Issue Date: November 7, 2011
Taking On Pharma’s Research Sites
A legacy of big pharma’s decade of lost productivity lies scattered worldwide in the form of underutilized research facilities occupied by semi-idled staff.
To shed these burdensome assets, ideally with minimal disruption to new drug pipelines, some pharmaceutical companies have turned to contract research organizations (CROs) that will take on the facilities and the scientists who work there in exchange for guaranteed revenues over a fixed duration. About 10 of these asset-transfer deals have been announced so far, under terms that allow the CROs to augment contract research for the seller with work from other clients.
Whether CROs can make these research facilities sustainable after the originating contract expires is something that’s being closely watched in the industry. “We’re in a period of experimentation, and I don’t think anyone has devised the perfect research outsourcing model,” says pharma outsourcing analyst John Kreger, a principal with the Chicago-based investment firm William Blair & Co.
The first asset-transfer deal was struck in 1995, when Quintiles, a CRO based in Research Triangle Park, N.C., acquired a 300,000-sq-ft facility in Edinburgh, Scotland—and its 200 employees—in a three-year, $39 million deal with Syntex Pharmaceuticals, a member of the Roche group that was based in Palo Alto, Calif. The contract was completed successfully and established Quintiles in Edinburgh.
The drug development landscape has changed considerably since then. Saddled with a patent cliff, problematic mergers, and a lack of productive targets from genomics research, big pharma has sputtered.
In contrast, the CRO industry—fueled initially by alliances with biotech companies—has experienced average annual growth rates of 8% since the mid-1990s, according to Eric W. Coldwell, managing director for health care equity research at Robert W. Baird & Co., a Milwaukee-based investment firm. Now the largest CROs are building global-scale capabilities extending from discovery through clinical research at the same time that pharmaceutical companies are looking to shed overhead, adopt more nimble structures, and shift from fixed to variable costs.
The outsourcing needs of the drug industry have spawned numerous CRO relationships, most of them sealed quietly without public announcements. “They’re very opaque,” Coldwell says. “CROs are precluded from discussing what they do with their clients, and investors get very little news flow in terms of their activities.”
The exceptions, Coldwell says, involve very large research contracts or asset transfers reported on financial statements. “The deals we hear about most are disproportionately weighted to asset transfers,” he explains. “But they’re a very small piece of the business.”
Most asset transfers today involve big CROs with the capital, management, and experience needed to run large-scale research facilities. The biggest buyer by far, Coldwell says, is Princeton, N.J.-based Covance. With nearly 11,000 employees in 60 countries, Covance has been involved in three of these deals.
In 2008, the company took on Eli Lilly & Co.’s 900,000-sq-ft preclinical research facility in Greenfield, Ind., and its 264 employees for $50 million and a minimum contract value of $1.6 billion over 10 years. Then in 2010, Covance acquired two facilities from Sanofi—one in Porcheville, France, and another in Alnwick, England—in a 10-year deal worth up to $2.2 billion.
In both circumstances, Covance was able to leverage its considerable heft to extract terms that drew business away from its competitors. Before it would close on the Greenfield site acquisition, Covance insisted that Lilly also contract for clinical-trial and central laboratory support services bundled into a comprehensive deal, according to the company’s chief executive officer, Joseph Herring. “We told Lilly, ‘You’re already supplying that work to our competitors, but if we match the price, then you can move it to us, and we’ll become your preferred provider.’ ”
Similar conditions were agreeable to Sanofi, Herring says, and now Covance—which has turned down 15 proposed asset transfers since 2009—is working to make all three sites independently sustainable.
In the case of the Greenfield site, this effort entails marketing the facility’s three core strengths—in vivo pharmacology, preclinical imaging, and toxicology—to other clients. After the deal closed, Lilly’s corporate logos and other remnants were immediately replaced with Covance signs to convince prospective clients that their confidentiality would be protected.
According to Herring, Covance also built in a worst-case exit strategy assuming that once the originating contract expires, the Greenfield site will be closed and the staff laid off. “That’s the only way you can build a model for downside risk,” he says.
