Could the European debt crisis be the event that consolidates the dose CMO industry? That thought might seem like a stretch,
but the financial turmoil roiling Europe could definitely have a big impact on the CMO industry.
Much of the media coverage of Europe's debt crisis has focused on the ability of governments in the so-called PIIGS countries—Portugal,
Ireland, Italy, Greece, and Spain—to repay or refinance their national debt. It is much more than that, however.
The European debt crisis is potentially a banking crisis as well because the banks hold much of the sovereign debt. If the
PIIGS were to default, the banks would be forced to write down the value of their bond holdings, and the resulting losses
would reduce their equity and the capital ratios that they must maintain under international and national regulations. That
scenario would force the banks to raise more capital and/or reduce their lending to bring assets back in line with their capital.
The reduced lending would be felt throughout Europe because the affected institutions, especially the big trans-European banks,
such as Deutsche Bank, are major lenders throughout the Euro zone.
Another concern is that government austerity programs, combined with reduced bank lending, will severely weaken the already
fragile economies of the PIIGS countries. Those economies are already a mess, plagued with low demand, high unemployment,
and low tax revenues. Lower government spending, tighter private-sector credit, and higher interest rates will further suppress
overall economic activity and household incomes in the coming years.
In fact, the bank pullback already is under way. Recent reports in the financial press (as of the writing of this article
in early August) indicate that the European banks are reducing their private-sector lending in the PIIGS countries in an effort
to reduce their exposure to the weakening economies.
The deteriorating European financial situation will play out to the detriment of European CMOs in two principal ways: undermining
their operating performance and affecting the availability and cost of debt needed to finance their businesses.
The deterioration of the operating performance already is occurring because expenditures on drugs are falling sharply through
reduced volumes and lower prices. These lower volumes and prices are especially apparent in countries where the national healthcare
systems are a primary buyer and distributor of drugs and therefore affected more by reduced government revenues and spending.
The deteriorating economies also will impact privately financed spending on drugs.
CMOs are feeling the effect of reduced spending on drugs through lower production and demand from clients for lower prices.
Furthermore, many European CMOs also are generic-drug manufacturers that use their excess capacity for contract manufacturing.
The reduced spending also is taking a toll on their generic-drug business.
Even before the financial crisis, many European CMOs and generic-drug companies were plagued by low utilization and narrow
profit margins. Further deterioration of operating profitability has a range of deleterious implications for the CMOs, ranging
from deferred maintenance and capital investment, all the way to receivership. Any sustained deterioration in operating profitability
will reduce the credit worthiness of CMOs and threaten their access to bank credit.
Availability of financing
The availability and cost of bank credit could impact a number of CMOs, including those that are owned by private-equity companies.
Private-equity firms typically use the debt capacity of the companies they own to reduce the amount of equity they have invested
in the companies and even as a means of generating cash that they pay to themselves as a dividend. In the case of European
CMOs, even though the owners in most cases didn't pay much or anything for their facilities, the owners could have borrowed
against their assets and they could be highly leveraged. Even where companies don't depend on debt for financing assets, any
deterioration of operating performance could affect CMOs' ability to get lines of credit for basic operating needs.
The financial crisis will hurt the CMO industry by making it more difficult for their clients to get external financing. Financial
crises always make investors more risk averse, and investing in new drug development is inherently risky. Europe has always
been a difficult place for early-stage companies to raise venture capital, and the deteriorating economic situation is likely
to make it worse.
The financial crisis is hitting the European CMO sector at a time when it is already weak. According to the PharmSource ADVANTAGE
database, Europe has nearly twice as many contract dose manufacturers as North America, including 100 solid dose CMOs and
70 injectables CMOs. Only about one-third of these CMOs are FDA-registered, meaning most of them are limited to competing
for business to supply European or emerging markets. As a result, competition for the available business already is intense,
thereby pushing pricing and operating margins to barely sustainable levels.
The overcapacity problem has come about because it is so difficult to close redundant manufacturing facilities in Europe.
Faced with huge severance costs and negative publicity if they close a facility, global bio/pharmaceutical companies have
preferred to give away facilities to management teams and private-equity firms that are willing to run them as CMOs. That
approach gets rid of the headache for the pharmaceutical company, but it has created an unsustainable situation for the CMO
Under these dire circumstances, we believe that a number of CMOs face significant risk of insolvency in the near term. While
most of them are privately held companies that don't publish their financial statements, the situations where we can see
the financial results show very poor operating margins and minimal debt capacity. The precarious state of the European financial
system and the implications of that weakness may be enough to push some of those companies over the edge.
Bio/pharmaceutical companies that depend on European CMOs face a major due diligence challenge. They need to monitor their
European CMOs closely, gain a thorough understanding of their balance sheets and cash flows, and be aware of their exposure
to negative developments in the credit environment. For CMOs owned by larger entities, the oversight should extend to the
corporate parents as well. There are some major CMOs whose corporate parents have extensive interests in sectors outside pharmaceuticals
that are heavily exposed to the financial crisis, such as retailing and property development. Bio/pharmaceutical companies
also will need to have alternate sourcing plans in place in the event that financial developments interrupt product supply.
Jim Miller is president of PharmSource Information Services, Inc., and publisher of Bio/Pharmaceutical Outsourcing Report, tel. 703.383.4903,
fax 703.383.4905, email@example.com