Over the last couple of years a wave of optimism has swept away the doom and gloom forecasts that for a long time have characterized the Western pharmaceutical fine chemical industry. Expectations of continuing profitable growth and high financial returns are replacing the doomsday predictions that not long ago called for the industry’s demise.

This change of mood is reflected in the growing interest and re-rating of the industry as illustrated in the double digit EBITDA multiples paid by financial and “strategic” investors in a number of recent transactions covering targets active in this field. Various factors can explain this change of attitude.

For one, high profile regulatory and operating setbacks encountered by many Chinese and Indian pharmaceutical fine chemical producers triggered a loss of confidence among Western customers in these countries as reliable quality supply sources. As a result, the focus of their outsourcing is returning back to the West.

At the same time, the rapid wage and input cost inflation observed in China, and to a lesser extent India, has led to an erosion of the cost advantage traditionally enjoyed by producers located in these two countries. Western sources are seeing their competitiveness revived, particularly when taking into account all associated indirect sourcing costs.

Also, the strength of the U.S. dollar exchange rate—the currency of reference for sales reflecting the importance of the North American market and the single largest import area in value terms—has immediately lifted up the bottom line of vendors operating in other currency areas.

The runaway success met by some products, such as HCV (Hepatitis C) antivirals, has also uplifted the mood of the industry. The synthesis of these products involves long multi-step reactions and large tonnages are extensively outsourced, occupying massive reactor volumes.

In addition, predictions that the share of drug substance outsourcing by pharmaceutical companies will continue to increase has had a positive impact on the industry. Pharma and biopharma companies more and more are de-emphasizing their own in-house production in favor of less asset intensive and flexible supply chain models based on strategic partnerships with selected Tier 1 suppliers acting as extensions of their own operations.

Lastly, the improved financial performance reported by several players is another positive factor. For example, average EBITDA margins derived from multiple companies grew from 12% back in 2012 to around 20% in 2016 and 2017, which is a remarkable increase. The rebranding of the industry from contract manufacturing to contract development and manufacturing (CD&M) has also played a role in making this a higher profile industry.

Despite the positive indicators of growth mentioned above, is the overall change of mood justified? Does it correspond to truly structural developments or will it prove to be short lived?
Not surprisingly, the answers to this question vary widely.

Some analysts strongly support the thesis that “this time it is different” because the fundamentals involved in terms of the competitive structure and customer purchasing dynamics have completely changed. “Chindia”-based competitors until recently represented the main threat for Western players. The supplier base continues to consolidate while pharma companies become more strategic in their dealings with vendors.

On the contrary, some industry observers predict that history will repeat itself and the interest surrounding the sector will soon fizzle out. Their expectation is that we will see again what occurred in the late 90s and early 2000s. At that time several new entrants were attracted to the pharma CD&M space. They had expectations of continuous growth and expanding margins. They paid top multiples to acquire pharmaceutical fine chemical businesses that were eventually divested at a loss a couple of years later. Some examples include:

• Allied Signal (now Honeywell) with PFC;
• Degussa (now Evonik) with LaPorte Fine Chemicals;
• PPG with Sipsy; and
• Rhodia (now part of Solvay) with ChiRex.

While nobody can pretend to have the ability to predict with certainty the future and to know how things will turnout, what is beyond dispute is that the pharmaceutical fine chemical/CD&M industry is facing a large, possibly unprecedented, number of uncertainties and challenges, some corresponding to major discontinuities.

These include the likely revival over the medium-term of Chindia-based competition with the eventual emergence of a few world-class champions able to compete with best-in-class Western players once the pruning of the supply structure in these countries is complete. Within this framework, it is important to note that the tighter enforcement of regulations and operating standards imposed by the Chinese authorities on the local pharmaceutical fine chemical industry is reminiscent of what has already occurred in this country in other industries such as the production of rare earths. Their aim is to drive out of the market players whose competitiveness hinges on a low cost position and fly-by-night type of behavior forcing their consolidation.

The ultimate competitiveness and viability of the supply chain, established by several Western pharmaceutical fine chemical companies/CDMOs that rely for a substantial share of their intermediate/building block requirements on China and India based vendors—a set up dictated by cost consideration—will be impacted by many factors including:

• A narrowing cost differential between Western and Chindia-based operations; and
• The drive of Chinese authorities to curb pollution leading to the sudden and unexpected closures, sometimes overnight, of sites if not even of entire industrial parks failing to meet the environmental and operating standards severely impacting access to some intermediates.

How the Western pharmaceutical fine chemical and CD&M industry will fare will depend on its ability to address challenges such as these, and turn these into advantage as opportunities and continue to cope with uncertainties. Within this framework, while there is little doubt that the Western industry will continue to exist and deliver over the medium- to long-term adequate returns, the very question of adaptability to an evolving environment and ultimate sustainability remains open for almost all individual players.

Many of these are small- to medium-sized entities that even when debt-free and with healthy cash balances have finite—and in absolute terms limited—financial and human resources. Within this frame, their degrees of freedom for undertaking bold moves such as extending the scope of activities to adjacent steps in the value chain or to other types of technologies without undertaking major bets are limited.

Success for this set of players will hinge on their ability to objectively define what is the distinctive value proposition they are providing and its continuing relevance for customers in light of their evolving requirements.

Prosperity, and in many cases survival itself, depends on continuous adaptation.

This may sometimes involve engaging in symbiotic relationships with other species allowing the two parties to thrive together rather than struggling as single individual entities. Having the wisdom to recognize that continuing on one’s own may not be the smartest course of action. Loss of independence is preferable to decline and eventual death. 

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Dr. Enrico T. Polastro is vice president at Arthur D. Little Benelux SA/NV. He can be reached via email at polastro.enrico@adlittle.com.