So far, however, the deal seems to be thriving. The site’s staff has grown to nearly 600, roughly 50 additional clients have ongoing projects there, and the proportion of revenue supplied by Lilly has dropped from 90% to roughly 50%. “The employees are highly motivated to succeed at the end of the contract, and so far we’re on track to do that,” Herring says. “Sanofi is still too early to call.”
Asset transfers make sense because CROs live, eat, and breathe productivity, says Thomas Perkins, Quintiles’ senior vice president for corporate development. “Why should pharmaceutical companies carry technology for noncore competency as part of their fixed infrastructure, when they can go to a CRO that will supply it for less?” he asks.
To illustrate, Perkins describes an asset transfer secured by Quintiles from Hoechst Marion Roussel, now Sanofi, in 1999. The 540,000-sq-ft facility in Kansas City, Mo., and its 500-strong staff, was purchased for $93 million in cash and guaranteed revenues of $436 million for five years.
Per contractual agreement, Quintiles maintained constant output at an annual cost reduction of 5%, achieved by bringing in third-party customers to maximize efficiency. Quintiles nearly tripled its staff in Kansas City, shifted to a fee-for-service relationship with Hoechst Marion Roussel after wrapping up the contract, and then sold the facility to the Greenwich, Conn.-based CRO Aptuit for $125 million in 2005.
Aptuit’s CEO, Timothy C. Tyson, says that for most pharmaceutical companies today, core competencies do not include the rote, technology-intensive components of preclinical research that CROs can do on a fee-for-service basis at a fraction of the cost. For that reason, asset transfers generally involve preclinical facilities, Tyson says.
However, taking these facilities on entails some risk, given that pharmaceutical companies facing patent pressure have lately focused more on late-stage than early-phase drug development. Indeed, last year, Aptuit announced it would close two large, early-phase development facilities in Livingston and Riccarton, Scotland, and 340 employees will lose their jobs.
According to Coldwell, drug development follows cyclical patterns, and the downturn in preclinical research is temporary. “It’s true that the early-stage work has been soft for about three years,” he says. “But eventually the focus on clinical work will reverse, and pharma will have to rebuild another early-stage pipeline.”
In the meantime, Quintiles’ Perkins warns that excess capacity in preclinical research compels vigilance in how CROs approach asset-transfer deals. “The asset-transfer model won’t function if you can’t fill capacity with third-party work,” he says. “If the facility isn’t cost-competitive for whatever reason—because the equipment is old, perhaps, or because it’s in a high-cost area—then you can’t compete, and it becomes a ball and chain.”
Tyson agrees, pointing out that the best deals involve world-class facilities geared toward long-term needs. In 2010, even as it was shutting down the Scottish facilities, Aptuit took on GlaxoSmithKline’s Medicines Research Centre, in Verona, Italy, and its staff of approximately 450, for an undisclosed price. GSK guaranteed revenues for three years, during which Aptuit will hawk the plant’s capabilities—lead optimization, medicinal chemistry, safety assessment, toxicology, respiratory analytical technology, and microdose manufacturing, among others—to prospective clients.
Unlike the more limited emphasis on manufacturing and safety assessment offered by the Scottish sites, Tyson says, the Verona facility offers integrated capabilities under one roof. “The work we do there goes from discovery through Phase II,” he says. “We’ve got a business development group working to generate visibility and to promote our capabilities to clients with similar needs and interests. When we get our scientists to talk about their capabilities, operations like this sell themselves.”
GSK’s three-year revenue stream gives Aptuit time to breathe as it looks for new clients. Indeed, revenue guarantees are crucial for asset transfers to succeed, according to Coldwell. “It only makes sense if the pharma partner guarantees profit protection,” he says. “Pharma cannot be trusted—it’s impossible to know what these companies are going to look like a few years down the line, if the chief financial officer or CEO will still have a job, or if their pipeline needs are going to change. You have to assume they will change.”
