Interest Rate Cuts Could Further Weaken European Competitiveness
On Tuesday, the Federal Reserve cut the benchmark interest rate by 50 basis points (0.5%), hoping to ease the spreading impact of the recent credit crunch. One of the consequences of this move is likely to be the further decline in strength of the US dollar (USD) relative to the Euro and the British pound (GBP), accelerating the long-term devaluation of the USD. The lower interest rates mean lower returns to foreigners lending to US borrowers, thus making foreign lenders less interested in making loans to US borrowers. This leads to less demand for USD from foreigners, which will drop the price for USD (the exchange rate).
The weaker USD will mean even more pain for European CMOs and CROs trying to sell their services to US pharmaceutical companies. Prices quoted in Euros are already 40% higher in US dollar terms, and prices quoted in pounds are twice as high in dollar terms. Those multiples are likely to increase as the interest rate cut impacts exchange rates. European CROs and CMOs have some protection from the erosion of their price competitiveness: bio/pharmaceutical companies seeking regulatory approvals in Europe won't have much choice but to source clinical research services from European CROs, and European GMP and clinical trial regulations create some bias in favor of sourcing manufacturing services from European vendors. But European companies looking to compete to deliver services that need not be delivered in Europe may find themselves squeezed by customer demands for price protection, e.g., by mandating prices quoted in dollars or some other sharing of exchange rate risk.
Another byproduct of a weaker USD is that it could make acquisition of US facilities and companies by European and Canadian investors even more attractive because the Euro- or GBP-denominated price of US assets will drop. Acquisition of US assets would be a viable defensive strategy for European service providers dealing with the declining competitiveness of their European operations. US acquisition is also a sound offensive strategy for European service providers, since so much of the new product pipeline is in the hands of small and mid-size US pharma companies.
CMOs with a lot of oncology drugs in their portfolios, especially injectables manufacturers, could be in for a big downside surprise.
A new study released by the Tufts Center for the Study of Drug Development puts the success rate of clinical-stage oncology candidates at 8 percent, compared with an overall success rate of 20 percent. The study used data for candidates that began human testing between 1993 and 1997 and that have known fates (thereby excluding all drugs that got stuck in a phase and were never terminated). The study also noted that it took oncology candidates an average of 7 years to complete clinical development vs. an average of 6 years for all candidates.
If success rates for oncology compounds continue to be this low going forward, it could have a serious impact on contract manufacturers, many of whom are counting on some of these compounds for future projects. Tufts CSDD points out that the number of oncology candidates entering clinical development more than doubled from the early '90's to the mid-2000's, meaning that now, more than ever, CMOs are heavily reliant on the success or failure of oncology candidates.
The large number of recent contract signings has raised hopes and expectations for CMOs. But this could be an unsupported euphoria. CMOs anxious to sell capacity often don't do rigorous due diligence on new client candidates and are susceptible to downside surprises. Those CMOs that are counting on oncology candidates to be successful could face the daunting task of trying to fill capacity on short notice in a few years time.
In theory, the current volatility in the financial markets shouldn't have much effect on funding for bio/pharmaceutical companies. The market for mortgage-backed securities has little or no relation to the venture capital world: venture capital investors don't invest in mortgage-backed securities, and don't package their investments into traded securities. Further, venture capital investing is high-risk by definition, so you don't expect VC investors to be spooked by a general heightening of risk aversion.
Still, we think that investment could be negatively impacted by the current turmoil in several ways. One way would be for the general decline in liquidity and heightened risk awareness to reduce the availability of debt financing for bio/pharmaceutical companies. According to data collected by investment bank Burrill and Company, bio/pharmaceutical companies have raised nearly $30 billion through debt placements in the past three years. The biggest deals have been done by big pharma companies, of course, but mid-size companies and even early-stage have benefitted. The latter have used convertible debt instruments (which gives the lenders the right to convert their debt into stock) to raise capital for R&D investment, especially during times when it has been difficult to complete IPOs. In the current risk-sensitive environment, when major private equity firms like Blackstone and KKR are having trouble selling bonds for their leveraged buyout deals, debt deals for early stage companies could be difficult to complete.
