Growth in CROs and CMOs

Organisations that have provided critical services to pharmaceutical companies have established an important role in the pharma industry.

In particular two types of outsourced capabilities are considered. contract research organisations (CROs) help bring pharmaceutical compounds through the development and approval process quickly and efficiently, while contract manufacturing organisations (CMOs) provide companies with outsourced manufacturing capacity. In many cases these companies offer not just surge capacity but also a proprietary process not readily available.

product pipeline

In total, pharmaceutical manufacturers spent roughly $7.5bn on research, development and manufacturing. The total amount outsourced is expected to grow at 9-10% over the medium term.

The process of bringing to market a new pharmaceutical compound is long and costly. Contract outsourcers represent one option for development. As providers of 'swing capacity,' they enable pharma companies to divert some of the cost and risk of development, but also dilute the potential reward. Pharmaceutical companies need to determine which of the many compounds under consideration have the best prospects of success.

How many warrant the full spending as a prospective blockbuster compound and should these compounds be developed internally?

In addition, outsourcers need to examine how much internal capacity exists for CT management.

Other concerns of the large pharma companies include questions about the product pipeline of the sponsor and compound developer, and the likelihood of achieving regulatory approval, and, of course, external market conditions come into play. What are the competitors developing? Will the life of the patent protection justify continued development spending?

Since a successful compound generates large financial rewards for the individual company sponsor, pharma companies have delivered extraordinary returns to their shareholders by pursuing r&d of new compounds. However, along with high returns comes a significant degree of risk, not only in development but also throughout the approval process, in which delays are exceedingly costly. One observer has noted that 'companies can generate an extra US$580m in sales over the life of the patent if they can save a year in the approval process'. Outsourcing may not only speed the development process but dilutes the financial cost of delays in the regulatory arena.

As the outsourcing industry has expanded, CROs aappear to be pursuing one of two strategies. They re either attempting to grow through acquisitions, sometimes diversifying beyond performing clinical trials, or are seeking to become clearly defined niche players with highly specialised capabilities. The acquisition strategies pursued by companies are consistent with a strategy to become more fully integrated pharmaceutical companies. Room still exists for the niche player; however, because of the considerable infrastructure, investment and expertise required from the start, the niche CRO may be initially established as a division of, or spin off from, an integrated pharma company or a larger player in a defined pharmaceutical market.

In time, as the larger CROs conduct a bigger portion of the discovery and development process, they may become more of an industry in their own right. As such, they will function more as partners to the established pharma companies.

expanding operations

The CMO industry, on the other hand, is increasingly composed of chemical companies that are expanding their fine chemicals operations, hoping to accelerate a shift away from commodity chemicals and thus raise future growth rates and price/earnings ratios.

DSM's recent purchase of Catalytica, Rhodia's acquisition of ChiRex and Dow's expansion of its contract manufacturing operations are just a few examples of this trend.

However, pharmaceutical companies are not always so ready to outsource manufacturing, as quality and supply are major concerns and as economies of scale are realised in the manufacturing process. As in the CRO sector, contract manufacturing companies are seeking to bring more to the customer's table.

Major transactions in 2000 and 2001 include Rhodia's $545m purchase of ChiRex, Clariant's $2bn acquisition of BTP, and DSM's $800m purchase of Catalytica.

There has been a modest decline, from 2.7 to 2.1, in median valuation measured by enterprise value as a multiple of sales between 2000 and 2001, for the transactions where information is available.

The role of contract researchers and manufacturers as providers of swing capacity suggests a volatile pattern of revenue and earnings growth. Indeed, the CROs and CMOs have recently published depressed financial results following a rash of merger and acquisition activity among their major customers, the integrated pharmaceutical companies. However, the long-term trend is for an increase in contract research and manufacturing activity as a result of the continued pressure of patent expiration and declining exclusivity periods. The following factors are positives for the industry:

However, as seen during the recent period of weakness in earnings and revenue, the outsourcing industry is not experiencing a straight line growth.

The following challenges exist:

After two years of decline, outsourcing appears to be re-emerging. In a November 2000 survey conducted by the Pharmaceutical Outsourcing Management Association, 90% of the respondents indicated that outsourcing was up year on year and expected the trend to continue in 2001 over 2000.

Despite the fact that the fundamentals have not yet fully recovered, the stocks have risen sharply over the past year, with p/e's rivalling the prior peaks seen in 1997-98. Although stock prices usually anticipate earnings, there is a risk that they are a bit ahead of themselves in this cycle.

growth rates down

The median annual growth rates are down significantly for both groups; CROs are a higher growth segment of the outsourcing industry. Both CROs and CMOs have seen a recovery in valuation from May 2000 to July 2001; both segments now trade at a market capitalisation to sales ratio of x1.6.

It is significant that the valuation of CROs, with their higher growth rate, was lower when the outlook was bleak (at x0.8) as opposed to the CMOs valuation of x1.3, reflecting the higher volatility of this segment of the industry.

Long term, the fundamentals of the pharmaceutical industry favour the growth of CROs and CMOs. However, the outsourcers may exhibit high volatility, making timing a key decision for the investor or prospective industry entrant.