Abstract: China pharma outsourcing industry grew in 48% annually in past eight years. The current financial crisis has exerted negative impacts on this Chinese industry and will likely continue to do so in near term. An inevitable growth slowdown from now on will thus be expected. However, the industry will still continue to grow in an enviable rate in following few years as a number of factors from both internal and external side continually drive it forward. There will also be three outsourcing waves to occur one after another along its future growing. All China-based CROs and CMOs are, however, still going to face a number of challenges. Successfully overcoming these challenges is critical for the industry to maintain such a growth momentum.
Introduction
Starting from almost scratch, Chinese pharmaceutical outsourcing industry has been experiencing fast growing in the past eight years. At present, the industry is composed of about 250 professional service providers including about 50 multinational service providers that have service facilities in China. In addition, growing numbers of traditional Chinese pharmaceutical and R&D-oriented biotech companies are increasingly approached for collaborations by drug companies from all over the world.
Despite the fast development, this Chinese industry is still relatively small in terms of its market size. At present the industry is valued at only about $1.42 B (please see Figure 1) and occupies only about 2.2% of the world outsourcing market. Compared with its counterparts in the Western countries and even India, the industry is also relatively weak in terms of its current service capability as majority of service providers are still young (most of them have less than five years of service experience).
Largely due to the coexistence of a large number of service providers in the already crowded industry, fierce competition has been seen in each service sector of this Chinese industry. That how this industry would likely develop in future has become a common concern to many professionals in all related industries. The current financial crisis also puts the future development of this Chinese industry into an uncertain path.
Figure 1. Development of China Pharma Outsourcing Market
How will China's pharma outsourcing industry develop under financial crisis?
Starting from the third quarter of 2008, the fast growing of this Chinese industry seemed to hit a road bumper mainly because of the global financial crisis. For example, in its 2008 3Q earnings report, WuXi PharmaTech, which had successfully maintained an average growth rate of 89% each year in the last five years, reported soft outsourcing demands. Its 2008 3Q earning was 6% shorter than expected, and its full-year revenue was up only 45% from 2007 if the operation income by its US division, WuXi AppTec, was excluded (WuXi acquired AppTec in January, 2008). The company thus forecasted that its full-year service revenue of 2009 would maintain at almost the same level as in 2008 ($265-275 M) and expected that the business of its China-based operation would grow only about 15-20% in 2009.
We expect that such negative impacts by the crisis will very likely continue in the near future. However, the degree to which each service sector of this Chinese industry is affected by the crisis might actually vary (please see below for more discussions).
1. Major pharma companies will shift their outsourcing priorities
Drug companies in particular those major ones will shift their priorities of projects to be outsourced. This is because these cash-rich major companies will gain more drug candidates from financially troubled small biotech companies. It seems that at present almost none of these major pharma and biotech companies have been affected by the crisis. In contrast, due to strong cash reserves, their pipelines would very likely be significantly enriched as most of them are currently posed to acquire more drug candidates from those small biotech companies that are cash poor and thus forced to give up their ownership. A typical example is the latest acquisitions by BMS of two late stage cancer drug candidates, XL184 and XL281, from Exelixis which just announced one month prior to the acquisition to reduce 10% of its workforce.
We believe that in near future outsourcing to China by these major pharma companies will still remain strong and even no apparent changes would be felt. The only difference might be the categories of the outsourced projects. As these major companies will now have more drug candidates in various development stages, they will certainly place more efforts on development rather than on discovery. It is therefore anticipated that, while less outsourcing in early stage drug discovery might be likely, more outsourcing in late stage drug development by these major companies will certainly take place in following one to two years.
2. Small and cash-poor biotech companies will be forced to consider outsourcing to China
It seems that the financial crisis hit hardest those small biotech companies that are still in various development stages. According to JZMed, in the last five months alone (since November, 2008) more than fifty biotech companies had announced cuts of their workforce. The percentage of job cuts within these companies ranged from 5% only to as much as 93%. A number of biotech companies also announced to reprioritize their R&D programs with more focuses only on late stage development. Several of them even completely cut early stage programs including those still in discovery and preclinical research. Some even planned to close their R&D facilities or put their programs on idle.
At this moment, most small biotech companies that are cash poor have to seriously think about how they could survive the financial crisis as many VCs are at present not favoring investing in small biotech. Most people in the industry believe that there are two options for these cash-short small biotech companies to consider at this moment:
► Selling their drug candidates or even their entire company to those major ones with significant discounts.
► Outsourcing their R&D projects to low cost areas such as China so that they could still continue their programs even with a limited cash reserve.
The first option works only to those companies that have developed a series of lead compounds. Some of them must have entered development stages and demonstrated promising results. To those that are still in discovery stage or early preclinical development stage, the current situation is extremely difficult as some VCs that have invested in startups or early stage biotech companies are currently selling their stakes in a marginal discount of as low as 10-60% of their original investment price. To these companies the second option would thus become critically important and could be the best choice. Therefore, outsourcing to China by these cash-poor small biotech companies might increase in near future.
