Uncertainty Looms in Custom Manufacturing

19 January 2004 00:00  [Source: ICB Americas]

As custom manufacturers and fine chemical producers gather this week for Informex, the annual trade show for batch manufacturing sponsored by the Synthetic Organic Chemical Manufacturers Association, the question on everyone's mind is whether a recovery is in the offing. The much chronicled problems of lower-than-expected drug output, overcapacity, increased pricing competition and the growing presence of offshore producers made 2003 one of the most difficult and challenging years for the custom synthesis sector.

"There is plenty of uncertainty," says Enrico Polastro, vice president and industry analyst in the Brussels office of Arthur D. Little (ADL). "Some say the worst is yet to come, while others say it cannot get any worse. In either case, it is fair to say that the market for custom synthesis is flat to declining."

The market for all of custom manufacturing is estimated at $8 billion, according to ADL. The pharmaceutical market represents $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, according to ADL. The market for custom synthesis of advanced intermediates is estimated at $3 billion, and active pharmaceutical ingredients (APIs)-excluding generics and multi-source pharmaceuticals-account for the re-maining $2.5 billion.

Always a "lumpy" business, custom manufacturing has faced recent problems with product delays, a slowdown in new drug approvals and more in-house manufacturing by pharmaceutical companies. "A single product can have a major impact on the entire custom synthesis space," says Dr. Polas-tro. "Witness the example of Crestor." Crestor (rosuvastatin), a new anti-cholesterol drug for AstraZeneca with potential blockbuster status, was ap-proved by the Food and Drug Administration last August. Astra-Zeneca had originally hoped for ap-proval in 2002, but regulatory review of the product was delayed in the wake of safety concerns over the statin class following the withdrawal of Bayer's Baycol (cerivastatin) in 2001. ADL estimates that Crestor could account for roughly $200 million in custom synthesis projects. "This is roughly equivalent to one year of projected growth in total custom synthesis de-mand if we estimate total custom synthesis demand at between $4 billion and $5 billion," says Dr. Polastro.

Worse still, custom players are also competing with AstraZeneca's new £90 million ($145 million) bulk drug manufacturing facilities in Avlon Works, UK, which is manufacturing rosuvastatin, the active ingredient in Crestor. The new facilities house two major plants and associated infrastructure for synthesis, purification, drying and milling, as well as additional quality assurance and warehousing units. AstraZeneca opened the second plant in May following Crestor's approval in Europe last March. The first of the plants had been operational for some time during the clinical development and early launch phase for Crestor.

The inherent "lumpiness" in the custom manufacturing market was apparent last year as the number of new molecular entities (NMEs) reached 20, only three more than the recent record low of 17 NMEs in 2002, according to data from the Food and Drug Administration. The NME output in 2003 and 2002 was well below recent levels-24 NMEs were approved in 2001 and 27 in 2000.These levels are, in turn, below the average NME output from 1993-1999, when an average of 33.1 NMEs were approved annually, with a peak level of 53 in 1996.

The decline in drug output, combined with overcapacity in custom manufacturing, has upended the fortunes of custom manufacturers. "It has shifted from a seller's market in the 'golden nineties' to a buyer's market now," says Peter Pollak, a Swiss-based fine chemicals consultant.

When Will Recovery Come?

Many of the large players remain guarded about the prospects for 2004. Although some say this year is likely to be better than last, others do not see the industry recovering until 2005 or later.

"Recovery is a gradual event," says Nick Hyde, business director, Dowphar-ma. "We expect that 2004 will be a little better than 2003 industry-wide, and that 2005 will show further improvement."

"This year will not be a real improvement over 2003," says Matthias Kotten-hahn, vice president, business development of Degussa's exclusive synthesis and catalysts business. "Right now phar-maceutical companies are reducing stocks in an effort to reduce their working capital, so we will not see gains there. I don't see an uptick until at least until the second half of 2004 and into 2005. We should then start to see some late-phase drugs moving toward FDA approval."

"We do not think that 2004 will be worse than 2003, and in general we are cautiously optimistic for 2004," says Nick Green, president of Rhodia Pharma Solutions. "We think there may be some pick-up in new chemical entities, and the removal of some capacity in the marketplace should also help."

One of the more prominent examples of this trend of rationalizing occurred last October, when DSM announced plans to mothball indefinitely all of DSM Pharma Chemicals' APIs and intermediates production facilities at Greenville, N.C., a move that is proceeding this year. A single GMP production facility in Venlo, the Netherlands, will also be mothballed. In total 361 cubic meters of reactor capacity will be re-moved from service in favor of more flexible facilities in Venlo, the Nether-lands; Linz, Austria; and South Haven, Mich. Analysts estimate that DSM will be mothballing between 20 and 25 percent of its pharmaceutical chemicals capacity, and they estimate that im-provement of its pharma business could take up to two years.

