Riding the Wave

The pharmaceutical outsourcing industry is well into its second year of very strong growth, and indications appear that it will enjoy a healthy third year as well.

Jim Miller

Most publicly traded CROs and CMOs enjoyed revenue growth exceeding 10% in the first half of the year and announced even greater profit increases. Among contractors that participated in the 2005 PharmSource–Pharmaceutical Technology¹ outsourcing survey—including a large portion of private companies that don't report publicly—more than 60% said their revenues will increase 10% or more in 2005. More than a quarter of the companies surveyed expect their revenues will increase more than 20%. Half of pharmaceutical company respondents said their contract services spending will grow 10% or more this year.

The prospects for 2006 look positive as well. Pharmaceutical company respondents to the PharmSource–PharmaceuticalTechnology outsourcing survey expect that contract services spending will grow in 2006 at the same rate as 2005. In the meantime, major CROs are building record backlogs of future studies to be conducted over the next 2–3 years.

In the midst of this good fortune, CRO and CMO executives must ask themselves: Are we enjoying a periodic upswing in the business cycle, or are we benefiting from a fundamental and long-term shift in how pharmaceutical companies do business? The answer will have a big effect on how they run their operations and the kind of investments they make in coming months.

Determining whether we are at a high point in a business cycle is a tough call because the pharmaceutical contract services industry is too young to track its business cycles. Certainly, the last 10 years have had some cyclical characteristics including a relative strength in the second half of the 1990s, a slowdown during the 2000–2003 period, and an upswing over the past two years.

This contract services cycle has been closely correlated with two other industry developments that also tend to be cyclical: the strength of the new product pipeline and the availability of funding for early-stage companies. These cycles turned up in 2003, and the contract services industry improved in lockstep. But now, the cycles are giving mixed messages.

After a strong run in 2003–2004, funding for early-stage companies has dropped in 2005. According to statistics compiled by Dow Jones VentureOne, the first quarter of 2005 saw the second lowest volume of venture capital flowing into biopharmaceutical companies in nearly five years. In addition, the window of opportunity for initial public offerings closed in the first quarter after having been open from late 2003 through 2004.

The soft financing environment comes at a critical time. Venture-backed companies must raise new money every 18–24 months, so companies that raised money in 2003 and 2004 must now replenish those funds. Early-stage companies spend what they raise quickly and outsource a high percentage of what they spend, so their funding problems could hurt the CRO and CMO industry in coming months.

The news is much better regarding the new product pipeline. The flow of new candidates appears to be very healthy, judging by the number of candidates reported in various pipeline databases and the pronouncements of pharmaceutical executives about the improving yields of their research and development programs. Further evidence that the demand is strong include the lengthening lead times for booking preclinical and Phase I research capacity at CROs, and the mounting backlogs for Phase II/III studies.

The robust pipeline is a function of maturing science and re-engineered organizational processes. These structural improvements should have long-term positive implications for contract services, because they can provide a steady flow of new candidates for years to come. A financing shortage could hurt the flow of candidates coming from small companies, however.

Attitudes toward outsourcing

The expanding pipeline is half the equation in deciding whether the contract services industry is experiencing a cyclical boost or a favorable structural development. The second half of the equation is the propensity to outsource.

Evidence of a long-term shift in business practices in favor of more outsourcing is ambiguous. Demand for contract services has clearly increased, but so far, this need appears to be more a function of the growing volume of candidates than it is a shift toward a new business philosophy. Pharmaceutical companies continue to invest in new or replacement research and manufacturing capacity, even as their outsourcing expenditures grow. More importantly, we have seen few examples of truly innovative outsourcing business models that suggest that Big Pharma has embraced outsourcing in a new way (i.e., deals such as those that Wyeth has structured with Accenture for data management and Research Pharmaceutical Services for study monitoring).

There is no question that executives at most major pharmaceutical companies are looking for ways to reduce costs, increase productivity, and avoid tying up resources in fixed assets. Outsourcing is one approach to achieving those objectives, but other popular strategic initiatives may have even greater effect. Those initiatives include increased in-licensing of early-stage candidates, more-aggressive procurement practices, and establishing operations in low-cost and tax-advantaged offshore locations.

Mistaking a cyclical uptick for a structural change can have disastrous consequences for CRO and CMO executives. In the 1990s, pharmaceutical chemical executives got it wrong, and they are still paying for their mistake. They misread an increase in demand caused by a cyclical upswing in the pipeline as a structural change in business practices in favor of outsourcing. As a result, the industry made large investments in new manufacturing capacity, only to see the cycle turn down just as new facilities came online. The resulting overcapacity forced companies to cut prices and carry unabsorbed overheads, thereby sharply reducing profitability and forcing some companies out of the business.

CRO and CMO executives will do well to read the tea leaves carefully before deciding that the current boom in demand for contract services is more than a cyclical upturn.

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.comwww.pharmsource.com.

References

1. An analysis of this year's survey appears in Outsourcing Resources 2005, a supplement to the August issue of Pharmaceutical Technology.