Jim Miller

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.

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.

IMPLICATIONS

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.

Operating performance

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.

CONSOLIDATION

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 industry.

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.

CHALLENGES AHEAD

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, info@pharmsource.com
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