Big Pharma Divests Plants
In the 1990’s, big pharma began the process of selling off their large plants to entrepreneurial companies called Contract Development and Manufacturing Organizations, or, “CDMO’s.”
It’s big pharma’s euphemism for “subcontractors.”
At first glance, it makes sense for big pharma industry players to jettison the plants that produce their products. Why? It forces global competition as the former cost center now becomes a subcontractor, one whose contract eventually terms out, and they likely will have to earn the business back or run the risk of losing it to a lower cost provider.
Further, big pharma historically had tied up significant capital dollars and expended a fortune in operational budgets to own and maintain the plants, eventually figuring out it could redeploy those resources to bring more products to market more quickly, focus on developing a diverse portfolio of niche products to support the blurred lines market of pharma, OTC, nutraceuticals and new products popping up to support a fragmented marketplace, and one needed to drive revenues to replace the large streams from proprietary blockbuster drugs rolling off patent and becoming generics at Walmart and Target.
A Challenging Transition
The transition to get former legacy-owned plants to independence and profitability has been a challenging one, and, like most industries that have been through deregulation, or whose largest players have spun off or spun out assets, the devil is in the details, normally embodied in the fine print of the contracts the divestiture was “papered” with, such as an asset purchase agreement (or asset sale agreement), master services agreement, or transitional services agreement.
These documents provide the guidance and engagement parameters to establish what the relationship will be between the former owner of the plant (“legacy owner”) and the new owner of the plant, a CDMO. Other variations on the CDMO model are the CMO, or Contract Manufacturing Organization, and the CRO, the Contract Research Organization.
In any case, it’s usually the pharma company subcontracting out to a third party for services it once provided itself.
Legacy plants are overbuilt, inefficient assets that were run as cost centers of big pharma. After acquisition by a CDMO, they are magically supposed to be efficient, low cost production centers. This poses challenges from a number of perspectives, the capital itself (buildings, facilities, equipment, machinery) and the workforce.
Quality Must Remain the Focus
Many pharma contracts have moved away from the normal locations where medicines, drugs and OTC products are made: mainland US, Puerto Rico, Europe, Canada, Japan, e.g., to China and India where production costs are much lower but regardless of production sourcing venue, low pricing often comes with tradeoffs - such as stability of supply and consistency of quality.
Quality remains the benchmark for the pharma industry, through “GMP” - Good Manufacturing Practice. GMP is a system for ensuring that products are consistently produced and controlled according to quality standards; in the US, Title 21 of the US Code of Federal Regulations breaks enforcement and regulation into three areas – Food and Drug Administration “Chapter I”, Drug Enforcement Administration and Office of National Drug Control Policy. Generally, “Title 21 Chapter I” is designed to minimize the risks involved in any food, drug, cosmetic production and protect patients and consumers. At the global level, developed countries have their own equivalent regulatory agencies and authorities. Current GMP, or cGMP, acknowledges that GMP is ensured through rigorous quality management systems, often a blend of human manual inspection and highly automated processes to ensure quality products.
The FDA ensures the quality of drug products by carefully monitoring drug manufacturers' compliance with its Current Good Manufacturing Practice (cGMP) regulations. The cGMP regulations for drugs contain minimum requirements for the methods, facilities, and controls used in manufacturing, processing, and packing of a drug product. The regulations make sure that a product is safe for use, and that it has the ingredients and strength it claims to have.
Some of those products which have had quality issues have once again been tech-transferred back to other suppliers, as the marketers of the drugs figured out that getting their products reliably, consistently produced at high quality, GMP level, is more important than an extremely low price. It’s the classic case of paying too little being more expensive than paying too much.
A CDMO planning to produce a new, or, transferred product must be subject to the approval process for new and generic drug marketing applications includes a review of the manufacturer's compliance with the cGMPs. FDA assessors and inspectors determine whether the firm has the necessary facilities, equipment, and ability to manufacture the drug it intends to market.
Workforce Dynamics
Transitioning the workforce culture from a bureaucratic pharmaceutical industry to an entrepreneurial “low-cost but high quality” nimble CDMO model poses many challenges. Pharma employees are highly compensated, and benefits are extremely generous, compared to most subcontracting businesses in other industries. With such high direct, indirect and SG&A labor cost input into the model, it becomes very difficult to be profitable as a true low-cost provider.
Pharma organizational structures and staffing models are robust – with high span of control duplication, further bolstered by regulatory requirements and the pharma mindset, which was to overbuild, overstaff and throw resources and people at problems and inefficiencies. The most profitable CDMO’s have embraced a culture shift, injecting the mindset with new methodologies, operational excellence, more laser-focused KPI’s, and flatter organizations, to cut cost, improve margins and ultimately lower the cost of drugs for their customers, the pharma companies, and the ultimate customers – patients.
