The Western Fine Chemicals industry must adapt to the new environment it faces. But, before I review possible future scenarios and avenues for breaking the downward spiral the industry seems to be caught in, it may be timely to take a step back and see what the fine chemicals world was like in 1994 and what were the views and discussion themes at the time.
Ten years ago, the main topics and themes of interest included:
| • | The increasing impact and role of biotechnology both as an opportunity to produce more efficiently some fine chemical structures as well as a threat given the new horizons associated with biopharmaceuticals; |
| • | The emerging wave of consolidation that had started to occur among pharmaceutical companies-witness at that time the acquisition of Syntex by Roche and the takeover of American Cyanamid by American Home Products—now Wyeth; |
| • | The advent of the life science company concept as well as the predicted trend towards outsourcing, among this set of players, of their fine chemicals requirements following as an example some bold statements by senior management of big pharma such as “Chemistry…out of the way!” The developments expected in India and China were viewed as increasing threats and raising forces in the fine chemicals space; |
| • | At that time there was little question about slowing growth or pressure on profit margins and |
| • | In fact, since then and until recently, the fine chemicals sector has attracted massive investments—a sort of “frenzy” and what could be called now with the benefits of hindsight-to borrow the expression of Alan Greenspan “irrational exuberance” spreading among both established players as well as new entrants. |
Between then and now a number of developments have occurred. For example, the life science segment, by far the major outlet for fine chemicals has experienced dramatic consolidation. The top 10 pharma players have increased their market share from 30% to around 45% during the past 10 years.
Also interesting to note, while 10 years ago the view was that an integrated model of a life science company combined under a same roof both agchem and pharma activities, nowadays this model appears to have fallen into oblivion—witness the example of Zeneca and Monsanto!
The Impact of Consolidation
Implications of this consolidation for the fine chemicals sector have meant delays or changes in overall sourcing strategies and increasing leverage applied by customers!
Parallel to this, the predicted upsurge in New Molecular Entities has largely failed to materialize. After a peak noted in the late 1990s, which was largely associated with the launch of several antiviral products targeting AIDS, the flow of new pharmaceutical products has been reduced to a trickle. While the reasons behind this decline reflect a multitude of factors, including in pharmaceuticals, closer scrutiny for the authorities, the consequences for the fine chemicals industry are clear: namely less opportunities!
Still, growth has remained healthy. Pharma growth has consistently exceeded by 4-5% GDP evolution-driven by an ever increasing demand—growth being particularly robust in the large U.S. market. However, while positive, it is important to note that this growth has been increasingly driven by the successes met by some blockbuster mega-brands, aggressive marketing and promotional campaigns including Direct to Consumer (DTC) ads in the U.S. having certainly played a role.
Megabrands, often the new more fashionable term for blockbusters, namely products whose sales exceed the $1 billion threshold, account for more than 25% of total pharma turnover, up from around 8% back in 1994. This move reflects the strategies of big pharma to focus on this type of product, often viewed as the sole one worth developing and marketing!
While the merits of such strategies are beyond the scope of this article, one thing is certain: it has left both pharma companies and their fine chemical vendors highly dependent and vulnerable on the fate of a handful of products. Witness the setbacks recently suffered by Merck following the withdrawal of Vioxx or the effects that an earthquake had on Bayer’s ability to supply Cerivastatin-Lipobay, which was ultimately phased out in 2001.
Supply Side Changes
If the demand side of the equation for fine chemicals has changed, so has the supply side! As an example, China and India have continued to make inroads on the world fine chemicals scene. The number of FDA-inspected facilities in India now exceeds Italy, which was long viewed as the world's leading source of off-patent API.
Similarly, India has overtaken Italy in terms of number of DMF logged with the FDA and this gap growing daily! Although no reliable statistics are readily available, these and other indicators suggest that inexorably India and China are taking marketshare out of Western fine chemicals producers. Need proof? Witness the increasing interest these countries attract from Western pharmaceutical companies that are planning to source out of these an increasing share of their fine chemicals requirements.
These and other factors spell bad news for the Western fine chemicals industry which, during the past 10 years, underwent massive expansion. Capacity, as extrapolated from a sample of fine chemicals entities, has steadily increased—an extra 30% reactor capacity having been added between the mid 1990s and 2000. This is reflecting the massive capex investments undertaken-these often having swallowed two, if not three times, total depreciation allowances—absorbing most if not exceeding the cash flow generated by the business.
Parallel to this, while most established players have been investing in extra capacity, others poured vast amounts of money into acquiring existing assets. That strategy resulted in sky-high multiples. In fact, some buyers paid—or overpaid—30 times earnings for some assets!
And, what about financial performance? What was once “the most attractive segment of the chemical industry” by many is now viewed as being—I am quoting—“in a fine mess” and going just one way: towards further setbacks and disappointment.
But will this be really the case? Certainly the much touted recovery anticipated for the fine chemicals industry during the past few years continues to remain highly elusive. Some observers now predict that the recovery will not occur until 2006, if not 2007!
It is beyond the point to debate when the industry will recover, a more fundamental question is whether and why a recovery should or will occur!
A Look at the Future
Within this frame it may be useful to draw some possible future scenarios:
| • | A business-as-usual scenario where the Western fine chemicals industry will see its profitability recover in a painless way thanks to an upsurge of demand that would absorb and solve the current overcapacity problems does not appear to be credible or sustainable. |
In fact, this scenario will most probably lead to a further deterioration of financial performance as it is difficult to conceive that the current overcapacity problems and major rivalry among vendors (a corollary also of a highly fragmented industry structure) will go away overnight!
