Any notion of “healthy” gross margins may sound like romantic nostalgia from the distant past. The common margin descriptors of today are “razor thin,” “lean,” “squeezed,” “shaved” and “starvation.” A widespread view is that anything else is not consistent with the current reality for CMOs in the pharmaceutical industry. My dissenting argument is that the long term health of a CMO and of its clients depends on adequate gross margins for contracted projects. Current trends are making adequate margins more essential than ever before. They are absolutely necessary if a CMO is to provide the service level and compliance assurance that the new reality requires. A major part of the tension between vendors and clients over margins is that the latter do not fully understand that a substantial percentage of the gross margin must go into infrastructure and other costs which are not part of the CMO bottom line.
- A simple illustration of infrastructure cost is the equipment for generating water-for-injection. This requires a boiler. In normal use, it must be replaced every 10 to 15 years. For Dalton’s scale of operations, a new boiler is $350,000. There are many other pieces of equipment with similar or shorter lifetimes, from air handling units, filling machines, analytical tools and production machinery.
In addition, we must allow for contingencies. This is a major consideration for those of us who provide sterile fill services. If a failure is detected in regular process checks, the cost of finding and correcting the problem can escalate quickly. Upgrading worn production infrastructure is another major financial issue. Costs have escalated because retrofitting existing machinery is now seldom satisfactory and the CMO is faced with the acquisition of new equipment.
A potential client came to us recently because of serious compliance issues with his current CMO. When told that the cost per unit for his fill requirements would be in the order of $2.50, he was shocked. “How can you charge so much,” he asked. “I’ve been paying only $1.50 per unit.” The answer is simple. At the $1.50 price, his old CMO was incapable of meeting current compliance requirements and that is why he was forced to find a replacement. The reality is that his vendor had probably been struggling with low margin business for some time, or had mismanaged decent margins by putting too much toward the bottom line. Chronic neglect of infrastructure and operations compliance always catches up with CMOs and eventually causes business failure. The final blow is very often the identification by the regulatory body of problems which the CMO decides are too costly to fix.
A trend that shows no sign of abating is that sponsors, the FDA, EMEA and other regulatory agencies increasingly view the CMO as the gatekeeper of quality. It is an inevitable consequence of the industry shift to the virtual model and having many suppliers of components on other continents. Although I am not uncomfortable with this, the higher level of compliance responsibility raises manufacturing costs and margins must reflect this. In my opinion, the increasing dependence of the client on the CMO for compliance is one of the most compelling reasons for clients to look beyond price in negotiations.
I don’t expect the tension between CMOs and clients over margins to diminish, let alone disappear. Clients are under constant scrutiny by the financial community. For developing companies, venture capital stresses cost management by executives.
For established companies, continued paring of costs is a key component for maintaining revenues in the face of payer pressure on drug prices and loss of exclusivity. Of course this leads to pressure on suppliers.
For their part, CMOs must constantly work to develop cost-saving efficiencies. My point is that those who believe that the supplier should accept starvation margins yet have total responsibility for everything are both unrealistic and short-sighted. Approaching contract manufacturing as a commodity service simply can’t work in the context of the virtual model of capital efficiency.
The CMO is a vital link in the supply chain. What I look for are clients who have a partnership orientation. I never expect price negotiations to be easy, but we know what margins are necessary for an ongoing, healthy CMO business. We have learned not to chase potential clients who are focused mainly or exclusively on price. They typically insist on multiple rounds of quotes with decreasing margins based on quotes from other vendors.
In most of the early and mid-stage projects that we are involved the contracts are not simply cost plus arrangements but involve significant risk sharing. The ideal client is one which is genuinely interested in an appropriate distribution of risk according to individual capacity in a spirit of fairness.
Balancing risk sharing relationships is not easy but we have learned a great deal over the past decade. The most satisfying business relationships have been contracts which irrevocably bound Dalton and the client, typically for a period of five years. When difficulties arise, we work through the challenges together because there is no practical option to do otherwise.
An adage heard in some circles is that the North American CMO is doomed to extinction because of offshore competition.
I certainly don’t believe it. Dalton is currently making a large capital investment to increase capability and capacity, and we are also making investments to ensure that we will meet future requirements for compliance.
The trend toward focused therapies for smaller patient segments should over the long term increase the pool of potential clients for small and mid-size CMOs. I am encouraged to see in my current client base a growing understanding that thin margins are not sustainable. Our goal must be a healthy ecosystem in which all players have the opportunity to prosper as we work together to develop innovative therapies to help humankind.