3. How is each service sector affected by the crisis?
Based on our latest studies on this Chinese industry, we reached following conclusions of the possible impacts of the crisis on each sector of entire outsourcing value chain.
a. Early stage drug discovery
As almost all small biotech companies that are financially troubled are cutting all early stage research activities, and as major pharma and biotech companies will become more focused on late stage development, it is expected that worldwide outsourcing in early stage drug discovery, including outsourcing to China, will very likely decrease dramatically in near future.
However, the actual situation may vary in particular for outsourcing to China. As discussed earlier, those cash-poor biotech companies that are still in discovery stage or early development stage may be forced to consider outsourcing to China in order to survive the tough moment. In the past this option would not be considered by these small biotech companies. But the abrupt change in financial and investment environment will force them to change their mind. So outsourcing demand in drug discovery by some of these early stage drug companies might slightly offset the otherwise declining trend.
b. Preclinical research
A similar effect would likely be expected on preclinical research sector. The reasons are as follows:
► In the past big pharma and biotech companies were hungrily hunting all types of drug candidates even including those still in preclinical development stage. However, as they now have more choices, those still in preclinical development stage will become less attractive to them.
► Most cash-short biotech companies are also cutting their programs still in preclinical research stage as they are still far away from valuable final products.
► On the other hand, those small biotech companies that otherwise would not consider outsourcing to China may now consider this option. Some of them may be able to continue their R&D programs with their current cash reserves if they opt to operate them in China as it would cost them much less.
c. Clinical research
Clinical research is the most costly part in the entire value chain of drug R&D. But it is also the most valuable part as it is closest to final product stage. It seems that even under the financial crisis most biotech companies still remain focused on clinical research. The degree of their focuses varies, still depending on how much cash each has on hand. Most companies cut early stage clinical research such as phase I and focus on middle stage such as phase II. As for phase III, because it is the most expensive research, some companies just suspend it and seek co-development with a major company.
On the other hand, outsourcing of clinical research to China by those major companies will very likely increase. The reasons were just stated earlier. So the net effect of the current financial crisis on China's pharma outsourcing in this sector will maybe positive instead.
d. Contract manufacturing
Contract manufacturing of APIs for drug candidates is closely associated with the development state of clinical research. As discussed above, while outsourcing of API manufacturing for early phase drug candidates might decrease, contract manufacturing of APIs for late stage drug candidates would increase instead. On the other hand, demands for contract manufacturing of APIs for marketed drugs (including generic drugs) would likely become even stronger as more and more companies are forced to conduct cost reduction in every aspect of their operation under the extreme financial situation. Another positive factor is the recent opening of FDA's China offices (FDA now has offices in three Chinese cities). The presence of the FDA in China will certainly ignite new hope for outsourcing companies as more, strict regulations and inspections will be expected to all Chinese CMOs that provide APIs or contract manufacturing services to Western companies.
Figure 2 summarized these effects.
Will China's outsourcing industry still grow fast in next few years?
In the last eight years China pharma outsourcing industry has experienced an average annual growth rate of 48%. However, we believe a growth slowdown of this fast developing industry will be inevitable from now on. A number of factors determine this development trend. In addition to the aforementioned negative impacts by the current financial crisis, fierce competition in global outsourcing industry will gradually squeeze the development space for this Chinese industry. Also, the constant rising of labor cost in China is gradually reducing the attractiveness of China as a primary choice of outsourcing destination.
However, even though its future growth would be possibly much slower than its past time, we believe that this Chinese industry will still grow for a few more years to come in such a fast enough rate that would make many of its rivals envy. In fact, beside these negative factors, a number of growth drivers, from both internal side and external side, will continually push the industry forward, though in a much slower pace.
1. Growth drivers
a. Internal drivers
A number of internal factors will make China still a good place for outsourcing for a few more years. Key factors include:
► Improved IP protection environment: Years of education and strengthening of law enforcement have significantly improved IP protection situation in China. Many pharma and biotech companies that have recently dealt with Chinese companies agreed with this statement. It is anticipated that the improvement in the image of China's IP protection will certainly attract more outsourcing companies in future.
► Improved service capability: In addition to the accumulations of service experience over years, increasing partnerships and alliances between Chinese CROs/CMOs and experienced multinational service providers are rapidly improving the overall service capabilities of this Chinese industry.
