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Volume 86 Issue 4 | pp. 31-36
Issue Date: January 28, 2008

Cover Stories: Entering The Tiger Cage

Optimism Prevails In Fine Chemicals

Signs point to a brighter business outlook, but the glass could be half empty for some custom chemicals firms
Department: Business
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Credit: gettyimages
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Credit: gettyimages

JUST ONE YEAR AGO, a survey of attendees at the annual Informex custom chemicals trade show, then in San Francisco, found that 63% of people involved with fine and custom chemicals thought industry sales would grow 5-10%, and another 7% expected to see increases of 20% or more. Overall, 59% of those surveyed characterized business conditions as good, and 70% believed business would improve in 2007.

That optimism, which started in 2006, built in 2007. It was evident at industry trade shows, in company presentations, and in conversations with executives. To see whether the bright outlook is warranted and whether competitive forces could curb it in 2008, C&EN talked with industry executives and pundits about recent trends.

The Synthetic Organic Chemical Manufacturers Association (SOCMA) releases its fourth annual business outlook survey this week at Informex in New Orleans. The survey, answered in late 2007 by 35% of the association's nearly 300 members, again found executives optimistic.

"In general, at least through the end of 2007, people felt that the state of industry is pretty good," says SOCMA President Joseph G. Acker. "It will be interesting to see whether or not that will change through the first three to six months of this year." Factors that might influence opinions include the U.S. presidential elections, energy prices, emerging competition, and the state of the U.S. and world economies.

"There seems to be a trend toward better profitability levels," says industry consultant Jan Ramakers, whose U.K.-based Jan Ramakers Fine Chemicals Consulting Group tracks company data. Through the first half of 2007, just over 70% of the top producers of life sciences intermediates reported operating profits as a percentage of sales of 10% or more. In the industry's worst years, such as 2003, only about 30% fared that well, and nearly half had operating profit percentages of less than 5%.

Company results for all of 2007 are not yet in, Ramakers cautions, and they still could be affected by rising energy prices, fluctuating currency exchange rates, and other economic factors. Although most fine chemicals producers are not based in the U.S., many of their customers are, and a weakening dollar hurts the profitability of those producers that sell in dollars but incur costs in euros or other stronger currencies.

"The big unknown is whether customers in the U.S. are going to allow for price adjustments or whether they will apply leverage," says Enrico T. Polastro, vice president and senior industry specialist with Arthur D. Little Benelux.

Competition
Emerging market suppliers are taking bigger chunks of business
Credit: NOTE: Percentage of a SOCMA member's market estimated to be held by suppliers in India, China, Eastern Europe, and Latin America. a Estimate. SOURCE: SOCMA survey data
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Competition
Emerging market suppliers are taking bigger chunks of business
Credit: NOTE: Percentage of a SOCMA member's market estimated to be held by suppliers in India, China, Eastern Europe, and Latin America. a Estimate. SOURCE: SOCMA survey data

ON THE PLUS SIDE, most companies reported higher sales in the first half of 2007 compared with first-half 2006, Ramakers says. He anticipates further modest growth for the fine chemicals industry. The world fine chemicals market has grown from about $56 billion in 1999 to about $80 billion in 2006. Almost all of that growth came from pharmaceuticals, which accounts for about two-thirds of the market, rather than agrochemicals and other uses.

Results of the SOCMA survey, which the organization shared in advance with C&EN, are even more upbeat. It finds that 88% of responders expect their sales to increase in 2008. Of those, 39% envision growth of 10-20%, and 30% foresee growth of more than 20%.

"Everyone is saying 2007 was a really great year and is expecting 2008 to be great as well," says James Bruno, director of the New Jersey-based consulting firm Chemical & Pharmaceutical Solutions. But he and other analysts say the effects of some one-time events, such as high demand for Roche's antiviral drug Tamiflu, can't be ignored. In early 2006, the pharmaceutical company hired about 15 firms to help it make more of the drug.

"Tamiflu put a lot of people into production, but all that material is now in stock, and it will take a while to use it up," Bruno says. Although many companies benefited in the short term, their long-term prognosis is in question. "Some of the companies that made Tamiflu and the intermediates gave up other business; some of that will come back and some of it won't," Bruno says.

One reason business may not return is the pharmaceutical industry's poor record of research productivity. Only about 20 to 25 new products get approved each year, which simply means there's not much new business to go around, consultants point out. The number of compounds in development remains high; the problem is that relatively few become commercial drugs.

"If you look at what's in the pipeline, over 50% are anticancer drugs," Bruno remarks. "But those tend to be small volumes and require specialized equipment, and not everybody has that. So who is going to make those drugs?" The best positioned custom chemicals manufacturers are those able to handle the complexity of cancer drugs and other new compounds that require a lot more chemistry input.

