Simpler is Better

Contract dose manufacturing has hundreds of participants, but two have dominated the industry in this decade: Cardinal Health (Dublin, Ohio) and Patheon (Toronto, Canada). With revenues of $1.8 billion, Cardinal Health's Pharmaceutical Technologies and Services (PTS) business unit is by far the industry's largest player, with capabilities spanning a broad array of technologies and dosage forms. At $700 million in revenues, Patheon is the second largest player, and an innovator of now-standard industry strategies such as using development services to drive new commercial manufacturing business.

Jim Miller

It is remarkable, therefore, that we enter the new year with both companies facing somewhat uncertain futures. Patheon's board of directors is considering "strategic and financial alternatives," including the possible sale of all or part of the company, in the wake of disappointing financial results and operating problems at several of its facilities. Cardinal Health announced in November that it would sell the PTS business because of disappointing performance and because it is no longer a strategic fit with the corporation's focus on the downstream healthcare supply chain.

The uncertainty surrounding the industry's two highest profile participants has raised concerns among both buyers and sellers of contract manufacturing services about the long-term prospects of the industry and the viability of the CMO business model. After all, if the two biggest companies in the industry can't make a go of it, how can the many smaller CMOs expect to generate profits and attract the capital investment necessary to remain successful?

It would be wrong to jump to conclusions about the entire industry based on the Patheon and PTS experiences. Their acquisition-driven business strategies are unique in the industry, and the challenges of organizational complexity and voracious capital consumption posed by such rapid expansion are not faced by the majority of CMOs, which have chosen a more conservative approach to growth.

Growth through acquisition

The mid-1990s seemed to be an ideal time to build a global contract manufacturing business through acquisitions. Contract manufacturers in the electronics industry were doing it, and their revenues and stock valuations were soaring. Furthermore, the pharmaceutical research and development pipeline seemed full, and there was much talk of the expected growth in outsourcing as both major and small bio/pharmaceutical companies scrambled for more capacity to manufacture the expected flow of new products. That was the environment in which Patheon and Cardinal Health initiated their acquisition programs.

Their earliest deals were right on the mark. Cardinal Health's first acquisitions, including Packaging Coordinators, Inc. and softgel manufacturer R.P. Scherer, remain the core of the PTS business and the principal sources of its revenues and profits. Patheon's initial strategy of acquiring redundant manufacturing facilities from major pharmaceutical companies was both cost-effective and strategic. It was able to buy assets at just a fraction of their replacement value while gaining long-term contracts and building important relationships with some of the largest drug companies.

Nonetheless, later deals ran into problems almost as soon as the ink was dry on the purchase documents. Cardinal Health's 2002 acquisitions of contract analytical laboratory Magellan Laboratories and marketing services provider Boron, Lepore & Associates, Inc. ran into problems soon after their acquisitions due to the loss of major clients. In late 2004, Patheon borrowed heavily and issued equity to acquire Mova Pharmaceuticals (Caguas, Puerto Rico), but an FDA warning letter and a variety of smaller but significant problems quickly eroded profitability and undermined the strategic and economic rationale for doing the deal.

Now, ten years after launching their acquisition-driven strategies, results at PTS and Patheon have been disappointing at best. Cardinal Health has invested $5 billion in building PTS, but its estimated $300 million in earnings before interest, taxes and depreciation mean it is yielding less than an ultrasafe US Treasury security. At Patheon, after nearly $1 billion have been invested, financial performance indicators have fallen short of levels required in its loan agreements, and the company has been forced to consider more radical restructuring moves to ensure its long-term viability.

Overcoming complexity

As experience has shown, the acquisitions entailed business and regulatory risks that often could not be foreseen or were easily overlooked. But, those risks were compounded by the challenges of operating such complex organizations. Integrating and operating these global manufacturing networks successfully requires a broad range of technical and business skills and systems and a cadre of experienced people. These are assets that take years to build. It can be argued that that the architects of Patheon and PTS failed to appreciate fully the operating complexity of what they were building.

A further complicating factor has been the fact that the vision of the market that provided the underlying rationale for PTS and Patheon has not been borne out. Major pharmaceutical companies have not embraced outsourced manufacturing to the degree that was expected ten years ago. Furthermore, the secondary role of contract manufacturers has meant that size and global capabilities have not proven to be the competitive advantages they were expected to be.

In today's CMO market, companies that offer a limited range of capabilities from a small number of sites appear to be enjoying the best results. They have grown organically by understanding their markets well and responding quickly to new opportunities. Focused offerings enjoy several advantages, including far less complexity in operations and a clear business development message. In addition, they can target their capital spending and innovation efforts to add cutting-edge capabilities that provide real competitive differentiation and advantage. Examples of focused manufacturing and packaging companies include DPT Laboratories (San Antonio, TX) in semisolid and liquid manufacturing and Fisher Clinical Services (Allentown, PA) in clinical packaging.

The large clinical CROs figured out the power of focus and simplicity years ago. Revenues and profits at Covance (Princeton, NJ) blossomed after it shed its clinical packaging and biomanufacturing businesses early in this decade. Pharmaceutical Product Development, Inc. (Wilmington, NC) has grown to $1 billion in revenues and strong profits by focusing on excellent delivery of plain-vanilla clinical research services. Charles River Laboratories (Wilmington, MA) divested its Phase II–IV clinical research operations earlier in 2006 to focus on its core strengths in research models and preclinical toxicology.

Company Web sites

Of course, any given business model does not remain successful forever; companies must continually adjust to the changing demands of their customers. Over the next few years, as major pharmaceutical companies seek to consolidate their vendor bases to gain savings in cost of goods, it may be that multicapability suppliers will have advantages over vendors that can offer only a single service. But, that advantage will be sustainable only if the business model makes financial sense and companies deliver excellent performance across all service offerings.

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