January 19, 2009

Volume 87, Number 03

pp. 13-20

Custom Chemicals

Contract manufacturers look for ways to cope with economic challenges and changes at pharmaceutical customers

Ann M. Thayer

AFTER BEMOANING the slowing growth of the drug industry in recent years, custom chemical manufacturers are taking solace in having these companies as customers. Pharmaceuticals, they are finding, are a bright spot in the current economic maelstrom.

In 2008, while the Dow Jones Industrial Average dropped about 33%—and stock indexes for the chemical, financial, and automotive sectors fell 45%, 53%, and 70%, respectively—the pharmaceutical and biotechnology sector declined by 18%, a comparatively good performance.

Lanxess

MAKING THE BEST OF IT A Saltigo researcher optimizes pharmaceutical manufacturing processes at the company's Central Organics Pilot Plant.

"We used to think companies that were diversified and had legs in polymers, electronic chemicals, and pharmaceuticals were great because of the stability that the extra legs provided," says Jeffrey M. Evans, president of the consulting firm Rondaxe Pharma. "In this economy, the only strong leg seems to be pharmaceuticals."

Health care tends not to be cyclical. Consumers may tighten their discretionary spending, but they still need medical care. Even so, any stability is tenuous today, since economic upheaval is bringing changes on a nearly daily basis, industry participants point out.

In a late-2008 report, the market research firm IMS Health predicted that worldwide pharmaceutical sales will grow about 5% this year, just as sales did in 2008. Last year also brought an upturn in Food & Drug Administration approvals.

In 2008, the agency approved 26 new chemical and biological entities, such as protein-based drugs, compared with the 20-plus-year low of 18 approvals in 2007. IMS estimates that another 25–30 new drugs could reach the market this year.

Taken together, these numbers sound like they should translate into better business for custom chemical makers, but a look at the details shows substantial underlying challenges.

For example, most drug industry growth will come from emerging markets, such as China, India, and Brazil. Meanwhile, in the U.S., the world's largest market, growth will slow to just 1–2% per year. Potential U.S. health care policy changes by the new Administration are compounding uncertainties at a time when regulatory hurdles are already rising and making approvals less predictable.

Meanwhile, only four or five FDA approvals in 2009 could potentially be blockbusters, IMS says. The rest are likely to be small-volume niche products. And patents will expire in 2009 on major products with $24 billion in combined annual sales, followed by another $95 billion worth of expirations by 2012.

In recent years, the custom chemicals business has been good, and suppliers' plants have been fully subscribed, says James Bruno, director of the consulting firm Chemical & Pharmaceutical Solutions. During the first three quarters of 2008, many companies reported increased sales. "But most of the really smart companies are extremely concerned about how wonderful things are, because it is not going to continue," he adds.

Many custom chemical firms say they are banking on more outsourcing as big pharmaceutical companies move to more flexible business models. The London-based market research firm Business Insights says the $20.5 billion-per-year contract manufacturing market should continue to grow about 10% per year.

BUT EVEN IF outsourcing does rise, it won't necessarily offset declining productivity. "Drug development pipelines are weak," Bruno explains, despite the large numbers of compounds being pushed into early development.

Some custom chemical manufacturers are turning to making generic pharmaceutical chemicals, presumably as a buffer against declines in innovative products. "It just delays the inevitable," Bruno says, "because if there are no launched drugs, there will be no generics; what we see now on the innovator side, we'll eventually see in generics."

Bruno sees outsourcing as cyclical and believes the current upswing will eventually slow. But unlike in past cycles, it will be harder for drug producers to reverse direction because they have sold manufacturing assets. "The ability to bring the work back in is going to be extremely limited because for the first time they have given up production," he explains.

Even before the economic crisis, large drug firms were facing difficult times and taking actions that manifest as both threats and opportunities for custom manufacturing firms. Notably, many drug companies have been aggressively cutting costs by selling or closing plants and refocusing their R&D efforts to prepare for lost sales and increased generics competition.

