Patheon’s Path to Growth: Economic Nationalism and Pharmaceutical Manufacturing
Increasing pressure for domestic pharmaceutical production could require a shift away from overseas manufacturing. This creates an opportunity for contract manufacturing organizations like Patheon to provide domestic production services.
Economic nationalism affects pharmaceuticals
Economic nationalism has experienced a resurgence in the U.S., with Republicans lambasting domestic companies that have outsourced their manufacturing to other countries. In January of this year, President Trump extended this critique to pharmaceutical companies, which in his view are “disastrous…they supply our drugs, but they don’t make them here” [1]. While the current political climate is uncertain, the administration could pursue a number of measures to encourage domestic pharmaceutical manufacturing, such as high import tariffs on pharmaceutical products or a border adjustment tax.
Domestic manufacturing: a challenge and an opportunity
Manufacturing a therapeutic drug begins with production of the active pharmaceutical ingredient (API), i.e. the molecule that has a direct therapeutic effect, and requires additional formulation and packaging, such as the capsule of a pill or the syringe containing insulin. 80% of APIs are produced overseas and 40% of therapeutics are manufactured overseas in their entirety [2]. Indeed, pharmaceutical products imported to the U.S. had an estimated market value of $86bn in 2015 [3].
Overseas manufacturing allows pharmaceutical companies to produce drugs at a much lower COGS than domestic manufacturing, given lower labor costs and more favorable tax policies [4]. For this reason, most pharmaceutical companies’ manufacturing facilities are located outside of the U.S. This reflects a significant CapEx investment, which would be difficult to move back to U.S. territory quickly and affordably [4]. Thus, any pressure to manufacture domestically would require a tremendous shift in pharmaceutical companies’ supply chains.
However, for the group of domestic companies that specialize in manufacturing drugs for other organizations, known as contract manufacturing organizations (CMOs), this could pose a multibillion-dollar new business opportunity. These companies could capitalize on the inability of pharmaceutical companies to cheaply and quickly transition to U.S. manufacturing by contracting to produce their products.
Thus, if new regulations or political pressures encourage a shift to domestic pharmaceutical production, contract manufacturing organizations could realize a significant opportunity. However, not all CMOs will benefit equally, as many have limited excess capacity [5]. Let us examine the example of one CMO that has been preparing to capitalize on increased domestic manufacturing demand: Patheon, a North Carolina-based subsidiary of Thermo Fisher Scientific.
Patheon poised to benefit
Patheon has been taking steps to position themselves to benefit from pressure to manufacture pharmaceuticals domestically. The company recently acquired several manufacturing plants in North and South Carolina, providing excess capacity that could support new domestic production projects as demand for domestic production grows. Most critically, one recent acquisition in South Carolina includes API manufacturing capability. Since the vast majority of APIs are imported to the U.S. and there is limited domestic production capacity, Patheon should be positioned to earn business and scale quickly. Moreover, many of their raw material inputs, such as drug capsules and vials, are sourced domestically, so they will have an advantage in providing a fully domestic supply chain [6].
Additionally, Patheon was acquired by Thermo Fisher, a large life sciences product development company, in mid-2017, which creates a promising platform for future growth to take advantage of increasing demand [7]. By going forward with their planned integration of Patheon’s manufacturing capabilities with Thermo Fisher’s early-stage bioproduction capabilities, the combined company will be able to provide an end-to-end manufacturing offering, from early science to commercial-scale production, positioning them well to compete for domestic business.
The path ahead for Patheon
To take full advantage of the opportunity, Patheon should continue building to support future growth in demand driven by a nationalist push for domestic manufacturing. First, Patheon should ensure it is able to provide an economical supply chain solution where all components are domestically sourced. If there were to be a shift towards tariffs on imported components, Patheon would then be better positioned to provide a lower-cost, domestically-produced solution. Second, Patheon should more actively seek to articulate the benefits of domestic production to potential customers, to ensure early customers and gain customer trust as the domestic manufacturing renaissance begins. Finally, Patheon should seek ways to generate medium-term cost reductions in the domestic production process, such as investing in automation to reduce labor costs. That way, even if regulations are ultimately not imposed on internationally manufactured pharmaceuticals, Patheon will still be able to effectively sell its domestic production capacity.