Degussa, which took a  500 million impairment charge in its fine chemicals business last year, is taking about 20 percent of GMP production capacity off line through the phase-out of the fine chemicals unit at Radebeul, Ger-many. The move, which will be completed by the end of 2004, will reduce Degussa's total cGMP reactor capacity from roughly 900 cubic meters to 700 cubic meters. The Radebeul site is one of seven cGMP manufacturing sites for Degussa. "The restructuring allows us to reduce costs and remain competitive," says Mr. Kottenhahn.

Other capacity rationalizations from 2003 include Clariant's decision to close four custom synthesis plants that made agrochemicals in the US and Germany. Ruetgers Organics Corp., a business unit of Ruetgers Chemicals AG, also announced plans to indefinitely idle its State College, Pa., manufacturing facility last October. And earlier this month, Great Lakes Chemical Corp. sold its fine chemicals business at Halebank, Widnes, UK to Pentagon Chemicals.

These moves followed several changes in 2002, including the mothballing of Rhodia's Holmes Chapel, UK, facility and Lonza's closure of Los Angeles facility, which primarily made early-stage intermediates. "Due to ex-cess industry capacity, limited expansion opportunity and duplication of capabilities of the Los Angeles facility and at our other plants in Switzerland and Pennsylvania, we decided it would be prudent to close this operation," says Joseph R. Colleluori, vice president of marketing at Lonza. "Cost savings were built into and achieved as component of this rationalization." Lonza says it does not have plans to further rationalize production.

"I think the removal of capacity will definitely help the market," says Scott Martin, vice president, fine chemistry services and intermediates business unit at Albemarle. "Also, although late-stage pipelines may not be as strong as in the past, we see a pick-up in chemical development for early-phase compounds."

However, even with recent rationalization, overcapacity still looms in the marketplace. Industry estimates for overcapacity range from about 25 to 40 percent. "Degrees of 'overcapacity' vary in line with the technology/capacity 'mix" of individual players, with some assets full and other reportedly empty," says Peter Jackson, vice president, pharma products at Avecia. "There is high de-mand for specialized early phase capacity and a well known surplus at late phase. The industry average is probably running at 10 to 20 percent below expectation."

Others put the upper range for overcapacity at higher levels. "I believe the range at many facilities is even wider, from 20 to 60 percent overcapacity, so an industry-wide range of 30 to 50 percent seems reasonable, although in the past year some have retired capacity," says Gary Mossman, president and CEO of Cambrex's pharma and biopharma business unit. "This is particularly the case with companies that produce primarily pharmaceutical intermediates or APIs for large pharmaceutical companies." The problem is less for generic and emerging innovator APIs, he adds.

It is that overcapacity, combined with the persistence of lower demand for pharmaceutical outsourcing caused by reduced drug output and more in-house manufacturing, that leaves some participants more cautious. "I believe that the recovery will begin in 2004, but the results for most companies will not be sufficiently realized until the 2005 time frame," says Lonza's Mr. Colleluori. "We are prepared for another challenging year in 2004 with expected overcapacity to continue in the custom manufacturing arena for intermediates and active pharmaceutical ingredients."

"We do see a general recovery in the later half of 2004 and into 2005," says Cambrex's Mr. Mossman. "However, we do not see a return to the high growth rates of the late 1990s as a result of the substantial new capacity that was brought on line over the past five years, the excess capacity caused by fewer new drug approvals and the resulting in-sourcing by big pharma."

Others are more guarded. "I do not see a recovery any time soon as the fundamental imbalance between demand (particularly FDA approvals for new drugs and restrictive outsourcing of big pharma) and offer (heavily underutilized production capacities both within the pharma industries and custom manufacturers) persists," says Dr. Pollak.

Although the timing of the recovery may be uncertain, most observers concede that the once-high growth rates for custom manufacturing are certainly a relic of the past. "In custom manufacturing, we are seeing the effects of a maturing business sector," says Dow-pharma's Mr. Hyde. "In the late 1990s, the high growth projections for the custom manufacturing market have pro-ven to be erroneous, but the sector is still viable. I think we will see a smaller number of large players, and there will also be a place in the market for smaller, niche players. The key will be differentiation. Both large and small players will have to show differentiated skill sets or toolboxes to remain competitive," he says.

Others agree, noting some improvement in certain areas. "We have seen an increase in business for early-phase units, and this is now translating through into larger-scale demand," says Avecia's Mr. Jackson. "However, evidence from the marketplace suggests that this is very patchy, and is very dependent on having the right 'niche' capability and technologies. We don't expect a return to the previous growth in business based solely on large-scale undifferentiated capacity," he says.

