Strong Demand versus Strained Capacity

The 2007 edition of the PharmSource–Pharmaceutical Technology Outsourcing Survey indicates that the contract services industry is going through a period of almost unprecedented growth. Pharmaceutical company budgets for contract services are rising, and contractor revenues are growing at double-digit rates, but the volume may be close to outstripping contractors' ability to deliver.

Among the pharmaceutical company respondents to this year's survey, 94% report an increase in spending on outsourced activity for the year (see Figure 1). That's a big jump from 2006, when only 84% reported a spending increase. The increase in spending is remarkably consistent across company size (see sidebar, "Respondents profile"), and rates of growth for spending on commercial and development services also are about the same.

Respondents profile

Survey results indicate that the growth in spending on outsourced activities reflects a fundamental move in favor of outsourcing rather than conducting activities in-house. Among biopharmaceutical and pharmaceutical company respondents, 27% reported that their spending on contract services is growing faster than their overall spending, up from just 18% of respondents in last year's survey (see Figure 2). More than 20% of respondents report that half or more of the spending in their particular area is outsourced, which is more than double the response from 2006 (see Figure 3). Here again, the results are consistent regardless of company size or activity (commercial versus development).

How do you expect your contract services spending to change from 2006 to 2007? (Figure 1)

Not surprisingly, the growth in spending is translating into a banner year for contract services providers. More than a quarter of service providers expect revenues to jump by 20% or more this year; in 2006, only 17% of contractor respondents expected such robust results (see Figure 4). Just as revealing is the fact that none of the service providers expect revenues to decrease in 2007; 10% of respondents to last year's survey had expected their revenues to decline. The growth is coming from all customer segments, with mid-size and generic biopharmaceutical and pharmaceutical companies showing particularly big jumps. Service providers report that new contract signings are rising a bit more slowly than revenues, but they are still growing at a robust rate.

How is your outsourcing spend growing relative to overall spending in your area? (Figure 2)

New opportunities

The growth in spending has created a more fluid contract services market that offers more opportunities for service providers. In this year's survey, 57% of biopharmaceutical and pharmaceutical company respondents report that they are actively looking for new service providers, either to increase their vendor base or to replace current providers; that value is up from 37% in 2006 (see Figure 5). The number of respondents who are unwilling to look beyond their current provider base dropped by two-thirds: only 5% of respondents say they use only current vendors.

What share of the total activity in your area is outsourced? (Figure 3)

It comes as a corollary to the search for new providers that efforts to consolidate the vendor base have slowed somewhat, especially among smaller companies. Nonetheless, among the largest biopharmaceutical and pharmaceutical company respondents, 37% report that they have already reduced the number of providers they work with, and another 20% indicate they plan to do so during the next two years. The influence of procurement professionals also is greater at the major pharmaceutical companies, but even smaller companies report that procurement staff are gaining more influence over sourcing decisions.

How do you expect your contract services revenue to change this year versus last year? (Figure 4)

Interest in sourcing from service providers in India and China continues to grow, although it is hardly at an enormous scale. In 2007, 27% of respondents report that their company is already sourcing from India and/or China, up from 20% in 2006 (see Figure 6). Another 30% is figuring out how to source from those countries, but more than 40% continue to say they have no interest in offshoring. Not surprisingly, the greatest interest is among the largest biopharmaceutical and pharmaceutical companies, many of which have established R&D hubs in India and China.

What is your company's stance regarding new vendors? (Figure 5)

Bumping against constraints

Our 2007 survey results suggest that the big jump in customer demand is really straining contractor capacity. This is especially true for basic infrastructure capabilities such as customer service and project management. Service providers themselves admit that rapid growth is causing strains. More than 50% indicate that a lack of capacity is constraining their ability to take on new business. Many of their customers have noticed that as well: 30% say that contractors appear to have all the work they can handle.

