More Change for Contract Research

Last month, Woburn, Mass.-based ArQule announced that it is exiting the contract chemistry services business in order to focus on developing its oncology drug portfolio.

The decision by ArQule, one of the largest U.S.-based providers of chemistry services to pharmaceutical companies, speaks volumes about the state of the business today. An exciting growth market just five years ago, chemistry services is now highly competitive, thanks largely to an onslaught of new companies based in countries such as India, Russia, and China where salaries for chemists are much lower than in the U.S.

Big drug companies in particular are gravitating to these firms at the expense of their traditional U.S.- and Europe-based chemistry providers. In addition, low offshore prices-it costs roughly $60,000 a year to hire a full-time equivalent (FTE) chemist in China or India-are eroding profits in the U.S. From $250,000 for a Ph.D. FTE chemist just two or three years ago, U.S.-based firms today often can only charge $200,000 or less.

At the same time, firms like ArQule that started out as pure contract research organizations, or CROs, are increasingly morphing-through acquisitions or internal development-into hybrid companies that provide chemistry to big pharmaceutical makers while trying to develop their own new drugs.

ArQule's decision to exit the business outright is an anomaly, and other chemistry providers say they are committed to the business. Some U.S. firms are even hiring chemists and building labs. Yet most chemistry services executives acknowledge that the business they are in today is much different-and much more difficult-than it was just a few years ago.

For drug companies that use outside chemists, this dynamism is perfectly fine. It is an exciting time in the pharmaceutical and chemistry services businesses, says Steve Street, vice president for chemistry and worldwide discovery at Pfizer, the world's largest drug company and probably the world's largest buyer of chemistry services. It's a dynamic environment. We and others are reviewing our strategies, and most of our suppliers are doing so as well. The environment will continue to change this year and next year.

Street knows this firsthand, as Pfizer is ArQule's largest customer, accounting for almost 85% of the $49 million ArQule recorded in chemistry revenues last year. Neither Street nor ArQule is saying what will become of the service agreement following ArQule's announcement, although Street notes that Pfizer's contract with the smaller firm extends until 2008.

ArQule was one of four chemistry CROs that Pfizer turned to for its file enrichment project, a several hundred million dollar effort to bulk up the firm's library of compounds that are screened against drug targets. While file-enrichment-related contracts with ArQule and ChemBridge run until 2008, deals with Discovery Partners International (DPI) and Tripos are set to expire around the end of this year.

According to Street, the project has been a success, but it has run its course. We see our strategy moving away from enriching our file, he says. We feel we have done significant work in that area to give ourselves the best chance of getting attractive chemical hits. Now, we are successively responding to those attractive hits.

Some in the CRO community contend that Pfizer is using the contract expirations to shift some of its chemistry outsourcing offshore. Street won't comment specifically on his firm's mix of chemistry outsourcing or the direction in which it is heading, saying only that, as a global company, Pfizer has chemistry relationships across the globe.

Whatever the reason, the business loss will be difficult for firms that have bulked up over the past several years to work on the Pfizer contract. Tripos, for example, obtained 33% of its revenue from Pfizer in 2002, 52% in 2003, and 54% in 2004-most, although not all, from the file enrichment program.

San Diego-based DPI, likewise, is closely wedded to Pfizer, getting 53% of its 2004 revenue from the big drugmaker. Riccardo Pigliucci, the firm's chief executive officer, acknowledges that the Pfizer contract has been a good deal for his company, and he notes that it could be extended in some form or fashion.

At the same time, Pigliucci says compound library synthesis is a fairly basic chemistry task that increasingly is being commandeered by offshore companies that can operate at a lower cost than a U.S.-based firm. We got out of the generic library business two or three years ago, he says. It got commoditized, and it was the right choice.

Pigliucci also sees straightforward FTE contracts-in which drug companies pay for the services of researchers on a monthly or annual basis-as beginning to head offshore as well. As a result, DPI is forging ahead with a strategy to enter multitarget, multiyear collaborations to provide pharmaceutical companies with a stream of preclinical drug candidates.

We are moving to fully integrated drug discovery deals that link chemistry with biology with information technology, Pigliucci says. To spearhead the effort, he recently hired Michael C. Venuti, a Ph.D. chemist formerly with Axys Pharmaceuticals, as chief scientific officer. He is what you call a drug hunter, Pigliucci says.

In a further transformative step, DPI announced two weeks ago that it had sold its discovery systems business to a new company headed by John Lillig, DPI's former chief technology officer. The equipment-related units being sold, for $1.5 million, include the Irori chemical synthesis system, the Crystal Farm automated protein crystallization unit, and the Universal Store compound storage system.

