Declining Market Demand Intensifies Competition

The year 2008 ended badly for many contract research organizations (CROs) and contract manufacturing organizations (CMOs), and 2009 has not started off very well either. That's especially true for service providers that support early development. Revenues for CROs offering preclinical toxicology services actually fell in the fourth quarter of 2008 versus a year earlier, and the first quarter of 2009 was down as well. CMOs offering process development and clinical supplies manufacturing services for both small- and large-molecule active pharmaceutical ingredients (APIs) were similarly hit hard.

Jim Miller

A principal culprit in the downturn, of course, has been the global financial crisis and economic downturn. Financing has been especially scarce for venture-backed early-stage companies, which have accounted for nearly 80% of the preclinical and Phase I pipeline in recent years. At the same time, the major global pharmaceutical companies, eager to reduce costs, have been restructuring their development programs, shedding as much as 25% of their pipeline candidates in the process.

With much of the work from major pharmaceutical companies already tied up in preferred provider and take-or-pay capacity reservation arrangements, the falloff in demand has intensified the competition among service providers for the remaining available projects. That competition is taking a number of forms.

PRICE COMPETITION

CROs and CMOs loath to compete on price. Not only does price cutting reduce margins on a particular project, it also sets up customer expectations that they can play one contractor against another to drive down the price substantially.

Contractors, therefore, prefer to focus on some measure of value as a means of differentiating themselves from competitors and justifying a higher price. The common differentiators include quality, experience, track record, specialized capabilities or knowhow, and customer service. It is often difficult, however, for the customer to draw clear distinctions between contractors based on these criteria, and within a range of qualified service providers the distinctions may be quite small.

Price cutting has become a problem especially in service segments that involve a lot of fixed assets and operating costs, including preclinical toxicology and manufacturing. The preclinical toxicology sector experienced a big increase in capacity during 2008 because most of the major competitors opened large new facilities or expanded their existing facilities. The new capacity came online at the same time as demand. Executives of the major preclinical CROs have been quite candid in public statements that price competition has become a factor in their market.

DECONSTRUCTING THE SERVICE OFFERING

Rather than just cutting price, CROs and CMOs have learned that they can keep business flowing by breaking up projects into smaller pieces. So, for instance, a $2-million process development and clinical trial supply project might be divided up into smaller contracts for process development, methods development, and clinical supplies manufacturing.

Breaking down projects this way works because it matches the way venture capitalists and corporate boards are doling out money these days. Cash conservation is a prime objective, and committing funds in smaller tranches achieves that. It also limits the amount of cash that might be wasted if a candidate fails at some phase. Boards of biopharmaceutical and pharmaceutical companies are now requiring staff to get bids on individual projects before agreeing to fund work, rather than committing funding for multi-year periods.

NEED FOR SPEED

Getting to proof-of-concept as quickly as possible has become a prime objective for both large and small biopharmaceutical and pharmaceutical companies alike. Getting to a decision point faster has a number of advantages: it allows companies to support more projects with a given level of staffing; reduces the cash burn for supporting general overhead (e.g., rent and executive salaries) while awaiting preclinical and clinical results; and shortens the time investors must wait before getting a payoff from their investment.

To address the need for speed, service providers are offering integrated packages of services that promise to get the client's candidate into the clinic in a relatively short time, e.g., from optimized lead to investigational new drug submission in as little as six months. Bringing back the one-stop-shop model, the service package typically includes process and analytical methods development and clinical supplies manufacturing tied together by the service provider's project management capabilities. The service provider's argument is that by managing the project and doing most of the work internally, it can reduce communication and scheduling problems that delay development projects, especially delivery of the active pharmaceutical ingredient.

The quick-to-clinic model has obvious appeal to venture-backed companies, whose staff often lacks the experience and expertise to get a candidate through preclinical and clinical development. Interestingly, it is beginning to attract the attention of major pharmaceutical companies, which are outsourcing more of their early-development needs and experimenting with more virtual business models.

PARTNERSHIPS

When funding gets tight, early- stage companies will often ask their service providers to reduce their prices in exchange for a stake in the potential success of the product, e.g., by taking equity or a royalty on future revenues. CROs and CMOs started seeing this trend six months ago, and some have entertained the requests seriously.

Partnership arrangements can be problematic for service providers. For one thing, they violate the basic fee-for-service nature of the CRO–CMO business model, which promises profits without the risks inherent in drug development. Further, they require skills behind the competency of most service providers, i.e., the ability to make highly informed judgments on the scientific and market prospects of a particular drug candidate.

Still, there are CROs and CMOs for which partnering is an explicit part of the business model. Some CROs, such as Quintiles, have established venture capital arms which invest in companies that then use their CRO capabilities to conduct trials. PPD has an explicit compound partnering program in which it will in-license products, undertake early development, and then outlicense them once it achieves proof-of-concept. Some CMOs offer proprietary drug-delivery technologies for which they negotiate royalty arrangements.

The difficult competitive environment is forcing service providers to examine their business models closely, and identify and deliver new sources of value to their clients. They have learned that trying to compete by adding a new processing or analytical technology doesn't work, because competitors can easily match each other. The current competitive environment is putting the focus on value and performance, which are the only solid bases for long-term success.

Jim Miller is president of PharmSource Information Services, Inc. , Springfield, VA, 703.383.4903, jim.miller@pharmsource.com