What is the status of your company's sourcing activities in India and/or China? (Figure 6)

The biggest single constraint cited by service providers is organizational processes, with inadequate capital to fund growth a close second. We explored this issue further by asking service providers whether their management and systems were adequate to handle growth of 20% or more (see Figure 7). Only one-third believe that their systems and management are up to the task: a quarter of contractor respondents indicate that neither systems nor management is adequate, and the rest that one or the other is lacking.

If your business were to grow 20% or more this year, how prepared are your company's management and systems for that growth? (Figure 7)

The survey suggests that service providers don't fully appreciate the impact that their capacity issues are having on their customers. When asked how they think their clients would rate the quality of their customer service, 35% of suppliers say customers would rate them as "excellent" (see Figure 8). When customers are asked how they rate their service providers' customer service, however, only 6% rate them as "excellent." Vendor performance on project management and technical/operational dimensions got similar marks. Overall, customer ratings of their service providers are not dire: most rate their vendors as "good" or "satisfactory" and less than 20% rate them as "fair" or "poor"—but there is clearly a big gap between customer and service provider definitions of service excellence.

How would you rate your service providers' customer service performance? (Figure 8)

Robust outlook for 2008

The picture of market conditions presented in the 2007 edition of the PharmSource–Pharmaceutical Technology Outsourcing Survey is much more robust than the 2006 survey led us to expect. Last year's responses suggested that spending would continue to grow, but that the rate of growth would slow. Most biopharmaceutical and pharmaceutical company respondents were projecting spending growth in the single digits, and most contractors were expecting the pace of new contract signings to decelerate.

Given that context, we are inclined to temper our enthusiasm over the indications from this year's survey that 2008 should be another strong year for the industry. Among biopharmaceutical and pharmaceutical company respondents, 43% expect spending for contract services to grow by 10% or more next year, versus 36% in the 2006 survey; only 7% expect spending to decrease. Service providers are very optimistic as well: 80% expect 2008 to be better or much better than 2007. In 2006, only 55% had such expectations for the following year.

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The high expectations of service providers are further reflected in another way. Most service providers accept that the major biopharmaceutical and pharmaceutical companies are moving to shrink the number of service providers they work with, but they are surprisingly sanguine about their prospects: 42% expect to gain business as a result of consolidation efforts, and 25% expect to feel no impact (21% claim to have already benefited from consolidation efforts). Such optimism is a bit surprising given the large number of small service providers in our sample (an appropriate representation of the industry). It suggests either giddiness in the midst of the current favorable market conditions or naiveté about their relative competitive position as ever larger competitors emerge.

The optimistic growth outlook is consistent with other indicators of market conditions that PharmSource tracks, including the flow of funds into early-stage biopharmaceutical and pharmaceutical companies from venture capitalists and Big Pharma licensing deals, and the forecasts from preclinical and clinical contract research organizations. Still, just as Wall Street analysts view excessive investor optimism as a sign that stock prices may be ready for a correction, the unbridled enthusiasm makes us wonder whether demand for contract services may be approaching the end of a cycle. Clearly, many industry participants are unprepared for any kind of jolt that might slow development spending.

Barring any unforeseen decrease in demand for services, this year's PharmSource–Pharmaceutical Technology Outsourcing Survey suggests that the biggest risk for contract services providers lies in their continued ability to meet client needs and expectations. As we previously noted, many admit they are reaching the limits of their ability to manage growth, and many appear to be vulnerable to growing customer dissatisfaction. In part, this reflects the varying but intense expectations of the various customer segments: small biopharmaceutical and pharmaceutical companies expect to be walked through the drug development process but often don't appreciate technical and operational excellence, and major biopharmaceutical and pharmaceutical companies demand technical and operational excellence. And both customer groups demand favorable pricing, despite their protestations to the contrary.

The capacity crisis may also reflect the fact that the industry continues to be dominated by small companies whose technically inclined owner–operators may lack the executive skills necessary to manage a growing enterprise. The industry is undergoing a process of consolidation that promises increased scale and greater management sophistication, but for now even the largest players seem to be struggling to meet the mounting expectations of customers. In the face of rapidly growing demand, contract service providers may need to learn to say "no" until their capacity catches up to their opportunity.

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.