Even with these moves, challenges still remain for Patheon and other companies seeking to take advantage of this opportunity. Does Patheon have sufficient capacity to scale up to meet demand? How would demand vary across different types of pharmaceutical products (e.g., chemically-synthesized small molecules vs. larger proteins), and how does expected demand match up to Patheon’s capacity? And there remains perhaps the ultimate question: will any restrictions on international pharmaceutical manufacturing actually materialize, or will they simply remain a nationalist rallying cry?
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[1] Webb, Jonathan. “Trump’s Next Supply Chain Target: Big Pharma.” Forbes. January 11, 2017. https://www.forbes.com/sites/jwebb/2017/01/11/trumps-next-supply-chain-target-big-pharma/#349ae6a8ed06
[2] Aylor, Ben. “Will pharma manufacturing come back to the US?” Boston Consulting Group white paper. https://www.bcg.com/publications/2017/biopharmaceuticals-biopharma-operations-will-biopharma-manufacturing-return-to-the-us.aspx, accessed November 2017.
[3] Lo, Chris. “Is US drug manufacturing homeward bound?” Pharmaceutical Technology, March 5, 2017. http://www.pharmaceutical-technology.com/features/featureis-us-drug-manufacturing-homeward-bound-5743166/, accessed November 2017.
[4] Miller, Jim. “Will pharma manufacturing move back to the US?” Pharm Source (blog), March 2017, http://www.pharmsource.com/will-pharma-manufacturing-move-back-to-the-us/, accessed November 2017.
[5] Stanton, Dan. “Patheon well placed if Trump succeeds in bringing manufacturing home, analyst.” Outsourcing Pharma, February 2, 2017. https://www.outsourcing-pharma.com/Article/2017/02/02/Patheon-well-placed-if-Trump-succeeds-in-bringing-manufacturing-home, accessed November 2017.
[6] Keown, Alex. “This can be Patheon’s fate in Trump’s call for increased drug production.” Biospace, February 6, 2017. https://www.biospace.com/article/this-can-be-patheon-s-fate-in-b-trump-s-b-call-for-increased-drug-production-/, accessed November 2017.
[7] Thermo Fisher. “Thermo Fisher Scientific to acquire Patheon, a leading contract development and manufacturing organization.” press release, May 15, 2017. Thermo Fisher Scientific website, http://ir.thermofisher.com/investors/news-and-events/news-releases/news-release-details/2017/Thermo-Fisher-Scientific-to-Acquire-Patheon-a-Leading-Contract-Development-and-Manufacturing-Organization-CDMO/default.aspx, accessed November 2017.
It’s interesting to read about a business that’s trying to encourage and capitalize off the push towards more nationalization and forced domestication of the supply chain. The main difficulty I foresee in building a strategy off of expected political change is how hard it can be to distinguish bark from bite, particularly with the current administration. Is Trump’s critique against pharmaceutical companies simply a momentary twitter tirade or does it signal more serious policy changes to come? If pharma-specific regulations do come how quickly will they come? Given the uncertainty it’s dangerous for Patheon to invest too heavily in building excess capacity because it may never come, particularly given the pressure on the health system to reduce drug costs acting as a powerful disincentive for pharmaceutical companies to do anything that will increase their COGS.
In order to hedge against this uncertainty Patheon should make sure they have a path towards profitability and cost-effective production even if tariffs never materialize. One way to do this would be to try and locate manufacturing capacity close to major pharma distribution centers to save on transport costs. They should also double down on the technology spoken about above to offer advanced value-add capabilities that aren’t as readily available overseas. For example, as personalized medicine and individual dosing becomes more popular they could build that kind of customization and flexibility into their newer manufacturing plants. That way their future success is diversified across multiple future trends instead of being tossed about by unpredictable and ever-shifting political headwinds.
I personally do not believe that governments will impose strict restrictions on drugs manufacturing. The reason is that access to healthcare is a sensitive and political topic. If companies start bringing up cases of drug shortages or high drug prices due to import restrictions, there might be substantial response among the society. Even though I can see the government encouraging to produce APIs locally, the economies of scale in API manufacturing, particularly in small molecules, are an important driver. Thus, splitting the production to multiple locations might be a challenge.