► Government support: Pharma outsourcing is considered part of China's biotech industry which is considered a high priority industry for future development by Chinese government. Governments at various levels strongly encourage and support the development of this industry including pledges of more financial investments and improvements in industry infrastructure.
b. External drivers
Externally, the current environment in global pharmaceutical industry exerts more and more pressures to all drug companies. Demands for more outsourcing to China by both major drug companies and small biotech firms will still remain strong. The continued influx of a large number of multinational service providers would not only greatly improve service environment but also significantly enhance the overall competency of this Chinese industry in global outsourcing competition.
c. Three outsourcing waves to occur along its growth path
Based on our studies, we believe that there would be three outsourcing waves that further drive the future growth of this Chinese industry. These outsourcing waves will occur one after another with the first one started a few years ago by those major pharma companies that intended to open up potentially huge Chinese pharmaceutical market and take the advantage of China's low-cost labor. These major companies have conducted a variety of outsourcing activities in China for a few years already. Noticeably, almost all of them were also building up their own R&D facilities in the country at the same time of their outsourcing there. Many of these R&D centers are now fully operational after constant expansions. For example, GSK's R&D center in Shanghai was designed to accommodate 1,000 scientists and it is already about half full now. It is expected that outsourcing demands from these major companies will gradually decrease as they will shift their focuses more onto using in-house resources as cost structure is essentially same.
The second wave of outsourcing is going to be realized soon mainly by the influx of small and even medium-sized biotech companies who are driven to China by the financial crisis (the reasons were discussed earlier).
The third wave that will gradually shape up in the following few years would be caused by the growing outsourcing demands by the domestic Chinese companies. At present Chinese biotech industry is still in its infancy. However, it has gained growth momentum as more and more Chinese returnees are establishing R&D-oriented biotech companies and as the Government also encourage innovative research on new medicines and pledges to provide more financial supports. At present many of these emerging biotech companies are still lack of necessary expertise and facilities. Some of them are even intentionally set as virtual or semi-virtual companies. The readily available resources in these China-based CROs/CMOs that have built up facilities, experience and techniques in drug discovery, development and manufacturing would be the best resources for these startups. It is also a short cut for these emerging companies as they could avoid building up fixed but necessary facilities themselves.
2. Growth resistors: Challenges the Chinese industry is still going to face
China pharma outsourcing industry is still going to face a number of challenges along its future development. In addition to international competition from other developing countries, many issues on domestic side will also challenge all China-based service providers.
a. Fast rising of labor cost
Currently, one of the primary attractions to Western companies going to China for outsourcing is still its low-cost labor. However, China's this advantage is gradually diminishing at present. All China-based service companies are currently struggling with the rapid rising of operation cost. Numerous factors contribute to the rising, but mainly including:
► Rising of energy cost;
► Rising of living standard in most Chinese cities in particular those large, coastal cities such as Shanghai, Beijing and Guangzhou;
► Tightened control of environment protection by government which certainly costs company more;
► Mandatory healthcare insurance for all employees;
► Appreciation of Chinese currency against foreign currencies.
In addition, due to high employee turnover rate mainly because of the high demanding of skilled workers, almost all China-based CROs and CMOs have had to raise employee compensation every year in order to retain their valued scientists. For example, in the last 3 years the average annual total compensation of scientists in all Chinese pharmaceutical companies has increased by 11%. To all China-based CROs and CMOs, one of the key challenges they have to seriously address is how to control the fast rising labor cost.
b. Abiding by the international rule of game
In the past one year or so, there were several incidents of quality issue associated with the Chinese companies involved in supply chain (such as the contaminated Heparin), which has resulted in stricter control in regulation/inspection in Western countries. The new policies implemented by the Western governments for all imported drug products will greatly curb the manner of raw material sourcing. To many Chinese companies that are involved in the supply chain of raw materials to Western pharma companies, it means that they have to strengthen quality control in their production process or raise higher inspection standards in their own supplier chain. Some companies that fail to do so or have no ability to reach the required level of quality control may face to be kicked out of business loop.
c. Competition from neighboring developing countries
At present Chinese service providers face huge competition from their counterparts in other countries, in particular its neighboring country India. Compared with their Indian counterparts, Chinese CROs and CMOs at present are still in a less favored position. Although still having the advantage in cost reduction over Indian CROs and CMOs, the service capabilities and communication skills of Chinese CROs and CMOs are still inferior. Most major pharma and biotech companies choose Indian CROs for collaborations of more advanced R&D projects such as the structure-activity-relationship (SAR) study for lead optimization and advanced clinical research. They also more incline to choosing Indian CMOs for manufacturing of more complex APIs.
Other future potential competitors might be from other Asian countries including Vietnam, Malaysia, and Philippines. Although at present pharma outsourcing in these countries has not become popular yet, there are already service companies in these countries providing low-end services to Western pharma companies. Multinational service providers also opened their subsidiaries in these countries. For example, Progenix, a UK-based CRO, recently opened a service branch in Malaysiaˇ¦s first life science park, Penang Science Park, located in Bukit Minyak. As time goes on, the service capabilities of many of these CROs and CMOs in these countries will gradually catch up in the foreseeable near future, and eventually will become strong competitors to Chinese CROs and CMOs as these countries still have better cost reduction advantage than China.
Summary
We believe that China's pharma outsourcing industry will continue to grow for a few more years but in a much slower rate than before. Considering a number of drivers that will still push the industry forward and a number of challenges the industry will still face, we therefore predict that in the following five to seven years China pharma outsourcing industry will grow in an average annual rate of 29% and the industry will thus reach a market value of about $8 B by 2015.