A shift like DPI's, however, does not come without a price. Even before the Pfizer contract expires, the firm is seeing its revenue fall-to $18.4 million in the first half of 2005, down 26% from the same period last year. And Pigliucci acknowledges that the company might have to take painful actions to reduce expenses if the new business it is pursuing doesn't pan out.

Adesis, a newly constituted chemistry CRO in New Castle, Del., knows all too well about such actions. The company, formerly known as CB Research & Development, cut its staff almost in half about 18 months ago after an important contract with a large pharmaceutical company-unidentified, but thought to be Pfizer-was reduced.

Susan Baylis-Powell, director of operations at Adesis, won't disclose specifics of the loss, but she acknowledges that it was disconcerting. From a peak of about 40 employees, the company saw its staff fall to below 25.

At the time of the contract reduction, CB Research was also experiencing heightened competition from offshore chemistry providers. A typical job for the company was the synthesis of compounds in quantities of hundreds of grams. Baylis-Powell and Andrew Cottone, vice president of chemistry and now co-owner of Adesis, watched in alarm as some big drug companies started holding reverse Internet auctions in which multiple chemistry providers-many of them based overseas-would place lower and lower bids to make such compounds.

CB Research founder Charles Beard realized that his company needed to revamp its business model if it was to survive in this new environment. He turned to Ving J. Lee, a chemist and West Coast biotechnology executive who had been a technical consultant to CB since 1999 and a board member since 2004. Lee helped lead the revamp process starting in mid-2004, first as chief scientific officer and then, in December, as CEO/CSO. Lee is now a co-owner of Adesis following the sale and renaming of the firm last month.

Like Venuti, the new CSO at DPI, Lee had worked for drug companies and felt he knew what they were looking for in an outsourcing partner. He challenged Adesis chemists to be versed in early-stage discovery, medicinal chemistry, and hit-to-lead projects, in addition to the scale-up chemistry for which the company was known.

Today, Lee says, Adesis' business is on the rebound. It employs more than 30 people, 85% of whom are Ph.D. chemists. Rather than two or three big companies accounting for 80% of its sales, big companies are now just 20% of Adesis' business, with the balance coming from multiple small and virtual biotechnology companies.

Lee wants to provide these companies with customer service and speed they can't get from an offshore chemistry provider. Our major focus is quick turnaround with rapid decision-making, he says. Every week can be an eternity, and even life or death, for a virtual company. And rather than just synthesizing compounds, he says Adesis scientists can facilitate decision-making for customers and influence the direction of drug discovery projects.

Other chemistry service executives point out that, unlike a Pfizer or a Merck, small drug companies typically don't have the resources to manage a relationship with an offshore company. Robert K. Maddox, president of the chemistry services company PharmaCore, knows this firsthand because his small North Carolina-based firm has contracted with two chemists in India to make bulk intermediates for its compound catalog business.

Although the arrangement is ultimately cost-effective, it is also resource intensive. One of our Indian chemists in the U.S. spends one or two hours every day managing that relationship, Maddox says. He figures this phenomena stems from the fact that a typical Indian CRO employs several non-Ph.D. chemists for every Ph.D. At PharmaCore, in contrast, 21 out of its 24 chemists have Ph.D.s, according to Maddox.

David Zembower, vice president of chemistry at deCode Chemistry, adds that the small or medium-sized biotech firms that are his company's typical clients are often betting on just one compound and aren't willing to tolerate the risk of a long-distance relationship that could go wrong. As he puts it, these firms don't have all that many shots on goal.

Small, chemistry-poor biotechnology companies are the lifeblood of J-Star Research, a chemistry CRO in South Plainfield, N.J., founded 10 years ago by Andrew S. Thompson, a former Merck process chemist who is now president of J-Star. In the late 1990s, big drug companies were as much as 70% of J-Star's business; today, Thompson says, they are less than 20%.

The shift is fine with Thompson. I'm not happy about the way big pharma does business, he says. It's all cost-driven with them. They have taken the Wal-Mart approach to obtaining scientific talent to support their research programs.

J-Star also has revamped its business mix. Thompson always wanted to do process chemistry-hashing out multistep syntheses that will work at commercial scale-and for a while it was about 60% of his business. Today, it's as much as 90% of his business and of a more complex nature.