Although CROs generally look for revenue guarantees, not all asset transfers require that CROs add work from third-party customers. For instance, Galapagos, a Dutch company that combines internal discovery programs with CRO services, took on a GSK facility in Zagreb, Croatia, last year, and a staff of 130, for an undisclosed sum, without any intention of offering its capabilities to new clients, according to the company’s CEO, Onno van de Stolpe. The deal calls for Galapagos to supply GSK with R&D services under a three-year, fee-for-service contract valued at about $20 million.
But the site’s future sustainability depends on what Galapagos itself can provide through its own research programs. “For us, the terms enable us to grow into the facility over time without having to assume 100% responsibility,” van de Stolpe says. “It’s an integrated site that can take a discovery hit all the way through clinical trials at about a third of costs in Western Europe. Staff quality is excellent and GSK equipped the site well. We think this acquisition fits into our strategy to build out our drug discovery engine.”
Other CROs are rejecting asset transfers altogether. Wilmington, Mass.-based Charles River Laboratories markets a blended model that combines doing contract research at its own labs with sending staffers to work in client facilities, says Brian Corning, the company’s executive director for consulting and staffing services. Pharmaceutical companies bring in Charles River staff to oversee their operations and to recommend best practices for improving efficiency. Charles River also can provide scientific support or staff to cover hiring, recruitment, employee management, and other administrative functions for contracts ranging from three to five years.
“We really form a partnership with our clients,” Corning says. “It’s not so much client-vendor as it is that our scientists work together; we visit performance indicators at preset milestones to make sure we’re on track with our goals.”
Regardless of the model, all CROs face an increasingly volatile, competitive market—and the temptation to bid low on outsourcing opportunities. The risk, says William Blair’s Kreger, is that some CROs might underbid their contracts and harm their ability to meet obligations.
And marking a new, and somewhat ominous, turn for the industry, two pharma giants—GSK and Pfizer—have begun to sharply reduce the number of CROs they work with on clinical research. GSK recently cut its CRO providers for Phase IIb through Phase IV clinical trials from roughly 30 to two: PPD, based in Wilmington, N.C., and Parexel, in Waltham, Mass. Likewise, Pfizer dropped its list of favored clinical CROs from 17 to just Parexel and Icon, which has headquarters in Ireland.
John Graham, GSK’s director for global strategic resourcing and partnerships, says the old clinical outsourcing model was unwieldy and inefficient. “It was uncoordinated across therapeutic areas, so we couldn’t leverage economies of scale,” he says. “By reducing the number of CROs we work with, we assume greater control over what they do. We have a stronger voice, and we can reduce the internal resources that we use for oversight.”
Kreger notes that earnings expectations for Parexel and Icon were revised sharply downward after the Pfizer deal was announced in May. The reason, he explains, is that both companies have had to hire hundreds of staffers in advance of being able to execute any work. “Right now, there’s a mismatch between hiring and revenue,” he says. “We think, ultimately, the deal will turn out to be positive for these companies, but if you look at stock and earnings, they’ve been negatively affected in the short term.”
Pharmaceutical companies also face risks from research outsourcing, Kreger adds, including the possibility of picking negligent partners and the loss of control that comes with shifting core functions beyond their four walls. As outsourcing opportunities grow, and drug development shifts to an increasingly virtual model, drug companies are reevaluating core competencies, which aren’t always obvious when chemistry, biology, toxicology, clinical trials, and manufacturing can all be done by external partners.
What pharmaceutical companies seem to be best at, he says, is functioning as sources of capital with a global reach. The degree to which asset transfers will be a part of the picture in the future remains unknown. In Coldwell’s view, they’re likely to be limited, given excess preclinical capacity, and the fact that many pharma research sites are becoming outdated. “The better choice for pharma is to shut them down unless the firms are really dedicated to the staff,” he says.
Kreger takes a more tempered view—acknowledging that while many facilities don’t make attractive prospects in isolation, the promise of additional revenue streams supplied by their pharma sellers can sweeten the pot. “We’re looking at a fascinating case study for how pharma is going to evolve,” he says. “All the major drug companies need to figure out how to do things differently. The good news is that the industry will be more efficient in the future, and hopefully we’ll have new products going through the pipeline with less waste.”
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