R&D outsourcing strategies

pharmafile | October 24, 2003 | Feature | Research and Development |  CRO, contract research, contract research organisation 

The R&D and sales and marketing functions of major pharma companies are suffering from declining productivity. To date, the industry's main strategic response to this – M&A – has not been fully effective in addressing this dynamic.

Of the 44 products generating blockbuster sales in 2000, 33 will lose patent protection in the US before 2007, exposing approximately $45.5 billion of US ethical revenues to generic competition. Globally, patents protecting 80% of blockbusters in 2000 will expire by 2007, freeing up $67 billion to generic erosion.

Many predict that a 'networked' pharma model is the answer to the longer-term challenges faced by the industry. According to this business model, major pharma companies, which currently operate approximately 80% of activities in-house, will eventually perform only 40% in-house. The remaining 60% will be conducted externally via a carefully selected, risk managed portfolio of straight outsourcing arrangements and strategic alliances.

Aspects of the 'networked' model are already emerging, with numerous strategic alliances and agreements between pharma, biotech and drug discovery companies. However, outsourcing has not grown as fast as many have anticipated, and continues to lag behind other sectors in terms of sophistication. This is due in large part to a lack of faith shown by pharma sponsors in the value and quality of outsourcing providers services.

Structure of the supplier base for outsourced R&D

The R&D outsourcing market has grown from $5.4 billion in 1997 to $9.3 billion in 2001, representing an average annual growth rate of 14.6%. The competitive structure of the pharma R&D outsourcing sector can be characterised as follows:

• five major multinational players, which have grown largely through M&A over the last decade
• mid-tier competitors, which have at least some focus on a particular segment of the R&D process (eg, pre-clinical research), therapy areas or geographical markets
• niche competitors, which are highly specialised, often with specific therapeutic or geographic expertise or access to proprietary technology.

While the CRO industry has gone through significant consolidation during recent years, more than 1,000 CROs operating world-wide remain, of which 600 are estimated to be operating in the US. The sector remains fragmented, with the top 10 players holding a market share of less than 45% in 2001.

The recent financial performance of the leading CROs shows that the 'mid-tier' CROs are catching up with the traditionally dominant players – the top five CROs recorded an average annual revenue growth of 13% in 2001, compared to 26% for the five companies below these.

In the face of significant CRO sector M&A activity during the mid-1990s, many industry commentators predicted that smaller and mid-tier CROs and R&D outsourcing vendors would be gradually squeezed out of the market. They argued that small and mid-tier players would be unable to compete with the increasingly powerful top five players. This forecast domination by the large, multi-service CROs, at the expense of smaller specialists, was based on a number of assumptions:

• That major pharma sponsors would increasingly value CROs acting as a 'one-stop-shop', offering multi-service offerings across the R&D spectrum. Only large players would possess the competitive mass required to seamlessly offer this wide range of services.
• That the consolidating market leaders would benefit from scale in their operations, and would be able to compete more effectively on price in a cost-sensitive market.
• That pharma sponsors would increasingly form long-term, more 'strategic' agreements for outsourcing R&D activities with the larger players, rather than adopting a 'pick and mix' approach with multiple vendors. This would secure business and ensure a smoother cash flow for the dominant CROs.
• That global market presence would be an important factor in meeting demand for clinical development services, with CROs needing to provide rapid access to development sites across multiple geographical markets.
• That consolidation in the supplier base for CROs would eventually allow the major players to increase their negotiating power with pharma companies and drive up their margins.

However, the industry has not evolved as many thought it would, and a number of these trends favouring large, full-service provision organisations have yet to fully emerge. This is witnessed by that fact that the smaller and mid-sized CROs continue to account for a considerable proportion of the outsourced R&D market. In particular, many large pharma sponsors are still some distance from regarding the larger CROs as true 'strategic partners'.

While the larger CROs have been adding additional services to their portfolios in an attempt to act as one-stop-shops, it is clear that many pharma sponsors are not yet comfortable with outsourcing entire portions of their R&D activities to a single provider. The majority of pharma executives surveyed for this report stated that they preferred a 'pick and mix' approach to vendor selection for different services than to rely on one strategic partner. One potential explanation for the continued use of CROs in a piecemeal fashion is that pharma sponsors organisations themselves are not suited to effectively managing a broad outsourcing agreement across different internal departments. A recent survey conducted by CMR International found that less than 30% of companies currently have centralised contracting groups for regulatory, pharmacology and toxicology, and research activities.

The financial pinch on the CRO sector has been driven largely by a resurgence of M&A activity in the pharma sector. Many of the large CROs rely on a small number of major pharma clients for a significant proportion of their revenues. For example, Parexel's top five clients accounted for approximately 40% of total revenues in 2001, and this company is less reliant on major clients than many of its peers.

Customer consolidation means that projects have frequently been put on hold, and pharma sponsors additional capacity post-merger has reduced the need for using CROs' to make up short-term resource shortages. CROs sales relationships with key executives in large pharma sponsors for commissioning work have also been disrupted. CROs are often commissioned for additional capacity to conduct R&D projects that are not regarded as 'crown jewels' and are lower priority. M&A activity has brought about extensive R&D portfolio reviews, and many non-priority projects have been shelved. As a result CROs have suffered.

Large vs. small vendors

The troubled financial performance of the leading CROs and lack of transformation in the nature of their relationship with pharma sponsors has again opened the debate concerning the pros and cons of using larger CROs versus specialist small providers.