"Virtually all are rationalizing their assets and their core activities," says Wolfgang Schmitz, managing director of Saltigo, the custom chemicals arm of Germany's Lanxess. "For some, this will mean drastic reductions in manufacturing capacities supplemented by even higher levels of outsourcing. For others, we expect some refocus on filling internal capacities while they review their business strategies."

Saltigo's response is to tailor its service offerings to the specific needs of each customer, Schmitz says. Last year, it expanded current Good Manufacturing Practice (cGMP)-compliant production capacity in Leverkusen, Germany, and at its new U.S. site in Seattle. Business was stable in 2008, and both additions are already being utilized, proof that the investments were warranted, he adds.

"We are optimistic that this trend will continue, but we need to be conservative in our growth plans since nobody knows how much the pharma industry will be affected by the crisis," Schmitz says. "At the moment, it's hard to predict the impact on our business." Saltigo is currently upgrading several plants to increase the versatility of its multipurpose equipment and to enhance capacity.

Aslam Malik, president of Ampac Fine Chemicals (AFC), takes a similar view of the dynamics at pharmaceutical customers.

"They are going through a lot of cost reduction and freezing projects," he says. "The question becomes how can we support our customers in tough times?" One way is cost reduction through continuous improvement efforts, he notes.

AFC had a good fiscal 2008, which ended in September, with revenues rising 19% to $124 million. Operating income was essentially flat, however, because of changes in its product mix and some delays in starting up a new process. This year, revenues are expected to drop about 10% because a major customer has reduced orders for an antiviral product by 85% while it absorbs existing inventory.

Longer term, Malik sees growth continuing. "We have been making very focused and targeted investments and looking at some strategic acquisitions to grow the business," he says. AFC added a plant to manufacture customer drugs in late Phase II and Phase III development, as well as smaller kilogram-scale facilities to support Phase I and early Phase II projects. "We now have the additional capabilities to go from Phase I to commercialization," he says.

DIVERSIFIED CAPABILITIES allow suppliers to go after a broad array of different-sized customers with products in different stages. Large drugmakers may intend to outsource more, but growth for custom chemical firms recently has come more from small, emerging, and virtual drug companies. Lacking infrastructure, these firms often look for partners to help advance their products.

The economic situation, however, has been hitting small companies hard. Large companies may be spending cautiously, but at least they are financially stable and have cash, which many have been using to strike licensing deals with small firms. Rondaxe's Evans calls it a buyer's market.

Meanwhile, small firms are finding equity funding hard to come by (see page 32). "Most small companies seem to be consolidating their spending to focus on one or a few clinical development programs that are most likely to succeed," Evans says. "It's scary, because if any one company could pick a successful program, it wouldn't be called research.

"These emerging companies are doing everything in their power and are not afraid to spend money, but they are putting it all in one place," Evans continues. "We really need a large proportion of these companies to be successful in their choices; otherwise, we are going to have a boomerang effect toward the end of next year with companies in trouble."

For custom chemical providers, this refocusing is translating into fewer, delayed, or cancelled projects, particularly in early-stage development. "Many emerging companies are revising their forecasts quite often and being more critical overall in their ambitions for growth," says Luca Mantovani, president of DSM Pharma Chemicals.

In response, the DSM business is intensifying its customer focus, investing in technology innovation, and increasing efficiency. "We will be able to cope with this challenging time and maintain our level of return, which has been good so far," Mantovani says. DSM announced corporate-level cuts in December to address economic conditions and, at the time, left better-performing life sciences operations untouched.

The spate of contaminated pharmaceuticals and other products coming from China in recent years has heightened the need for supply-chain security, and that has had positive effects for some companies. "I have seen some drug companies with tight budgets choosing to spend top dollar in the U.S. and Europe versus lower cost regions of the world in favor of supply-chain security," Evans says. And small companies betting on a single product may tolerate less risk than larger ones with established products.

