For more than ten years now the pharmaceutical contract development and manufacturing organization (CDMO) industry has continued to attract the interest of financial investors, and to a lesser extent, industrial investors. This interest is reflected in a number of transactions where private equity houses have acquired various CDMOs, often paying hefty valuation multiples. Parallel to this trend, publicly quoted CDMOs have seen their stock prices reach new highs; corresponding to a total enterprise value (TEV), which is the sum of stock capitalization plus debt, north of twenty times EBITDA (earnings before interest, taxes and depreciation allowances).

Several factors are behind this interest and high valuations among the investment community. These include expectations of continuing growth driven by megatrends such as a graying world population and advances in health care standards in emerging and developing countries that are poised to drive up pharmaceutical consumption. Other factors include the increasing trend toward outsourcing of development and manufacturing activities by pharmaceutical companies combined with opportunities to improve margins by consolidating the CDMO supply structure and optimizing operations implementing best practices learned from other industries.  

Only time will tell whether or not these expectations will effectively materialize and justify the current valuation multiples. Obviously, there is no simple answer—investment requirements differ widely depending on the particular CDMI’s scope of activities and focus. However, past experience indicates that often financial investors and new entrants are surprised by the substantial capital expenditure (CapEx) outlays absorbed by the CDMO business. These swallow the better part of operating cash flows, resulting in modest, if not even negative, free cash generation levels. This situation often forces investors to revisit their financial plans with original CapEx projections proving to be inadequately low for effectively supporting growth targets.

This is particularly the case for Western CDMOs focused on small molecule drug substance and active pharmaceutical ingredient (API) synthesis. A recent study sponsored by Aschimfarma—the Italian association of API producers¹—and the Arthur D. Little yearly Round Robin covering sixteen Western small molecule API CDMOs with a combined turnover in excess of USD$3,000 million, yearly investment outlays committed by the sector have tended to increase over the years and are now corresponding to approximatively 11% of sales (see Figure 1). Comparable figures being noted amongst Indian API CDMOs.

To understand what average yearly CapEx outlay of 11% of sales mean, it is important to assess this figure within the broader context of the CDMO financial performance. Based on the Round Robin results—yearly investments correspond to almost 60% of the EBITDA generated—on average around a little less than 20% of sales. This means that after deducting variations in working capital, interest charges and taxes only modest free cash flows corresponding to approximatively 3% of sales are left for repaying debt or for rewarding shareholders through dividends (see Figure 2).

A look at the split of yearly investments committed by API CDMOs shows that on average about 50% of these are devoted to maintenance and compliance—be it regulatory or EHS (Environmental, Health & Safety) related. Little, if any, room for maneuver exists for cutting this type of investment without severely undermining and mortgaging the very survival and continuity of the business.

Only the remaining half of investment outlays can be considered as discretionary being associated with growth initiatives such as capacity expansions or securing access to new capabilities.

CapEx outlays differ widely between the various CDMOs surveyed, ranging between a low of 4.2% of sales to a high in excess of 25% of turnover. This reflects factors such as ownership structure, growth ambitions and conditions of the assets. A closer analysis shows a convergence in terms of the type of investments undertaken by small molecule API CDMOs and some common recurring themes emerge.

As illustrated in Figure 3 these include: adapting the production infrastructure; beefing up process development capabilities; securing access to high containment synthesis capacity; developing capabilities in physical processing/particle engineering; reinforcing presence in main geographical areas of focus; and exploring the potential of continuous processes. Some larger players are devoting investments to expand their scope of activities to the drug product/formulated drug form (FdF) and biopharmaceuticals.

The driver behind these investments is the imperative for CDMOs to adapt their offerings and capabilities to the evolving requirements of pharmaceutical companies and the expectations vested by these in their drug substance suppliers. These reflect, among other factors, changes in the types and number of products entering development or reaching the market, accelerating time to market/product development cycles and the decreasing role played by Big Pharma as sources of NME (new molecular entities) innovation (see Figure 4).