On the other hand, when it comes to large molecules such as biologics, there might be justification to produce locally as operational excellence is more important rather than economies of scale [1]. Thus, innovative companies that master the complex production process of large molecules and reduce the operational costs will have significant advantage over low-cost producers.
[1] Peter Pollak, Andrew Badrot and Rolf Dach. “API Manufacturing: facts and fiction”. Available online: https://www.contractpharma.com/issues/2012-01/view_features/api-manufacturing-facts-and-fiction/
While I think you’re right that Patheon should educate customers on the benefits of manufacturing APIs domestically, if they are serious about investing in increasing domestic capacity, they also need to engage with regulatory and governmental bodies in an effort to encourage domestic production from the “top down”. Patheon could frame the production of APIs domestically as a “national security” issue in that a nation needs to be able to produce the drugs necessary to provide for its populace. By actively lobbying the government and appealing to their nationalist sentiments, Patheon could help facilitate the potential domestic production market opportunity instead of waiting and hoping that it will materialize. Like an activist investor, they need to help “catalyze” the change that they want to see in order to create value and justify their investment in increased capacity.
Gabby, very nice combination of solid content and excellent prose. I think your article is right to highlight that strong regulatory (maybe tax too) pressure would really be needed to incentivize the on-shoring of pharma manufacturing. From what we’ve learned so far, pills and vials are a very tradeable / transportable good; the labor rates are hugely different between say, India and the US; and big-picture “line changeover” costs are huge in terms of tech transfers etc.
One thing I would challenge though is whether we are fully considering how tax plays into all of this. It’s true that lower taxes are required on “the islands”, however I think that theme may fit more into affecting pharma companies’ geographic sourcing strategies from a enterprise tax planning perspective rather than from fundamental COGS differentials. US pharma companies generally see effective tax rates of 20-25%. They get there through transfer pricing, specifically allocating higher pre-tax profits to their subsidiaries operating in lower tax jurisdictions. Operationally, they would domicile IP in, say, Ireland and then claim that API produced in Ireland should see the value of the IP.
So if the API is produced in the US, and other steps (drug product, form/fill/finish, final packaging) are done in the US, I would ask whether the transfer pricing opportunity would fundamentally disappear. To support customer profitability, perhaps an alternative would be for the contract manufacturers to have a PR-heavy boost to post-API manufacturing coinciding with an expansion in international API capacity. Then the newly-increased API facilities could serve biotech customers who don’t engage in sophisticated cross-border tax planning.
Great article, Gabby. While I agree with your second and third recommendation that Patheon should seek ways to generate medium-term cost reductions in the domestic production process, I am not sure if a domestically sourced supply chain is a viable solution for Patheon. API production specifically is controlled by a few major players, mostly overseas, and is an area that is almost impossible for a company like Patheon to break into. There are multiple examples of generic drug manufacturers that tried to vertically integrate by producing their own API and failed to do so. This goes back to the point that API business is an entirely different business than contract manufacturing and requires very different business models, resources, and skillsets. In my opinion, Patheon should focus on their core business, expand their capacity, and take advantage of the need and benefits of domestic drug manufacturing.
Gabby – thank you for sharing this thoughtful piece on the opportunity our current regulatory environment presents to US-based contract manufacturing organizations to enter the drug manufacturing space.
While I agree that the threat of Trump’s statements about pharmaceutical companies could ultimately push some production domestically, I struggle to believe that US companies will be able to respond in a way that makes domestic production cost-effective. Patheon is smart to consider ways that it could capture some of the potential demand given its pre-existing fixed-cost assets, but if I were management I would hesitate to expand capacity until I saw a more clear and definite change in regulation. The risk of investing in greater capacity that goes unmet is real, as is the risk that regulatory changes do not last beyond the current administration after which incentives could quickly shift back towards international production. In my opinion, the key success factor for any pharmaceutical manufacturer is finding ways to be the lowest cost provider of drugs — something that US-based manufacturers are unlikely to achieve any time soon.