"We do not believe that custom manufacturing business will return to a 15 percent per year growth rate," says Antonio Germani, director, pharmaceutical contract manufacturing, BASF. "The custom manufacturing business is closely linked to the global pharma market, and if that grows at a rate of 7 percent per year, we expect the same trend for custom manufacturing. We are expecting a consolidation period as a result of the fragmented nature of the supply arena."

Have the Fundamentals for Pharmaceutical Outsourcing Changed?

Given the difficult market conditions, a critical question for custom manufacturers is whether the basic business model that supports outsourcing of pharmaceutical manufacturing remains valid and what client bases are likely to use that model. "I don't think that pharmaceutical companies have strategically changed their rationale for outsourcing," says Dowpharma's Mr. Hyde. "We have had some recent tactical shifts from certain pharmaceutical companies that have decided to use internal capabilities as opposed to outsourcing. However, long-term, the economics of outsourcing manufacturing still makes sense for pharmaceutical companies."

"I believe the fundamental business model is sound, but due to the convergence of a number of factors such as pipeline success, large-scale merger and acquisition activity, in-creases in third-party licensing, regulatory changes, exchange rate and fuel costs, numerous companies, including Lonza have been exposed to a parti-cularly harsh business environment," says Lonza's Mr. Colleluori. "That being said, pharmaceutical companies are beginning to realize the value associated with the contract manufacturing industry and the benefits of conserving capital and resources for internal activities other than production," he says. "As pharmaceutical companies continue to feel pressure on pricing and access to new products, the inherent and strategic value associated with contract manufacturing will result in a reduction of direct pharmaceutical manufacturing operations. This will, however, be a slow and long-term process."

Others, though, point to important changes in the business model for pharmaceutical outsourcing. "I believe the underlying fundamentals of outsourcing pharmaceutical fine chemicals have changed during the past year and half," says Cambrex's Mr. Mossman, who outlines several key factors. "First, there are ever-increasing offerings and aggressive pricing from service pro-viders from China, India and a few eastern European countries," he says. "However, Cambrex, due to its niche approach in generics and its focus on emerging innovators, has not encountered head-to-head competition with competitors from China or India. There is also significant in-sourcing by several big pharma companies to better utilize their facilities with excess capacity," says Mr. Mossman. "Also, big pharma is reducing the number of ap-proved suppliers with preference given to those who can offer a full spectrum of capabilities. Thus, custom providers must differentiate and articulate their core technology platforms, breadth of capabilities and define defensible niches and uniqueness," he says.

With the greater competition in the marketplace, others also emphasize the need for increased differentiation. "The fundamentals are moving to reflect more competition and capacity for relatively less outsource demand, especially at late phase," says Avecia's Mr. Jackson. "Continuing consolidation may go some way to reduce capacity overhang, but the business model is changing. Business success for custom manufacturers will increasingly be driven by their ability to add value through technology differentiation, offering specialized early phase and differentiated late-phase services and by the breadth of their offer, essentially whether they have skill sets in biotech as well as small molecules."

Others agree. "I don't think the fundamentals have changed, but there are some important ongoing shifts" says Degussa's Mr. Kottenhahn. "Biophar-maceuticals are a growing area, for ex-ample, but the total market is also growing, so traditional custom synthesis for small molecules will not shrink but will continue to play a major role in terms of volume. Also of growing importance is the development of new drugs from virtual pharmacopanies."

Others also emphasize the growing importance of emerging pharmaceutical companies in the outsourcing equation. "Emerging pharma companies, who account for about 70 percent of Phase I therapeutics, will largely drive growth in custom development," says Cambrex's Mr. Mossman. "There has been an improved funding landscape with emerging pharma and biotech companies in the past year. Several of our customers received additional funding in 2003, which resulted in new development projects and the continued progress of existing projects."

The other issue is the growing presence of offshore suppliers. "The threat is particularly serious in the area of APIs for generics," says Dr. Pollak. "While Indian fine chemical companies cover about 10 percent of the merchant market today, they have far more DMFs [drug master files] registered than any Western county. This indicates that India will become a major player within the next few years," he adds.

"There is certainly mounting price pressure on custom manufacturers, which face increased competition from Indian and Chinese producers," says Dr. Polastro. "Some say the days for Western fine chemical producers are numbered." In trying to project the impact of offshore competition, ADL sampled Western producers to gain their input on current and future outsourcing trends. "The sample showed that the current share of outsourcing from China and India is between 5 and 10 percent, and by 2007 that share is expected to increase to between 15 to 25 percent," says Dr. Polastro.

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