In this new environment, CDMOs have to adapt their production capacity. Rather than on large volume vessels and dedicated units, the focus of investments is on flexible synthesis capacity comprising a larger number of smaller volume reactors structured as trains with readily reconfigurable interconnections. Such a design reflects the evolution noted in terms of number, diversity, structures and volumes of small molecule APIs being developed or reaching the market.

Within this frame, it is important to note that the massive displacement of small molecule API by biopharmaceuticals predicted by some industry observers with the advent of the first recombinant products and Mab (monoclonal antibodies) has failed to occur. The latter continue to represent the backbone of the pharmaceutical industry accounting for about 75% of total sales and more than 60% of all NME approved by the FDA over the last ten years.

While the dominance of small molecule API remains unchallenged, major developments and changes have occurred in terms of the type of molecules reaching the market, which has affected CDMO suppliers. These changes include the increasing complexity of molecular structures as reflected in their higher molecular weights and larger number of chiral centers.

Parallel to this, volume requirements of APIs are decreasing—yearly tonnages exceeding the 10-ton threshold are increasingly becoming the exception—a development driven by the combination of higher potency and smaller patient pools targeted by the new drugs being developed or reaching the market.

These drugs are increasingly addressing “specialist” indications including orphan diseases or patients carrying selected genetic markers, a development often referred to as the advent of “personalized medicine.” According to the Personalized Medicine Coalition (PMC), about 50% of the NME approved by the FDA during the last five years have corresponded to personalized drugs.² This is illustrated by the number of “ib” drugs in advanced development or on the market. Each of these products are most often specific to selected genetic markers and cancer types. The resistance issues to a given drug often observed in cancer patients after a few months of treatment provide an additional boost to the proliferation of these types of products to extend treatment options.

The increasing R&D focus of pharmaceutical companies on orphan indications and diseases characterized by substantial unmet therapeutic needs also results in accelerated development and registration timelines—fast track approval procedures are increasingly becoming the rule.

Similarly, the share of NME developed by startups and emerging pharma as opposed to large established pharmaceutical companies is continuing to exceed 50%.

These developments are having far reaching implications for small molecule API CDMOs. As volumes tend to decrease, new molecules continue to involve a growing diversity of chemotypes—each often invariably requiring in their synthesis different chemistries. As a result, development timelines are accelerating—vendors must adapt their capabilities and offerings accordingly.

This includes having access to smaller-scale capacity suitably designed for optimal flexibility and the ability to swiftly accommodate a wide range of different reactions and products with minimal, if any, adaptations. Such flexibility obviously comes at a cost given the features that need to be incorporated in the new capacity design in order to allow for a wide range of situations and contingencies. This includes a larger number of vessels consisting of different construction material, downstream and ancillary equipment.

Similarly, another must for CDMOs is to be able to support this capacity with adequate process development muscle. The synthesis procedures and technology packages provided by customers are rarely robust or reliable enough to be applied at more than the gram/laboratory scale. This reflects the limited process development work undertaken by the pharmaceutical originator because of either the lack of their own in-house resources or faster than expected product time to market following, for example, fast tracking of the drug by the FDA.

Another consequence of shorter development timelines is the limited data often existing on the potency and associated industrial hygiene profile of API in the development pipeline and their intermediates. To mitigate potential risks and avoid potential liabilities, the precautionary principle is becoming the rule among most pharmaceutical companies. These are systematically requesting their API vendors to protect the work force and environment by performing the product synthesis in contained capacity.

These requirements, combined with the increasing share of high potency API in the development pipeline or reaching the market, is behind the multiple investments undertaken by CDMOs in high containment—OEL 3 or higher—capacity. Contrary to the recent past, when capabilities alone helped CDMOs in securing a competitive edge, nowadays, CDMOs must have these capabilities just to be qualified by several pharmaceutical companies as a perspective supplier.

The increasing complexity, size and weight of molecules being developed or reaching the market also has implications on their druggability—affecting aqueous solubility and intestinal membrane permeability with far reaching impacts on their pharmacokinetics, bioavailability and ease of formulation. Recent studies indicate that the share of “problematic of orally formulate” API given either poor water solubility or inadequate intestinal membrane permeability in the development pipeline now exceeds 70% (see Figure 5).