There is some evidence to support a resurgence in demand for smaller, more responsive vendors, with these providers winning outsourcing contracts at the expense of the traditionally dominant players. An industry-wide survey carried out by the Pharmaceutical Outsourcing Management Association in 2000 predicted a shift in sponsor spending away from the large publicly traded CROs toward smaller, privately held companies. Forty five per cent of clinical research respondents forecast increased spending with small providers in 2001, compared with 18% forecasting increased spend with large CROs. A survey of pharma sponsors conducted by CenterWatch found that over 40% of respondents expected to use smaller and niche CRO services more frequently in the future. A similar percentage of those surveyed stated that they would use a combination of niche and large full-service CROs. Less than 20% reported that they plan to use large full-service CROs alone more frequently.

Aside from pharma sponsors being dissatisfied with service quality from the larger outsourcing providers, the financial resurgence in the small and mid-sized CROs can also be attributed to wider market-led factors:

• Smaller CROs have been forming consortia and 'virtual networks' to conduct large-scale studies across markets, benefiting from the ability to win large-scale projects while not having to invest in capital intensive infrastructure and international networks.
• As the number of novel medicines nearing launch diminishes, R&D expenditure is gradually shifting away from large, multinational phase III studies, suited to the scale that the large CROs offer, towards smaller-scale R&D projects. Smaller CROs can benefit from this trend, offering niche expertise in particular therapeutic areas and drug delivery technologies.

Outsourcing agreements

Pharma companies have traditionally adopted a short-term, non-strategic approach to outsourcing. However, this is likely to change as increased financial pressures force companies to identify and focus solely on core competencies. A more strategic approach to outsourcing defines the types of relationship that the company wants to establish with CROs prior to entering into any agreements. Using different types of relationship to secure the optimum output from outsourcing vendors is an important aspect of effective outsourcing.

'Facility-for-service' deals have started to appear, such as Aventis' R&D facility divestment to Quintiles and Sankyo's agreement with MDS Pharma Services. These will become more commonplace in the future as sponsors strive to shift capital infrastructure costs onto outsourcing providers.

The majority of outsourced R&D requires a degree of client customisation and knowledge sharing to achieve the expected results. Many aspects of clinical development require multiple interactions inside both the sponsor and the outsourcing vendor. Effective outsourcing will only occur when the vendor and the sponsor work closely together. With this in mind, the majority of top-tier pharma companies have now established preferred-supplier networks. Typically, three to six pre-selected CROs are given the opportunity to bid for a project ahead of their competition.

Theoretically, at least, the CRO benefits from inclusion in the preferred supplier network by becoming a 'contracted in' provider, resulting in repeat business and access to larger, more profitable projects. The sponsor can benefit from a closer working relationship with the CROs, lower transaction costs (such as those associated with CRO selection/evaluation of multiple bids) and, occasionally, client-specific capital investments that the CROs make. CROs are only likely to invest in capital specific to a particular clients needs if they have some guarantee of longer-term financial return in the form of continued business (for example, facility-for-service deals). While preferred supplier arrangements can offer both parties some valuable benefits, CRO executives are often dismissive of these networks as being a route towards strategic partnership, stating that:

• CROs are often forced to fit their bids into pharma sponsors' standard contract terms, which can result in margin erosion and, in the face of significant cost pressures, threats to quality service provision.
• Internal management resources within pharma sponsors are often not sufficient to effectively manage the relationship with CROs within the preferred supplier network.
• Sponsor concerns over confidentiality often mean that knowledge sharing within the preferred network remains limited.
• Networks are often used by pharma sponsors merely as a means of driving down costs, with their primary aim being the installation of a transparent and competitive bidding process between major CROs.

Thus, despite the face logic that preferred supplier networks bring CROs and sponsors closer together, they often have the opposite effect, resulting in relationships characterised by hostility and mistrust. The potential for improved working relationships has not been realised due to poor system compatibility, incompatible processes, lack of effective supplier performance evaluation and a lack of investment in relationship management, on both sides.

In addition, pharma executives have remarked that sticking too rigidly to a preferred supplier network or strategic partner can be damaging. Pre-selected outsourcing vendors can be hired where greater expertise or a more competitive solution can be sourced elsewhere (eg, from a niche technology provider). CROs can become too 'cosy' within a preferred supplier relationship and begin to lose market competitiveness or their service edge, as they feel assured of future business. Clearly, pharma sponsors need to achieve a compromise between lowering selection/transaction costs and improving working relationships, while also ensuring that their selected network companies remain market-led and competitive.

The future of outsourcing

The R&D outsourcing market is predicted to grow from $9.3 billion in 2001 to $36 billion by 2010, representing an average annual growth rate of 16.3% (compared to an average growth in global R&D expenditure of 9.6% during the same period). This forecast growth relates to a gradual evolution of the current environment  for example, 'business as usual' – rather than a fundamental shift in industry dynamics.

The top-tier CROs will attempt to transform their profitability through focusing on higher value-added services, moving away from reliance on basic clinical development (phase I-IV) service revenues. These higher profitability services include pre-clinical and bioanalytical testing, laboratory services, drug discovery and informatics.

The demand for R&D enabling technologies such as genomics, high throughput screening and proteomics is sufficient to support a large number of small specialist players. However, consolidation will eventually occur among these smaller providers as winning technologies emerge.

The future for mid-tier outsourcing players is uncertain. Currently, these CROs tend to differentiate themselves through focus on particular geographies and/or therapeutic segments. However, as the major players mature, they too will accumulate significant experience in particular aspects of R&D, negating the mid-tier CROs' differentiation.

This article is based on the Reuters Business Insight report: 'Pharmaceutical R&D Outsourcing Strategies; An analysis of market drivers and resistors to 2010' by Steve Birch.

For a free executive summary of the report please contact Minal Chouhan on

020 7675 7320.