To balance customer desires for low-cost sourcing and high quality, Schmitz says, Saltigo addresses risk tolerance for each one individually. "We work to jointly decide on the sourcing strategy and to jointly control the supply chain," he says. "This allows them to balance their budget expectations while addressing the requirement for quality."

Managers at Sigma-Aldrich's SAFC unit say their business has benefited from a "flight to quality" for more secure manufacturing. At the same time, Sigma-Aldrich executive Frank Wicks acknowledges that "the Asia-Pacific and India markets are opportunities" for the company. Wicks recently replaced Gilles Cottier as head of Sigma-Aldrich's Research Essentials business, and Cottier has assumed Wicks's role as head of SAFC.

Although the value gap between East and West is narrowing—because of rising costs and increased inspections and regulatory scrutiny in Asia—many custom chemical firms are buying or building their own operations in Asia. SAFC, for example, is building a plant in China so it can supply local customers and give those outside the region a trusted partner there, Wicks explains.

In 2008, Hovione purchased 75% of the Chinese firm Hisyn Pharmaceutical, which had been its supplier since 2005 and will now produce contrast agents that had been made in Portugal. "We needed to find a place that could cope with large capacity and could be competitive for some time to come," Hovione Chief Executive Officer Guy Villax says. "We also want to learn how to operate inside China. Although we've been in Macau for almost 30 years, we realize that China is China and Macau is Macau."

Villax says he's not surprised that customers are concerned about quality and are asking vendors for assurances. "It's a huge issue, and I think everyone is coming to the realization that when you apply too much competitive pressure, there are big risks," he says. "China will remain a very important manufacturer to the world, but you really need the people and resources to have appropriate oversight."

Similarly, Jay Vyas, managing director of India's Dishman Pharmaceuticals & Chemicals, is striving for a balance between East and West. "India will play a crucial role in outsourcing, so we see tremendous opportunity," he says. The combination of Dishman and Switzerland's Carbogen Amcis, which Dishman acquired in 2005, "can offer the best risk-mitigation solution and cost effectiveness," he adds.

IN TODAY'S ECONOMY, Vyas believes the biggest slowdown will come in discretionary "lifestyle" drugs rather than in essential therapeutics, such as anticancer agents, where his company's business is focused. Still, Carbogen is seeing some slackness at smaller customers. On the plus side, "although the number of requests has gone down, our actual hit rate has gone up," Commercial Director Rhona McIntyre says.

She believes customers are looking for suppliers with track records, demonstrated value, and a range of technologies. In keeping with its main focus, Carbogen is investing $25 million in a high-potency drug facility in Bavla, India, that will open midyear. Cytotoxic and other potent drugs are considered an attractive growing niche. SAFC, for example, invested $75 million in 2008 to expand its high-potency capabilities.

"Obviously, there are other players, but not very many who will operate at the scale we will offer," McIntyre says. She also calls Carbogen's combination of lower cost operations in India with development and scale-up expertise in Switzerland "a fairly unique offering."

Carbogen is on track to reach its sales targets for the fiscal year ending in March, says Managing Director Gaudenz von Capeller, who expects any decline in Phase I and II projects to be compensated for by later stage and commercial products. "We also have the first orders on the table for the new facility in Bavla," he adds. The company is looking at acquisitions, possibly in formulation or finishing of high-potency drugs into their final-product forms.

"Our strategy is to continuously invest in new capabilities and technologies to meet more challenging customer requirements," von Capeller says. The company has a technology team that has been working to advance new capabilities such as large-scale chromatography and crystallization services.

Other custom chemical firms have similar competitive strategies, especially around technology innovation. "We look at ways to innovate in terms of processes but also in order to provide better service," DSM's Mantovani says. A recent example is the development and scale-up of a cGMP-compliant continuous microreactor to handle a hazardous nitration for a customer's compound.

Likewise, Malik says AFC has made a push into continuous cGMP processes, and SAFC is adding continuous-process technology in Buch, Switzerland.

