Over the past 20 years the Western fine chemicals industry has passed through various phases. In fact, its performance follows a rollercoaster path! This can be illustrated by the evolution of Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) margins as extrapolated from a representative universe of Western entities active predominantly in synthetic fine chemicals. As we can see in Figure 1, EBITDA margins for Western fine chemicals producers have steadily eroded during the period 1997-2004.

After reaching a peak in the mid-to-late ’90s, EBITDA margins have been cut nearly in half from 20% or so of net sales to low double-digit figures in 2004! It’s interesting to note that over the same period, the spread of the EBITDA performance envelope—defined as the extremes between top and bottom performance—has considerably broadened, with some entities seeing their EBITDA margins dramatically deteriorate and become flooded by red ink! At the same time, top performers have continued to generate healthy EBITDA margins—clearly indicating that the industry remains attractive for those players able to master the key success factors.





The peak noted in 1997 most probably corresponds to a combination of factors, including both a buoyant demand — witness the number of NCEs (New Chemical Entities) such as anti-HIV treatments reaching the market — and a short capacity situation. The downturn observed during the 1999-2004 period corresponds to the conjunction of the opposite factors — namely sluggish demand and ample available capacity following the wave of investments undertaken by several players. This overcapacity was further exacerbated by the increasing inroads made by Asian competitors.

However, a glimpse of hope seems to have appeared in 2005 as an uptick in financial performance levels was observed, and the post-1997 downward trend in EBITDA margins has reverted. Forecasts for 2006 remain cautiously positive, with the margin recovery predicted to grow further!

While a turnaround seems to be underway, the situation remains fragile: several players owe their recovery to the success of individual products and projects, such as Roche’s Tamiflu, whose long term outlook is not exactly cast in iron.

Similarly, despite some restructuring and change of ownership for some businesses — mostly part of large diversified groups having entered the fine chemicals space at the peak of the cycle — competitive intensity levels remain high. In particular, customers continue to apply leverage on their fine chemicals vendors, with the threat of Asian competition staying acute.

Within this framework we can legitimately ask whether the improvement in financial performance levels noted in 2005 and predicted to continue in 2006 will be sustainable or short lived. In a nutshell, is the Western fine chemicals industry at the edge of a full recovery — in medical terms, a remission — or will it soon relapse towards new depths?

This obviously depends on a multitude of factors, such as the vigor of the demand/supply structure, since the approaches of key competitors to the market each taken individually or in combination having the potential to trigger the advent of one scenario or the other. Among these factors the impact of Asian competition has been emphasized most, often hitting the front lines in the industry press. But is this threat real or has it been blown out of proportion?

Prima facie the economics of fine chemicals production appear dramatically in favor of China- and India-based operations. For example yearly unit labor costs in these countries represent only a fraction of those noted in the West. These costs stand at around $3,750 and $5,000-$7,500 in India and China respectively, versus the typical $50,000 in West Europe or the $19,000 noted in Poland, a good proxy for the Central and Eastern European region (see Figure 2).


While low unit labor costs often go in parallel with subpar labor productivity, this does not necessarily appear to be the case for fine chemicals as measured by staff productivity ratio. This ratio is calculated dividing value added — namely net sales less raw material costs — by total direct labor wage costs, both elements often being readily available from annual reports or tax returns for most companies. This ratio too shows a situation very much in favor of both China and India, value added per unit of staff standing in these countries at a towering 7 to 9 times unit yearly wage costs — dwarfing the 3 to 4 ratio prevailing in the West (see Figure 3).


As we can see by working out simple mathematical ratios, if less headcount is typically needed in the West, unit costs are so much higher compared to China and India that they offset any advantage associated with higher unit productivity!

Similarly, investment requirements in China and India are reported to be substantially lower compared to those in the West. Outlays per installed cubic meter of reactor capacity are said to be at least 40% lower in these countries. Some industry observers report investment requirements standing even lower, at 10-20%.

Anecdotal reports indicate for India total investment of $20 million for a greenfield site with an installed reactor capacity of 400m3 corresponding to a tiny $50,000/m3 — a figure we must compare to the $200K to $500K+/m3 used as the rule of thumb in the West! While such claims appear to be somewhat exaggerated (and extreme caution needs to be applied to ensure adequate comparability), it is beyond doubt that investment requirements in China and India are lower compared to the West. This simply reflects lower unit labor costs, labor being a major cost component in the construction and assembly phase of the investment.

Additional factors contributing to the cost competitiveness of China and India include:

• Generally lower environmental changes: While growing rapidly, reflecting tighter regulations and enforcement — these still represent only a fraction of the requirements noted in the West.
  
• General disregard for the cost of capital: At least in China, investments are typically considered sunk costs, providing for additional degrees of freedom in selling prices.

Other cost items are comparable, if not higher, in China and India. These include raw material inputs, barring a few exceptions, these being sold at world market prices, with logistics adding extra costs in both China and India. As an example, producers located in the latter country are often handicapped by the local climatological conditions, multiplying solvent losses due to evaporation!