Various techniques, like milling, micronization or spray-drying—often referred to as “particle engineering or pre-formulation”—have been and continue to be developed to modify the API physico-chemical properties to facilitate its formulation, for example, by increasing its specific surface, reducing its particle size or making it amorphous disrupting the “native” crystal structure. In light of this, a number of API CDMOs have expanded their scope of activities to cover also the particle engineering step. Notable examples include Hovione and Lonza—the latter through the acquisition of Capsugel—Bend and subsequently Micromacinazione. Several other vendors followed suit albeit at a smaller scale.

Another development behind the investments undertaken by API CDMOs is associated with the concerns among pharmaceutical companies on the sustainability and robustness of supply chains for their drug substance and related intermediate requirements, particularly when involving vendors in China and India.

This is leading to a renewed interest in “near shoring” by developing Western supply sources that are viewed as more reliable and easier to monitor and deal with. Anticipating this re/near shoring by European and U.S. pharmaceutical companies, several Western API vendors are starting to plan major capacity expansions—Dottikon Exclusive Synthesis recently announced its intent to invest about $600 million as a notable example.³

Parallel to this, other players like Dipharma, Flamma, Olon and Sterling Pharmaceuticals have moved for position securing access to process development and kilo/pilot scale capacity in the U.S., a key market for them. The intent being to reinforce their local presence and ability to serve U.S. customers—a substantial share of these often include startups and emerging pharmaceutical companies requiring more frequent interactions and hand-holding support compared to large pharma.

Several CDMOs are also devoting increasing attention and resources to continuous processes. If commercial scale applications in API synthesis remain limited, the wider adoption of continuous processes is viewed as having the potential to disrupt the industry by making obsolete traditional batch equipment. This would lead to a redefinition of investment requirements and changing production economics while shortening cycle times.

The focus of CDMO investments in continuous processes is mostly on demonstration scale equipment and in developing expertise on selected products. The idea being to prepare for the future once these techniques become an integral part of synthesis route and process design routines applied by pharmaceutical companies for their development products.

Similar jockeying for positioning among CDMOs can also be noted in the investments undertaken by various players seeking to expand their scope of activities beyond just small molecule API synthesis. For example, larger players like Lonza, and to a lesser extent Novasep, for example, have established themselves as full-fledged CDMOs for both small molecule API and biopharmaceuticals. Other smaller players are actively developing capabilities in areas lying at the interface between small molecules and biopharmaceuticals.

Here too these moves are prompted by the increasing number of ADC, oligonucleotides and peptides entering development and reaching the market, creating new opportunities for vendors but also introducing new requirements for successful participation. Investments undertaken by API CDMOs also include the investments either through organic development or acquisitions of some players like Cambrex, Carbogen, Lonza or Novasep in the area of drug product/FdF development and manufacturing services.

The underlying rationale for the vendor is to offer to pharmaceutical customers an alternative to their own in-house production for both the drug substance and the drug product by outsourcing to a single vendor the entire supply chain. Such a setup is claimed by proponents to allow for compressing total sourcing costs, reducing lead times and eliminating sources of errors. Such a view is hotly disputed by opponents stressing the risk of relying on a single supplier for the entire supply chain. This divergence of opinions is also reflected by the different paths observed by the Cambrex and Lonza stock following their acquisition announcements of Halopharma and Capsugel-Bend, respectively.

The first has seen its stock price sharply fall with 50% of the company market capitalization evaporating, eventually prompting private equity investors to take the company private. On the contrary, Lonza has seen its valuation multiples more than treble following the Capsugel deal. While other factors may have played a role, such as, for Cambrex, fears of reduced orders by Gilead, which at that time accounted for more than 30% of the company turnover, investor reactions most probably reflect their skepticism on the value creation potential for Cambrex to move in FdF. 

References
1. Indagine sul comparto dei principi attivi e degli intermedi per l’industria farmacutica – Ferderchimica – Aschimfarma November 2020
2. The Personalized Medicine Report 2019 – Personalized Medicine Coalition
3. Dottikon set to boost drug ingredient output – C&EN November 3, 2020