Rather, business as usual does not appear to be sustainable; a shakeout is bound to happen as red ink becomes the rule, thereby forcing even the most patient investors and industrialists to act.
The second scenario revolves around the often painful process of restructuring. In such a scenario, the Western fine chemicals industry aggressively slashes its cost base—closing facilities and shredding its work force in order to adjust to a more hostile environment.
This seems the path adopted by a number of companies as witnessed by the wave of layoffs and job cuts announced during the past 12 months! But will this be the way toward salvation? Perhaps, at least over the short- to medium-term, as such moves address just one side of the equation; i.e., costs. Moreover, it can be questioned whether enough capacity will be effectively retired or if assets will not simply change of hands. Witness the Honeywell Bahamas unit acquired from PFC in 1998. It was subsequently mothballed between 2000 and 2002 before being reacquired by the original owner at a fraction of its original price.
Probably something more is required to revive the Western fine chemicals industry. The chrysalis scenario calls for an in-depth transformation of the Western fine chemicals industry where innovation and the ability to evolve, adapting to the new competitive environment will be the key for success.
Indeed, traditional business models have proven their limitations and need to be reassessed; every aspect of how business is conducted must be reviewed.
Chemistry...or Alchemy?
Let’s just illustrate this by a few examples. In the past, several fine chemicals players have prided themselves with their full backward integration and ability to start from very simple, basic elements, to synthetize complex molecular structures—almost like the good old alchemist who started out with base metals and turned them into gold!
This approach, while securing high gross margins, has major implications on the fixed assets and fixed cost structure, also risking the creation of major inflexibilities and swallowing substantial capex outlays. Possibly a lesser degree of integration starting, as an example, from semi-advanced intermediates sourced from third parties focusing on the last critical synthesis steps could be worth considering as a strategy to reduce both fixed costs and capex requirements while allowing to expand overall degrees of freedom.
 Building the right molecule is an increasingly complex and expensive proposition in the fine chemical industry. |
The revenue potential of projects granted to third party fine chemicals vendors appears to have shrunk. This stresses the need to adapt and innovate to profitably handle smaller projects, with agility and speed increasingly becoming the rule of the game. On the marketing side things have also changed. As an example, large pharma is not any more completely dominating the scene as a customer group for fine chemicals vendors.
Other groups do exist, including:
| • | Medium-sized pharma; |
| • | Start-ups (a set of players having an increasing role in the development of NCEs, 40% if not more of new molecular entities stemming from this set of players); |
| • | Generic houses (These companies that are increasingly looking to develop some form of competitive edge. For example, some generic firms have exclusive access to the drug substance by entering into custom synthesis supply contracts with fine chemicals vendors. This is a radical departure from traditional approaches when this set of players happily relied on informal agreements with a range of vendors. |
| • | Specialty pharma is a recently (re)discovered breed of companies that is worth a closer look. Indeed, several hundreds of such companies exist; their business models as far as their fine chemicals requirements are concerned, differ widely. These include: |
| • | Segment concentrators, namely mini replicas of large pharma focusing on selected therapeutic or product niches (Allergan and Amersham, now GE Health Care), representing typical examples respectively in ophthalmology and in-vivo diagnostics; |
| • | Project recyclers, such as Medicines Corp. or Helsinn, that resume the development of projects discontinued by the original inventor targeting niche indications; |
| • | Portfolio scavengers such as King or New Horizon Pharma, that specialize in marketing small products divested by larger pharma, their lever for value creation revolving around focus on selected customer groups; |
| • | Product resurrectors, such as BioVail or Watson, that inject new life into old molecules through reformulation or development of new indications. Watson did just that with oxybutynin; |
| • | Focused multisource marketers offering a complete product range targeting selected end markets such as APP, Bedford Labs or Mayne, all in the injectible field. |
Adapting to a New Landscape
Each of these groups has different fine chemicals requirements and sourcing patterns. All of this is stressing the need to adapt sales and marketing approaches to rediscover the virtues of customer segmentation, move beyond the traditional paradigm of focusing only on large pharma, a business model which has too often resulted in increasing customer dependency and rivalry with all vendors chasing the same opportunities. Similarly, it may be worth assessing the business scope retained, namely, molecule builder or, rather, solution provider?
This question may seem like rhetorical consultant jargon, but it has major implications on how fine chemicals vendors view and define their mission. Do they simply supply specification products or can they also provide value-added ancillary services?
As an example, it could be worth assessing the opportunity for off-patent API producers to offer, together with their API, the associated registration dossier files, a move that may reduce business volatility, lessening the threat of competition for them while allowing them to capture a larger share of the value added. Within this framework, a source of inspiration may be represented by the strategies of some Indian companies that do not anymore compete just on the basis of low delivered prices but are rather emphasizing the differentiation element. Similarly, the increasing profile of India on the world fine chemicals space should not be viewed as just a threat by Western suppliers but also as an opportunity as some vendors are starting to supply select API and intermediates to Indian companies. Clearly all this requires adapting the approaches to the business, innovating on what is done and how it is done!
Once again, the fine chemicals industry’s environment has evolved but has somewhat lagged in adapting itself with such problems as eroding profit margins and melting valuation multiples. While cost-cutting and restructuring may provide some breathing room more fundamental steps are now required and embracing innovation in every aspect of the business is one of them!