Another negative secondary effect for the bio/pharma industry would be for current events to change investor perceptions of risk. One of the factors that drove the mortgage-backed securities business has been the large sums of money available for investment. That drove investors to seek ever-riskier investments in an effort to boost returns, and the competition to invest in those vehicles drove down the risk premiums that they normally would be expected to command. We think that all that money has fed venture capital investing in bio/pharma, and the need to put that money to work has led to a lot of questionable companies and compounds being funded. How else do you explain why there are 50+ HIV/AIDS vaccines in development? A new attitude toward risk could affect the funding available for these marginal companies.
A reduction in funding for bio/pharmaceutical companies would impact the CRO and CMO business quite negatively. The ramp up in early phase compounds over the past 5 years as fed the tremendous growth in demand for early development services including preclinical toxicology and clinical scale API manufacturing. It has also encouraged a resurgence of the "one-stop shop" model, which first emerged during the funding frenzy of the late 1990s. If the funding bubble bursts, a lot of CROs could find themselves in a heap of trouble.
The latest data on the drug development pipeline from IMS (provided to us by an equity analyst who tracks the CRO industry) indicates the continuation of a disturbing trend: the number of drug candidates in early development continues to grow, but the number of candidates in Phase III and registration remains flat. As the chart indicates, this picture has been the same for 5 years now, and there is no indication that it will change any time soon.
The pipeline data contrasts with other indicators we track, especially the continuing climb in CRO backlogs (work under contract but not yet performed). It's also at odds with the anecdotal reports we get from contract manufacturers, who seem to be having a strong year for new signings. However, the data is very much in sync with the low number of NME approvals by the FDA in recent years.
We've seen little discussion of why the sharp fall-off in candidates from Phase II to Phase III continues. Although there are many novel therapies in the pipeline, e.g., gene therapy and antisense drugs, we haven't seen an indication of a massive failure of candidates in any particular classes of drugs. Of course, there are a large number of oncology candidates in the pipeline and they have an inherent high failure rate.
Another hypothesis is that companies are trying to move more candidates from discovery into early development but then killing them before they get into costly Phase III trials. This suggests that industry is pursuing strategies based on accepting that the only way to bulk up late stage pipelines is to offset high early attrition rates with the sheer volume of new candidates.
One implication of this picture is that CMOs should probably not be too optimistic about their future prospects despite a large number of new contract signings. It seems that the probability of candidates actually making it to commercial success is pretty slim.
If you've got some hypotheses on what is going on in the pipeline, we'd like to hear them.
News from the bond markets this week may have some implications for Blackstone Group's plans to finance its acquisition of Catalent Pharma Solutions. The Wall Street Journal is reporting that investors are starting to insist on stiffer terms in bonds sold to finance leveraged buyouts by private equity firms. Investors apparently are balking at provisions that have allowed borrowers to pay interest by issuing additional debt to bondholders (so-called payment-in-kind provisions) and that have imposed minimal covenants on the borrowers. These provisions have not been typical in buyout lending in the past, but had become popular in the lax lending environment. Investors are starting to demand higher interest rates as well.
The WSJ reported on June 27th that a $1.5 billion bond deal meant to finance the leveraged buyout of U.S. Foodservice by two major private equity firms had to be pulled because investors balked at the terms, while a $4.5 billion debt offering to finance the acquisition of ServiceMaster had to reduce its payment-in-kind provisions.
The WSJ article noted that the stiffening bond environment reflected the large volume of offerings coming to the market and the recent difficulties of two high-risk hedge funds managed by Bear, Stearns. It noted that a $60 billion bond offering to finance the buyout of Chrysler from DaimlerChrysler also hit the street this week.
The Blackstone acquisition of Catalent was completed in April and is not at risk; most of these deals are closed with bank financing to bridge the time until the debt can be raised. However, Blackstone and Catalent could be looking at more costly debt, which could change their strategy and plans for operating the company.
Hopefully, the changing environment won't change Blackstone's plans to do the deal with public bond debt. Companies issuing public debt must file reports with the SEC similar to what publicly-held companies must file. If Blackstone chooses to go an alternate route, we will miss out on a valuable window into Catalent's performance and plans.
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