People come to us when their process doesn't work, he says. We are fundamentally changing the chemistry. Gone for the most part is synthesis of benchmark compounds, building blocks, and combinatorial chemistry scaffolds. They have all gone offshore, Thompson says.

According to Thompson, J-Star has so far survived the rise of foreign CROs, but not without some trepidation. For two or three years, we lived in constant fear that our next contract would go offshore, he says.

More recently, the tide has turned, and J-Star's labs are humming. Thompson employs about 30 chemists, mostly Ph.D.s, up from 25 a year ago. He just opened space for seven more chemists plus new labs that meet the current Good Manufacturing Practices standards (cGMP) needed to manufacture active pharmaceutical ingredients or late-stage drug intermediates to be used in clinical trials. Thompson expects cGMP synthesis to become about 30% of his business, but a critical 30% because much of his other business will feed into it.

Providing cGMP synthesis and larger volume chemical production has also been a lifesaver for Albany Molecular Research Inc., one of the marquee names in the U.S. contract chemistry business. That's because AMRI's traditional business in early-phase chemistry services is, for the moment at least, in decline.

In the first half of 2005, the firm's revenue from discovery services-small-scale chemistry done in the beginning phases of the drug development process-was $13.2 million, down 19% from the same period in 2004. And 2004 was even worse, with discovery services revenue down 29% compared with 2003.

More than making up for the decline, however, AMRI's revenue from development and small-scale manufacturing-mainly cGMP production for preclinical through Phase I and II clinical trials-was up 35% in the first half of 2005. Revenue from the large-scale manufacturing of APIs and other pharmaceutical chemicals through the firm's three-year-old Organichem subsidiary was up 11%.

Thomas E. D'Ambra, AMRI's CEO, acknowledges that his company's discovery services business is not growing, and he says loss of business to offshore companies, or the offshore labs of big drugmakers themselves, is partly to blame.

He knows drugmakers are trying to cut costs, but he senses a tension at big companies between the scientists who conduct R&D and the managers who scrutinize their spending, often pushing it to CROs that are far away and may not offer the same quality as U.S.-based firms. If it were up to the scientists, some of those contracts wouldn't have ended, he says.

At the same time, D'Ambra understands that some chemistry services will inevitably go offshore, and he, like other U.S. outsourcing executives, doesn't want to lose that business. Some CROs, such as Pharmacopeia and Ricerca Biosciences, have responded by establishing relationships with offshore partners. DPI was one of the first U.S. contract chemistry firms to open its own offshore lab, through a partnership in Calcutta.

AMRI proceeded cautiously at first, but in the past year it has become one of the most aggressive U.S. companies setting up overseas. Sixteen scientists now work at a contract research facility that AMRI opened in Singapore early this year, and the company just completed a new 45-hood facility nearby to which they will soon relocate. Meanwhile, AMRI employs about eight scientists in Hyderabad, India, and recently opened two new labs there that can accommodate up to 32 people.

D'Ambra says the facility in Singapore, a country that he credits with a history of intellectual property (IP) protection, will be a discovery outpost conducting high-end medicinal chemistry, structure-activity relationship analysis, and custom synthesis. The Indian labs will conduct development and small-scale chemistry that is less IP sensitive.

If the new offshore laboratories are intended to keep AMRI healthy in the medium term, D'Ambra's long-term plan is to make his company a little more like the drug companies it serves. In 2001, it embarked on an internal drug discovery program that has been steadily advancing ever since.

In its second-quarter earnings report, AMRI said it remains on course to move forward with two potential drug candidates. Initial toxicology studies have started for its priority candidate, and the company says it is on track to file an Investigational New Drug submission with the Food & Drug Administration early next year. And last week, AMRI announced the licensing of one of its drug candidate families to Bristol-Myers Squibb (see page 12).

As it did with offshore chemistry services, AMRI has started out cautiously on the road toward discovering and developing its own drugs. Other chemistry service firms, however, have dived in headfirst through intensive programs or outright mergers with drug companies.

One of the first to be acquired was MediChem Life Sciences, which in 2002 was bought by the Icelandic drug discovery company deCode Genetics. More recently, Argenta Discovery, a British chemistry CRO, merged in 2004 with Etiologics, another British firm, to form a hybrid company that offers research to other firms while developing its own respiratory drugs.

Then in March 2005, Evotec OAI, one of the largest European drug services firms, announced that it had acquired most of the drug discovery firm Evotec Neurosciences (ENS) for about $85 million. Evotec OAI, itself a result of the 2000 merger between the British contract chemistry provider Oxford Asymmetry International and the German biology and screening services firm Evotec BioSystems, had spun off ENS as a separate company in early 2004.

