CMOs must face new realities

Different arms of the pharmaceutical contract services market have been evolving in very different ways. In the clinical and preclinical research sectors, large CROs have experienced annual growth rates of 15–20% during the past 3 years, more than double the rate of European and North American contract manufacturers. Furthermore, this rapid growth has been accompanied by consolidation of these service sectors, resulting in the 10 largest CROs accounting for approximately 75% of the clinical and preclinical markets.

Jim Miller

The large clinical CROs benefited from a number of favourable trends, including growth in the drug development pipeline and efforts by major pharmaceutical companies to reduce the number of vendors they work with. At the same time, however, the big CROs have been making important strategic moves and investments that have enabled them to consolidate their market domination, including investment in electronic data capture and other information technologies, as well as expanding their geographic scope to include the emerging markets in Asia and Latin America.

Major preclinical CROs are consolidating their market positions by building very large research facilities (30000 m² or larger) and entering into long-term contracts with major pharmaceutical companies for use of that space; for example, Eli Lilly and Company (IN, USA) recently outsourced all of its GLP-compliant toxicology testing to Covance (NJ, USA), one of the two largest preclinical CROs. In addition, major CROs are entering into joint ventures to service large pharmaceutical companies' expanding base of R&D operations in China.

CMOs lag behind

CMOs have not enjoyed nearly the success CROs have. The formulation manufacturing and small molecule API segments have experienced overall growth of less than 5%. CMOs have been hurt by a number of factors, including the shrinking number of new product approvals by European regulators and FDA; declining sales for key client products; clients repatriating products to underutilized in-house manufacturing facilities; and overcapacity that has fuelled price competition. The two bright spots in the manufacturing universe have been biomanufacturing (especially mammalian cell culture) and manufacturing of clinical trial supplies.

Immediate prospects for CMOs could change for the better if their clients can get more products approved in the next year or so. However, CMOs may be in trouble in the long term as most of them continue to operate with business models and strategies based on old perceptions that don't reflect the current realities of the pharmaceutical industry. This is particularly true in several key areas.

Market growth. Most CMO strategies were established in the early part of this decade when new product approvals were expected to be plentiful, and drug prices and unit volumes were rising. The assumption was that growth would continue, meaning there would always be a need for capacity and that CMOs could expect annual price increases. This led CMOs to invest in substantial capacity expansions and acquisitions of redundant facilities from major pharmaceutical companies. It was also a time when it was assumed that "price doesn't matter" as drug sales were so high and profitable that pharmaceutical companies were more concerned about assuring a dependable supply than they were about cost of goods.

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However, the pharmaceutical industry's growth prospects have changed considerably since then. New product approvals have continued a 10-year decline, governments and private insurers have fought back against drug price increases, and safety concerns and utilization guidelines are limiting the growth of blockbuster drugs, especially biologics.

Emerging markets. Five years ago, CMOs geared their strategies to the North American and European markets, where prices were highest and usage was growing the most rapidly. CMOs geared their facility design and quality assurance practices to meet FDA and EMEA standards of compliance.

Today, market focus of the major pharmaceutical companies is turning to the emerging economies of Brazil, Russia, India and China. Serving these countries is an entirely different challenge: they either have their own vigilant regulatory agencies, as in the case of Brazil and China; or lower compliance standards that make the costs of maintaining FDA and EMEA compliance uneconomic. In many cases, laws and/or regulatory practices require local manufacture and discourage imports, and most Western CMOs lack facilities in the emerging economies to take advantage of these expanding opportunities.

Manufacturing and sourcing strategies. While many major pharmaceutical companies have announced their intentions to outsource more, they have also continued to invest heavily in new facilities and equipment, particularly for development and manufacturing of large molecule products. Capital investment by the fifteen largest pharmaceutical companies grew 16% in 2007 to approximately $22 billion (€15.6 billion). With the pharmaceutical companies on a spree to acquire or in-license large molecule candidates, the high-value opportunities CMOs were counting on will likely remain in-house.

CMOs are also being hurt by increasingly global sourcing strategies. Global sourcing has introduced new low-cost competitors in countries such as India and China, and greatly extended the pharmaceutical supply chain, meaning that dose CMOs must often deal with the inability of clients to ship adequate API supplies, resulting in schedule disruptions and revenue shortfalls.

A new business model

The CMO industry is facing an overcapacity problem that is becoming increasingly worse: CMOs are building new capacity, Indian and Chinese companies are entering the market, and new companies are entering the industry by purchasing old facilities from Big Pharma. In the absence of other differentiating elements, overcapacity will drive down prices.

The CMO business model is still based on selling capacity, but manufacturing capacity is really an undifferentiated commodity. CMOs must find new business models and strategies that reflect the many dimensions of the industry's realities, such as Big Pharma's growing emphasis on reducing costs and making costs more flexible, and the globalization of the industry from both the end-user market and sourcing perspectives. These models and strategies need to do a better job of differentiating CMOs to prevent price competition. There should be multiple models targeting different customer groups and needs.

One option being used by some companies is the integrated service offering provider. These organizations are especially suited to small and mid-size bio/pharmaceutical companies, as they provide a complete suite of physical product services from early process development through to commercial manufacture. The main value of these companies is their ability to move products through development and commercialization quickly and cost effectively because of their skills in product development, regulatory strategy and project management.

Manufacturing excellence

For CMOs targeting major pharmaceutical companies, I expect manufacturing and supply chain management excellence to be the hallmark of the emerging strategies. Those CMOs will seek to bring manufacturing practice to a level still unknown in pharmaceuticals but common in most of the industrial economy. Characteristics of these best-in-class manufacturers will include:

• A focus on reducing manufacturing costs through continuous improvement activities and optimizing plant utilization.

• Manufacturing in a more 'just-in-time' environment to prevent companies from carrying large inventories of raw materials and finished product.

• Operating global plant networks, including operations in emerging markets such as India and China, to achieve lower costs and improved access to these markets.

The 'manufacturing excellence' business model will be the real game changer for the CMO industry. It is the one strategy that offers major pharmaceutical companies the ability to completely alter their business models by addressing costs and globalization without sacrificing security of supply. CMOS that can deliver this will be big players and big winners in the contract manufacturing stakes.