Bruno also points out that more than 50% of the new drug pipeline are biological entities. "Although there are a couple good players in biologicals, capacity is limited, and we're going to need to be able to improve upon that quickly," he says. "It's going to require making investments, and you need capital to do that." He suggests companies should commit to compounds in their earliest phases of development as a way to bank on their futures.

Capacity utilization at pharmaceutical fine chemicals plants is notoriously difficult to define because products are made in widely varying batch sizes and producers continually switch products. Some companies operating in specialized niche areas, such as high-containment and energetic chemistry, are seeing strong demand for their services and have been increasing capacity. But general multipurpose capabilities are oversupplied, consultants say, especially as low-cost sources from Asia expand.

Meanwhile, the industry's main customers are undergoing radical changes, some of which play into capacity issues. Although the global pharmaceutical industry is still expanding, sales growth is expected to slow to 5-6% in 2008. Responding to pressure from investors, all top 12 global drug companies have announced manufacturing restructuring programs, of which 11 specifically mentioned plant closures, says Peter Pollak, a consultant based in Switzerland.

"This is indicative of a paradigm change within the pharmaceutical industry," Pollak says. "Captive manufacture of active pharmaceutical ingredients (APIs) is no longer considered a core competency, and outsourcing is evolving from an opportunistic to a standard approach." Prospects for more outsourcing have been reverberating throughout the custom chemicals industry. In SOCMA's survey, 80% of respondents expect to see more outsourcing, compared with 70% the year before, Acker points out.

IN PRINCIPLE, outsourcing is good, but with caveats, Ramakers says. "Part of the captive market is going to be brought outside to the merchant area, but that in itself doesn't increase the overall size of the market, it only increases the size of the accessible market for third-party manufacturers."

Ramakers expects that drug companies will try to sell the facilities that are associated with the outsourced products. Doing so wouldn't do anything to improve the capacity situation. "If they were to shut down the capacity, there would be a higher utilization rate overall," he explains. And Bruno points out that although it may be easy to close plants in the U.S., labor laws make it hard to do so in Europe.

Meanwhile, according to SOCMA's survey of custom chemicals companies, only 16% of responders indicate that there is any likelihood they'll reduce capacity, whereas just over half are actually likely to invest in more equipment. Even though no one is in the mood to close capacity, one potential benefit Ramakers sees in a fine chemicals maker acquiring pharmaceutical company assets is that they might be put to more flexible use for making a wider variety of products.

Such transactions are already happening, often to new market entrants. PRWT Services recently acquired Merck & Co.'s Cherokee API facility in Riverside, Pa., and got a five-year supply agreement with Merck worth $100 million to $200 million per year. And Canadian firm Keata Pharma is purchasing a Pfizer facility in Ontario and will get a three-year supply deal.

Another point consultants make is that the rising tide of outsourcing may not float all boats. "Things may look better going forward, but it may end up being for the privileged few," Bruno cautions. Most drug companies have a handful of preferred suppliers with which they do the majority of their business. "So maybe they will outsource, but not to the whole world, because as much as can go goes to those suppliers first."

Drug companies mindful of costs might also take a closer look at low-cost Asian suppliers on the other end of the value spectrum. Although the SOCMA survey shows that companies see competitors from Asia and elsewhere taking a larger percentage of their market, 75% say the product quality is not as good as that from established market suppliers, compared with 60% who felt that way last year.

Profitability
After a trough in 2003, industry performance has rebounded to near levels last seen in 2000
Credit: NOTE: Operating profits as a percentage of sales. SOURCE: Jan Ramakers
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Profitability
After a trough in 2003, industry performance has rebounded to near levels last seen in 2000
Credit: NOTE: Operating profits as a percentage of sales. SOURCE: Jan Ramakers

China's environmental and product quality problems are causing a backlash that may play favorably into the hands of Western companies accustomed to meeting higher standards. Moreover, fixing these problems is not cheap. "There have been price surges for some pharmaceutical intermediates, and China appears to be rapidly losing its cost competitiveness," Polastro notes. At the same time, European and U.S. firms are horizontally integrating by adding Asian operations or partners (see page 19).

Nevertheless, an increasing number of Asian companies, particularly in India, are becoming major players in the custom chemicals market. Among these are Nicholas Piramal India Ltd., Dishman Pharmaceuticals & Chemicals, and Shasun Chemicals & Drugs, all of which acquired Western assets and customer bases. Others, such as Hikal and Divi's Laboratories, have grown substantially without the benefit of any acquisition.