Along with operating advantages, continuous processes are supported by the regulatory bodies, Mantovani says. "They can be much more standardized and therefore offer advantages in terms of validation and follow-up on quality," he adds. "I think this will open up tremendous opportunities in the pharma chemicals industry."

When it comes to technical capabilities, Hovione's Villax espouses flexibility. "You need to listen to customer needs and to be early adopters of technologies, but at the end of the day, if what you do is make active pharmaceutical ingredients, what you really need to be is a generalist," he says. "You need to be able to do whatever it takes. If we don't know it, we learn. If we don't have it, we invest."

Villax says he is seeing an "almighty thirst" for analytical results. "The most significant bottleneck is analytical chemistry," he says, because customers are requesting more and better information to provide to regulators. "We now have more analytical chemists than chemists in R&D," he adds.

ALONG THESE LINES, Villax continues, having expertise in areas such as process analytical chemistry can be a "significant differentiating opportunity. FDA is eager for people to do this, and at this moment, very few know how."

In its fiscal year that ended in March 2008, Hovione saw its revenues exceed $100 million for the first time. Just last month, it bought Pfizer's Loughbeg active pharmaceutical ingredient plant in Ireland. For the next fiscal year, Villax anticipates about 10% growth coming from across the company.

Along with technology and cost advantages, another competitive strategy is offering a broad base of services that can be used by a variety of customers (see page 22). Companies such as Albany Molecular Research Inc., Aptuit, and others with such diversified operations are reporting good revenue growth, even in current market conditions, but they, too, are cautious about making predictions.

"It is going to be tough, at least in the first two quarters," says Frank J. Wright, Aptuit's vice chair. Because of Aptuit's large customer base, he believes it can fare better than niche or specialist providers. "Our clients are in so many different parts of our organization that it is difficult to see business drop off the edge of a cliff the way I think we will see for some niche providers," he says.

But Aptuit and other full-service providers won't be immune to the general economic squeeze. For example, some delays are arising as major pharmaceutical companies await the outcome of their reorganizations before committing to clinical programs, Wright says.

There are mixed views on what will happen if or when funding again becomes available to small drug companies. Some custom chemical executives point out that in previous funding droughts, biopharmaceutical firms were the first to experience a softening but also the first to rebound. Seeing these constraints as temporary, many anticipate that pent-up demand will mean a flood of projects once funding woes ease.

Rondaxe's Evans is less optimistic. "In difficult times, the cream is going to be forced to rise to the top and we are going to see other programs just go away," he says. "Programs that shouldn't be funded are not going to come back." Still, he does believe that sizeable amounts of cash are sitting on the sidelines waiting to flow into the drug industry when confidence returns.

In today's climate, many custom chemical manufacturers are emphasizing their own financial stability since expectations are that some companies won't survive. Growth in 2009 is expected to continue but not rival previous years, suppliers say, especially because it's unclear how long the downturn will last.

For example, SAFC's pharma segment experienced double-digit growth for about four years, but that growth slowed in 2008, Wicks says. Still, over the five years, SAFC has grown from being a $200 million bulk chemicals provider to a fine chemicals business with annual sales approaching $700 million. Much of its growth has come from specialized niche technologies such as high-potency manufacturing and solid-state chemistry.

Looking ahead, Cottier says, "we want to continue to grow even in this tough environment and are going to consolidate our position among the top 10 players in the fine chemicals market."

Despite the growth and changes individual companies have undergone, the highly fragmented custom chemicals market still suffers from many old ailments, such as overcapacity and a lack of capability differentiation, Bruno says.

Nevertheless, Bruno says he's "fairly confident" that 2009 will be a good year, but he has questions about 2010. "If we don't get this credit situation resolved soon, all of the drugs that we planned on making in 2009 may slip into 2010," he says. "But that could be a blessing because instead of having a really great 2009, maybe we'll have just a good 2009 and a good 2010."

Chemical & Engineering News

ISSN 0009-2347

Copyright © 2009 American Chemical Society

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