Similarly energy and utility costs are substantially higher in India — often exceeding total labor charges. This is reflecting the lack of adequate infrastructure — most producers having to produce their own electricity in-house through costly diesel generators, the distribution system being just too unreliable and plagued by frequent black-outs.

Applying a simple model — taking into account parameters such as reactor volumes, unit labor, cycle time and assuming the input costs as discussed above — it is possible to estimate transformation costs associated with running a given reaction in various parts of the world. Taking into account only cash costs, neglecting non-cash items such as depreciation, and assuming that raw material costs are identical across all regions, it can be estimated that, for a typical batch reaction involving a reactor capacity of 4 cubic meters, a cycle time of 24 hours, requiring one unit of staff and a batch size of 400 kg, these costs range between $25 and $7.50 per kg (see figure 4, in Euros).


If we take as the index of 100 a Western European base, then India and Chinese coastal locations stand respectively at 35 and 40 on the index, suggesting, based on cash transformation costs, a major cost advantage! This simply reflects lower unit labor and general manufacturing costs; the cost advantage is further amplified should non-cash cost items be also included. Based on these numbers it would be logical to conclude that Western producers stand no chance in the face of Asian competition!

Fortunately for Westerners, the picture is not as simple as that, and jumping to quick conclusions may well yield the wrong answer. A more comprehensive analysis is required to assess the ultimate competitiveness of a given production location. Within this model it is critical to take a broader look, challenging also common wisdom and going beyond short-term considerations. These include:

• The sustainability of the reported cost advantages of both China and India. While it is beyond doubt that these countries still have a long way to go before catching up with the labor costs noted in the West, the pace of wage inflation in both China and India is substantially higher, particularly for qualified staff, reflecting raging competition for scarce resources. For example, in the coastal provinces of China, wages are increasing at double-digit rates, prompting investors to move their plants to the Inner provinces. Similarly, the differential in terms of environmental charges between the West and China or India can only go one way — namely narrower, with environmental awareness developing in parallel with economic growth!
  
  
• Risks associated with sourcing fine chemicals out of China and India. These go beyond a more extended supply chain and, as a corollary, higher probability of disruption, such as delays in delivery dates or stoppages in product flows. These risks also include such factors as quality issues, loss of proprietary information, and the systemic risk elements intrinsic to each country, reflecting their socio-politico-economic situations. Within this model the long-term development path for both China and India is unlikely to follow a smooth road, and it is impossible to rule out disruptions tied to growing tensions among different constituencies of the population or increasing strains in the financial systems! Customers looking for a safe heaven should examine other regions, such as Singapore or Switzerland. These are not particularly known to be the cheapest places on earth, but stability comes with a cost!
  
  
• Empathy and ease of communications. Although somewhat of a soft factor, the ability to establish a productive dialogue between the vendor and the customer represents a key to building trust while avoiding misunderstandings and loss of time. Proximity and common cultures certainly represent key enablers, while different sets of values and mental models between Westerners and Asian may create major hurdles!
  
  
• Hidden costs. Rather than direct purchasing prices, total acquisition costs include time spent in developing and monitoring the source in Asia, as well as shipment charges and extra safety stocks required to mitigate risks of supply chain disruption. These costs need to be closely monitored.
  
  
• Technology and operation sophistication. Applying the simple — if not simplistic — model outlined earlier, it appears that the cost advantage of Asian suppliers increases with the complexity of the molecule, the longer and more complex the synthesis, and the higher the manpower and reactor volume requirements. However, this is a gross oversimplification, as the model needs to be adjusted to reflect the efficiency and effectiveness with which the process is run. In particular it is critical to take into account elements such as effective cycle time, frequency of batch failures, as well as other costs associated with non-quality as well as actual yields.

A closer assessment, taking into account all these parameters, will often reveal that the actual handicap of Western fine chemicals producers is not as large as originally thought, particularly if adjusted to reflect the risk element!

An indirect proof of this is the simple observation that despite all their claims, not many pharmaceutical companies — by far the largest end user of fine chemicals — are actually sourcing their requirements out of China and India. Rather they continue to prefer relying on Western suppliers, particularly as they have been able to extract price concessions out of them!

Have Western fine chemicals vendors acted wisely in giving up such pricing concessions? Would they have indeed lost mass customers if they had refused? Probably not, as their offerings, despite apparently higher prices, were worth more to the customer than those of their Asian competitors! This emphasizes the need for vendors to realistically assess the value of their offerings. They must refuse to reduce value to the lowest common denominator — namely production costs!

Dr. Enrico T. Polastro is a vice president and senior industry specialist of the European Pharmaceutical and Fine Chemicals practice of Arthur D. Little. He can be reached at polastro.enrico@adlittle.com. Sonia Tulcinsky is a consultant with the practice.