"The pieces are starting to get in place as they try to enhance their capabilities in the eyes of Western customers," Polastro says about the Indian acquirers. "Now they have to prove whether this is going to work or not. The challenge will be whether they are able to generate additional business to sustain these facilities and replace the legacy business." Polastro and other consultants say that it's still too early to reach a conclusion.

Indian firms are not alone in furthering industry consolidation. In 2007, PPG Industries exited fine chemicals by selling its business to Zambon, Aptuit purchased Evotec's chemical development business, and Rockwood Holdings sold Novasep to other investors. Novasep then bought PharmaChem Technologies.

Consolidation generally is viewed as a good thing. "Certainly one of the problems is that there are too many players in the field and fragmentation is bad in terms of profitability," Polastro says. "But this isn't an industry where there is a massive scope for economies of scale. Larger does not necessarily mean better." Companies such as Honeywell, Clariant, and Rhodia have tried to build larger businesses, only to discard them later, he points out.

DURING 2007, instead of acquiring businesses, many companies made selected investments in new technology or production capacity to meet customer needs. "I'm heartened by an uptrend in R&D spending," SOCMA's Acker says, referring to the survey, because of what it implies about companies targeting profit growth with new product development and process improvements rather than by cost cutting.

Outside investors brought in by Excelsyn in 2007 will help it expand, and Cambridge Major Laboratories sold a majority interest in itself to the private equity fund Arlington Capital Partners. Subsequently, Cambridge Major Laboratories was able to acquire ChemShop, a Dutch supplier of API R&D services, to gain a position in Europe.

Private equity investors have taken on an increasingly important role. SNPE, the French state-owned chemical company, sold Isochem in the U.S. to Buckingham Capital Partners. In 2006, TowerBrook Capital Partners bought much of Clariant's pharmaceutical fine chemicals business and renamed it Archimica.

Clariant then sold its custom manufacturing business to International Chemical Investors Group in 2007. ICIG already owned two former Cambrex businesses. Other private investors include 3i, which backs KemFine; Lloyd's Bank, a financer of Aesica Pharmaceuticals; Argos Soditic, which is behind Axyntis; and Arques Industries, a majority owner of RohnerChem.

Consultants have mixed views on these investments. Separating fine chemicals businesses from large corporations may create leaner, more entrepreneurial operations. "Sometimes the private equity investor is able to carve out a business that has been neglected," Polastro says, and give it the freedom to perform better. But other times, any problems the business had may remain with the new owner and can't be fixed. In this case, he adds, "buying questionable assets at low prices is not necessarily good value."

In short, some mergers and acquisitions make sense and some don't. Those that do tend to involve good assets and the combination of complementary businesses. "A company has to have a good reason to do it, such as adding differentiating technology or gaining access to a marketplace, but not just to add sales," Bruno adds. "Unfortunately, I think a greater number of recent deals were not good acquisitions, and only a small number really had thought put into them."

To the benefit of companies trying to sell operations, and maybe the industry as a whole, private equity investors may be the only ones with enough cash to make deals. On the down side, these investors typically have a time horizon of five to seven years, after which they want to get a return on their investments. Consultants are concerned about how soon investors will want to cash out and what the impact will be when businesses are again on the block.

IN THE MEANTIME, Ramakers and other consultants believe merger and acquisition activity will continue. Interestingly, 80% of respondents to the SOCMA survey believe significant consolidation is very or somewhat likely to occur over the next three years, but only 42% consider it at all likely that they themselves will merge, acquire, or be acquired.

Where the acquisitions could take place is up for grabs. "I won't be surprised if more Indian companies buy European assets," Ramakers says. He also suggests the day may come when Chinese companies are in a position to do so as well. Just a few weeks ago, WuXi PharmaTech, a chemistry research services provider from China, paid about $140 million to buy Minnesota-based AppTec, which provides biology services.

In the past three years, the fine and custom chemicals industry has come out of a slump. More than half the responders in the SOCMA survey expect that any new business they land will last three to five years, and 29% see it continuing for six years or more. Although profitability has improved, it is not yet back to the high levels of the late 1990s, Ramakers remarks.

Consultants hope that companies have learned from mistakes of the past when, for example, they rapidly expanded capacity for compounds in development that were never approved or paid huge premiums to acquire businesses.

"A number of companies are actually giving serious consideration to what's going on and are looking beyond 2008 and 2009 to what will happen in 2010 and 2011," Bruno says. "They are starting to be a lot wiser and are formulating plans better." Nevertheless, he sees the future unfolding along a bell-shaped curve: Some companies will do well, many will just do okay, and some are going to disappear.

 
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