Workforce culture can be a major stumbling block for companies looking to make the transition from former big pharma cost center, or a purpose-built production facility dedicated to a single blockbuster drug, to a nimble, flexible low-cost provider. These two realities exist in conflict.
Getting a long-term employee who’s never felt career risk or who has never been asked to double or triple their productivity over a period of time to embrace change remains a challenge.
The pharma industry is full of bright, highly trained, dedicated employees, many of whom have worked within rigid organizational cultures for many years, and now they are being asked to change, adapt, and sacrifice. That can be difficult for them.
Compounding Factors
A compounding (pardon the pun) factor which creates the need for greater organizational intensity is that the pharma products marketplace has changed – the product array has become more specialized, niche-based, for a mix of traditionally volume-intensive products such as OSD (oral solid dose), SFF (sterile fill and finish), e.g.
Both large pharma companies divesting the plants, and many of the CDMO startups which have acquired them, have found out that the typical two or three year transitional services agreement – a window of time that the acquirer presumes it can drive new business to the plant – is simply not enough time to transition the business.
Professionals on both sides of the arrangement – the supply chain and procurement people at pharma companies, and the people now working for the CDMO which was once a pharma cost center – agree that the time it takes to stabilize the spun off plant with enough diversified commercial business to produce net income and EBITDA – the main profitability KPI for CDMO’s – is more like six, seven, or eight years.
Boomerang Risk
There have been numerous scenarios in the pharma space where fledgling sites have either been fully returned to the former legacy pharma owners, in a “boomerang” scenario, or “fullback” or the sites have been sold to another suitor, or the former legacy owner and CDMO create a tighter working partnership to ensure site sustainability.
Many CDMO’s have found that the deals they thought were excellent – such as acquiring sites for $1 – aren’t that spectacular when the plants cost a small fortune to run. The quality of pharma assets is extremely high as glittering equipment made from stainless steel abounds in large spotless plants, the size of which appears deceptively intimate as the plants are generally built with smaller production rooms, specialty suites, and dedicated areas and equipment to segregate materials, workers, processes, finished goods, e.g. from other areas of operation.
Infrastructure Management
One area which CDMO’s must endeavor to reduce cost and footprint on is energy – and both energy costs and supply reliability fluctuate wildly throughout the world. Management in pharma plants have many blind spots, not the least of which is energy cost as a production input. Many of the plants sold to CDMO’s in the last decade have energy and production equipment from the 1970’s and 1980’s, for which replacement parts are scarce and operating efficiency is low.
Without proper CAPEX to sustain the plants, they run the risk of breakdown or supply interruption because while the hallways may be sparkling, too little attention has been paid to “what if” or “wargaming” scenarios when a $27 million production line producing a much needed medicine shuts down because someone didn’t have the $150 replacement part ready on the shelf, or the supply chain itself did a poor job of contingency planning.
Integration challenges abound when a unit is acquired by a CDMO, such as consistency of IT platforms (ERP and other systems are robust, but expensive to modify, integrate, e.g.) and of course titles, salaries, benefits, protocols, procedures, all vary tremendously. Whether the legacy culture was Merck, Pfizer, Novartis, Abbott, AbbVie, Johnson & Johnson, Roche, Bayer, AstraZeneca, GlaxoSmithKline, e.g. these companies all have their own ways of doing things, and all of them well conceived, but they are varied. After a CDMO acquisition is made, it’s still difficult to create a fluid organization and (to quote Jim Collins in Good to Great) move “the right people to the right seats on the right bus,” especially if the acquisition parameters have boxed the acquiring CDMO in on the ability to run their enterprise with flexibility, lower cost, and profit motive in mind. These all become threatened when Pete can’t be laid off for two years, Sally can’t have her title changed, and BigPharmaco frowns on headcount changes even though it doesn’t own the plant or the employees anymore.
In any industry, a poorly crafted deal without equal sacrifice, equal opportunity and a clear, sustainable path forward becomes a very bitter pill to swallow; however, a jointly crafted, fair, flexible, longer term arrangement which places patient needs, sustainability of supply and product quality above a hastily conceived divestiture/acquisition to get a plant off the books, (or on the books in the case of the acquiring CDMO), is most important to ensure future success.
And meanwhile, the CDMO industry will likely continue to consolidate, creating both competitive intensity and opportunity, and hopefully greater focus on sustainability as patients rely on the industry for lifesaving and life-enhancing medicines.
As CEO, Paul Fioravanti recently spearheaded the turnaround of Avara Pharmaceutical. See his websites at qadentmanagement.com and qadentceo.com
Copyright 2019 Qadent Management Services, LLC and/or Paul Fioravanti, MBA, MPA, All Rights Reserved.