creatively segment the market by identifying the segments that offer the best trade-off between value creation potential and fit with one's own capabilities;
- Develop realistic profit and growth expectations and calibrate investments accordingly;
- Secure a firm grip on the profitability drivers of the business;
- Proactively manage the business portfolio by ensuring the most appropriate trade-off between impact and diversity;
- Realistically assess bargaining position vis-à-vis customers as well as the degree of control effectively available on the business;
- Realise that size or investments in forefront technologies do not automatically provide success;
- Continue to nurture customer relations by ensuring however that the 'right' type of customer or customer contact is effectively cultivated;
- Relentlessly ensure that optimal value is delivered to the customer by recognising that what is optimal often differs;
- Last, but not least, it will be essential to learn from the past and to refrain from quickly jumping on the bandwagon without necessarily knowing where it is heading.
Enrico Polastro is vice president ofArthur D Little. E-mail: email@example.com.,Sonia Tulcinsky is senior consultant of Arthur D Little, Brussels, Belgium
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