Evotec executives decided to reacquire the firm, which is developing central nervous system drugs, after seeing significant progress in its portfolio. Now, Evotec says its strategy will be to increase its focus on proprietary drug discovery and run its contract research business mainly to generate cash.

A final hybridization merger came in July when the U.K. chemistry CRO BioFocus was acquired by Galapagos, a Dutch genomics company. In announcing the deal, the pair predicted that BioFocus' chemistry expertise will greatly accelerate the progress of Galapagos' programs and assist in Galapagos' transition to a fully integrated drug development biopharmaceutical company.

For deCode, according to Zembower, the chemistry vice president, this kind of acceleration and assistance has gone both ways since deCode's acquisition of MediChem in 2002.

MediChem was launched in 1987 and went public in 2000. In its early days, Zembower says, it mainly provided customers with short-duration chemistry projects that were targeted and specific. He says the firm began to transition in the late 1990s to more IP-intensive projects that included integrated medicinal chemistry, process development, and cGMP manufacture for clinical trials. The shift began internally, but the rapid rise of offshore competition for lower value services really helped propel it, Zembower recalls.

By 2002, MediChem was a full-service drug discovery services house and deCode Genetics saw in it the chemistry know-how needed to convert its genomics data into small-molecule drugs. Today, as deCode Chemistry, the former MediChem organization is still conducting sophisticated pharmaceutical chemistry projects. The difference, Zembower says, is that about half the time the customer is deCode Genetics.

Aside from occasionally having to reassure a potential customer who is hesitant to do business with the service arm of a drug company, Zembower says he sees no downside to being part of deCode. On the other hand, a tangible benefit has been developing new drug development skills such as toxicology and predictive ADME (adsorption, distribution, metabolism, and excretion) testing. Such investments are made to aid the parent company, but, once in place, can also be offered to outside customers.

It remains to be seen whether the hybrid model has staying power, or whether it is only a way station on the road to the service-free approach that ArQule has chosen. What is clear is that the ability to pull off a hybridization deal is mostly limited to public companies that can use their stock as currency.

Small, private chemistry CROs like J-Star, Adesis, and PharmaCore will likely be sticking with a pure service model for the foreseeable future. PharmaCore's Maddox says his firm is happy with this approach-despite intensifying competition and narrowing profit margins. Indeed, the company almost doubled its chemistry staff last year, he says, and has moved into new, larger laboratories in High Point, N.C.

Interestingly, in contrast with Thompson at J-Star and Lee at Adesis, Maddox says most of his customers are large drugmakers. These companies are still looking for U.S. suppliers, he says. Their people still have projects that are technically challenging and need to be done quickly.

Peter C. Meltzer, president of Organix, a chemistry CRO based in Woburn, Mass., would agree. Meltzer is something of a founding father of the U.S. chemistry services industry, having started Organix with two partners in 1986, long before the offshore trend and even before drug companies were doing much outsourcing at all.

Unlike firms such as AMRI, MediChem, and ArQule that came after, though, Meltzer and his partners have chosen to keep Organix private and free from outside investors. Moreover, they have eschewed the push into cGMP and large-volume pharmaceutical chemical manufacturing pursued by many other chemistry CROs.

According to Meltzer, Organix follows a few basic rules that have allowed it to stay competitive in a globalizing business. It responds quickly to customers, it adheres rigidly to timetables, it takes advantage of rapid access to quality starting materials, and it tightly controls the intellectual property of its customers.

Meltzer acknowledges that Organix is vulnerable to offshore competition. We have lost clients who have moved operations to India in particular, he says, but we have also gained clients who did the same and found they couldn't get the service they wanted. On balance, Meltzer says, Organix grows modestly every year and today employs 35 people, 26 of whom are Ph.D. chemists. Our goal is longevity for our staff, not fast growth, he notes.

Talk to small-company executives like Meltzer, Thompson, or Maddox, and a picture emerges of a drug industry that is beginning to sort out its chemistry outsourcing strategy after a period of considerable experimentation and turmoil. These executives are convinced the business is stabilizing and the toughest days are over for the U.S. chemistry services sector.

But talk to Street, the Pfizer research executive whose organization spends hundreds of millions on outsourcing each year, and that picture quickly fades. One thing I'm certain about is that the whole area continues to evolve, Street says. And as to the mix of companies and countries with which Pfizer does business, Whatever it is today, he says, I can guarantee that it will be different in three or six month's time.

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