Seeking a Fresh Start

The Chapter 11 bankruptcy filing of aaiPharma (Wilmington, NC, www.aaipharma.com), parent of AAI Development Services, was the culmination of an agonizing year-long odyssey. It also was a first step in restoring one of the best-known brands in the CRO industry.

Jim Miller

The filing was triggered by aaiPharma's inability to service the $350 million debt it took on in 2002–2003 in an effort to remake itself from a CRO into a specialty pharmaceutical company. The company used the debt to acquire a product line, only to find it was unable to maintain the sales of those products in the face of generic competition. Efforts by some former executives to cover the sales' shortfalls ultimately led to a massive restatement of financial reports, government investigations, default on the debt, and the resignation of key executives.

As the products business went bad, aaiPharma fell back on its CRO business, AAI Development Services, an industry leader in nonclinical drug development services, including analytical and bioanalytical chemistry, microbiology, and formulation. Underscoring the return to its CRO roots, the company brought in Ludo Reynders, a respected former Quintiles executive, as its new CEO.

AAI Development Services generated $95 million in revenue in 2004, up 6% from its 2003 performance. The financial problems sparked by the products side of the company have taken their toll on the CRO business, however. CRO revenues for the first quarter of 2005 were down 20% from the year before. In its 10-Q filing, the company admitted that "customer concerns with respect to our uncertain financial condition have adversely affected our ability to obtain new development service projects, particularly long-term projects."

Most CROs had strong growth in the quarter.

The Chapter 11 filing gives the company some breathing room to restructure its operations and finances. It appears the process will move relatively quickly because the filing was preceded by two major developments: the securing of $210 million in debtor-in-possession (DIP) financing and the signing of an agreement to sell the pharmaceutical products line. The DIP financing includes $180 million to replace the company's senior credit facility plus a $30-million revolving credit facility, which will help fund its ongoing operations.

The agreement to sell the pharmaceutical products line is with Xanodyne Pharmaceuticals (Florence, KY, www.xanodyne.com), a privately-held specialty pharmaceutical company that focuses on the women's health, pain management, and urology markets. The deal calls for Xanodyne to pay aaiPharma $170 million plus potential royalties for its currently marketed products, plus rights to some products under development by aaiPharma.

Documents filed by aaiPharma with the Securities and Exchange Commission (SEC) indicated that the pharmaceutical products sale could be completed as soon as the end of June, with emergence from bankruptcy following shortly thereafter. It is in the interest of the company's subordinated debt holders, who will own the company after its emergence from bankruptcy, to normalize the situation as soon as possible to preserve the CRO business.

Those debt holders will effectively have two choices. The first is to hold on to the company in hopes that the CRO business can grow to a point where it can be sold at a price that will recover the debt. The second choice is to cut their losses by selling the CRO business now for whatever price it can command.

In an SEC filing made just before the bankruptcy filing, aaiPharma presented projections indicating that the CRO business could generate revenues of $142 million by 2007, up 40% from $102 million in 2005, with operating profit of $31 million. The company could reach a valuation of at least $200 million at the profitability level, but achieving it will require that the company salvage its market reputation quickly and make some smart moves to build its business. It also will require that company management not be distracted by the lingering investigations and lawsuits that surround it. For that reason, a sale of the CRO business to a third party (leaving the corporate aaiPharma shell intact to handle the legal issues) could be the best option.

2005 starts strong

The strong revenue momentum that the pharmaceutical contract services business generated in 2004 carried into the first quarter of 2005. Most industry segments generated double-digit revenue growth for the quarter, and new contract signings remained strong.

Demand for early-development services, including preclinical and Phase I research, remained especially strong, and waiting times for capacity continued to stretch into the 3–6 month range. Several CROs brought on new Phase I capacity, including PPD's (Wilmington, NC, www.ppdi.com) 300-bed Austin, Texas, facility and Radiant Research's (Bellevue, WA, www.radiantresearch.com) 120-bed facility in Dallas, Texas. Substantial new preclinical capacity won't be available until late in 2005 or 2006, however.

A big driver of clinical CRO revenue was the growing strength in Phase II–III activity. Bookings for new late-development studies began growing in early 2004, and the revenue effect of those signings is being felt this year. Clinical CROs reported continued strength in new business signings, with the large public CROs benefitting from their ability to secure preferred provider relationships with major pharmaceutical companies.

The growth in late-stage development is especially good news for API and dose manufacturers as well as providers of analytical chemistry, formulation, and packaging services. Conversations with exhibitors at April's Interphex show confirmed that the nonclinical service providers are experiencing growing demand as well.

Prospects for the industry look good through the rest of the year. The only cloud on the horizon appears to be reduced funding opportunities for early-stage companies. The initial public offering window closed in the first quarter of the year, and several companies postponed their new public offerings or took a substantially lower price per share to seal their deals. Venture capital funding remained strong in the first quarter but dropped precipitously in April. The funding environment is a critical concern for nonclinical CROs and small clinical CROs, because early-stage companies make up a large portion of their business. The large clinical CROs get a large and growing share of their business from major pharma-ceutical companies, and they should benefit as Big Pharma enhances its new product pipeline with licensing deals and acquisitions.

Jim Miller is the president of PharmSource Information Services, Inc., and publisher of Bio/Pharmaceutical Outsourcing Report, tel. 703.914.1203, fax 703.914.1205, info@pharmsource.comwww.pharmsource.com.