Pfizer Restructuring a Boon to CMOs and CROs

Executives of contract research and manufacturing organizations (CROs and CMOs) are undoubtedly licking their chops over the prospective flood of business opportunities with Pfizer, Inc. (New York, NY). The opportunities are expected to arise from Pfizer's decision, announced by new CEO Jeffrey Kindler, to close down or sell five R&D sites and three manufacturing facilities and outsource more of the activities conducted at those sites. Given that in 2006 Pfizer spent nearly $7.5 billion on R&D and a similar amount on cost of goods, even a small incremental increase in the share going to contract services would be a bonanza for the pharmaceutical services industry. In fact, the plan calls for Pfizer to increase its outsourced manufacturing activity from 15% of requirements today to 30% in the next few years.

Jim Miller

Taken in total, Kindler's plan for fixing Pfizer amounts to a wholesale overhaul of the traditional Big Pharma business model. It entails a focus on costs that has been unusual for Big Pharma, albeit standard practice for most major industries. Consider these quotes from the Jan. 22 meeting where the Pfizer senior executive team unveiled their plan for Wall Street analysts:

• ". . . establishing a lower, more flexible cost base";

• ". . . establish a more flexible cost structure that can be modulated depending on our needs and opportunities at any given time";

• ". . . maintaining a flat R&D budget" while tripling the number of Phase III candidates by 2009;

• ". . . no-growth R&D budget environment";

• ". . . a culture of productivity and continuous improvement and continuous increases in efficiency";

• ". . . major development sites in Mumbai and Shanghai."

Those statements suggest that the CMOs and CROs that benefit from Pfizer's increased outsourcing activity are really going to have to work to maintain the business and keep it profitable. Clearly, Pfizer will be looking for more than just vendors: it will be looking for partners to help remake its R&D processes and manufacturing operations. The partnership role will require service providers to examine their own cost structures and business practices to find opportunities to continually deliver cost savings and performance improvements. Doing so will be wrenching for many service providers, who have become accustomed to the traditional Big Pharma way of doing business and have been quite profitable operating that way.

Consider a traditional practice such as "take-or-pay" contracts, which obligate a customer to pay for capacity regardless of whether the capacity is used. These have long been standard practice in the pharmaceutical outsourcing industry, especially for services in which capacity is viewed as being tight, and they are quite popular today in the preclinical toxicology segment. Nonetheless, take-or-pay deals would seem to be contrary to Pfizer's objective of keeping costs flexible. How will service providers balance their own needs to maintain capacity utilization against Pfizer's needs to keep costs flexible?

Pfizer's insistence on maintaining flat R&D expenditures while increasing the number of development projects will challenge CROs and CMOs even further. Profit margins will undoubtedly come under pressure, especially as the company explores sourcing options in Asia and as it insists on continuous improvement in pricing and performance each year. Those pressures also will force service providers to manage their businesses more effectively and also may lead to a rush of innovation as companies seek to squeeze costs out of the development process.

Kindler's 2008 target for closing the facilities and realizing the cost savings suggests that contractors should start harvesting the windfall from Pfizer spending by the second half of 2007. The initial efforts are likely to hit some significant rough spots, given the large number of projects and the challenges of overcoming Pfizer's preference in recent years to work in house. The current industry environment, characterized by high utilization and tight capacity at most development services operations, also will be challenging for Pfizer.

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It's difficult to gauge how far reaching the effects of Pfizer's restructuring will be on the pharmaceutical services industry. Much depends on whether, and to what extent, other major pharmaceutical companies follow Pfizer's lead. In fact, other major pharmaceutical companies with their backs against the wall have been changing their traditional ways of doing business: witness Merck's new willingness to outsource manufacturing and Wyeth's efforts to restructure its R&D processes. Most major pharmaceutical companies, however, are still run by company veterans for whom the traditional business model is deeply ingrained. If Kindler's remodeling effort is successful, it may encourage the boards of other Big Pharma companies to look outside for new leadership with a fresh perspective. That could really shake up the CRO and CMO business.

Cardinal PTS Goes to Blackstone

The other big outsourcing industry news in January was Cardinal Health's (Dublin, OH) announcement that it will sell its Pharmaceutical Technologies and Services (PTS) unit to The Blackstone Group (New York, NY), a very large private equity firm, for $3.3 billion. PTS has capabilities in packaging, oral drug delivery, and sterile products manufacturing, with more than 30 sites worldwide.

The sale of PTS was not itself a surprise because Cardinal Health had announced its intention to sell the business in November 2006. The surprise was that PTS never went to auction: Blackstone was able to pre-empt other potentially interested parties with its bid, which is 1.8 times PTS's revenues of $1.8 billion and 10 times its earnings before interest, taxes, depreciation, and amortization (EBITDA) of $320 million.

Undoubtedly, Blackstone was willing to bid so aggressively for PTS because it knows the business and industry so well. Its senior advisor on the deal is Alex Erdeljan, the former CEO and chairman of R.P. Scherer, the softgel manufacturer that was bought by Cardinal Health in 1998 and forms the core of PTS's oral drug delivery business. After the R.P. Scherer sale, Erdeljan was a managing director with Global Healthcare Partners, a part of CSFB Private Equity Group, which owns contract manufacturer NextPharma Technologies (Surrey, UK).

In addition, just a week after the deal was announced, Blackstone announced that George Fotiades, the former CEO of PTS and COO of Cardinal Health, would join the board of the new PTS. Fotiades is also an R.P. Scherer veteran.

Although the price paid for PTS is significant, it is practically "chump change" for Blackstone. Right after announcing the PTS deal, Blackstone won the bidding war for Equity Properties, a company that owns a large commercial real estate portfolio. The deal, the value of which will exceed $38 billion, is said to be the largest private equity deal of all time.

Blackstone's other pharma-related properties include Emcure Pharma-ceuticals, an Indian pharmaceutical business with activities in API manufacturing; developing branded formulations and biotech products; Nycomed, a mid-sized specialty pharmaceutical company headquartered in Denmark; and Gerresheimer, a manufacturer of specialty glass products used in packaging in the pharmaceutical, cosmetic, and specialty food and beverage industries.

On the basis of its past history, Blackstone is likely to hold on to PTS for three to five years, perhaps acquiring additional businesses to add to its offerings. With the favorable industry market conditions and PTS's major investments nearly completed (especially in sterile manufacturing), Blackstone is entering the contract manufacturing and development business at an especially propitious time.

Jim Miller is president of PharmSource Information Services, Inc., and publisher of Bio/Pharmaceutical Outsourcing Report, tel. 703.383.4903, fax 703.383.4905, info@pharmsource.com, www.pharmsource.com.