A Riskier, But Perhaps More Profitable, CSO Business

At a time when much of the pharmaceutical outsourcing sector is struggling-with CROs particularly dragging over the last several years-the contract sales and marketing industry remains solid. One thing the CROs and CSOs do have in common is a desire to form risk-sharing partnerships with their clients that will bring them higher margins than traditional fee-for-service contracts. Last October, PDI's LifeCycle Ventures Inc. subsidiary inked a five-year agreement with Glaxo Wellcome Inc. for the exclusive US marketing, sales, and distribution rights for Ceftin, an oral antibiotic used in treating acute bacterial respiratory infections. PDI had to create an infrastructure with all the various commercial components, and since the deal, its share prices have been on a singularly impressive roller coaster ride. But PDI is once again looking for risk-sharing arrangements, although future deals may involve a more limited set of services than it is providing in connection with the Glaxo deal.

At a time when much of the pharmaceutical outsourcing sector is struggling—with CROs particularly dragging over the last several years—the contract sales and marketing industry remains solid. And the top three CSOs (Ventiv Health Inc. , Quintiles Transnational Corp. 's Innovex Inc.,and Professional Detailing Inc. ) have each put up impressive recent growth numbers.

One thing the CROs and CSOs do have in common, however, is a desire to form risk-sharing partnerships with their clients that will bring them higher margins than traditional fee-for-service contracts. In the case of CROs, the interest in such deals is arguably driven by the need to break away from a business model that may no longer be viable (see "Quintiles' Internet Gambit," IN VIVO, October 2000 [A#2000800175]). For CSOs, the motivations include leveraging the professional and well-trained sales forces that they have assembled over the last five or six years into more lucrative agreements, as well as preparing for the long-anticipated slowdown in the pharmaceutical sales force arms race.

Perhaps the earliest and most creative example of a risk-sharing CSO deal was that struck between CV Therapeutics Inc. and Innovex in May 1999 [See Deal] for the promotion of CVT's Phase III angina drug, ranolazine. In that deal, Innovex agreed to make an up-front equity payment; fund pre-market activities through a load; and provide sales and marketing services. In exchange, Innovex will pay CVT royalties, ranging from 25% to 33%.

Ventiv got into the act in September 1999, when it signed a six-year, three-product deal with Bristol-Myers Squibb Co. The agreement calls for Ventiv to provide full promotional analysis and optimization, 730 field reps who carry BMS cards, and educational marketing. It is designed as a combination fixed fee/revenue sharing agreement, and is projected to generate $350-$400 million in revenues for Ventiv.

And last October, PDI's LifeCycle Ventures Inc. subsidiary inked a five-year agreement with Glaxo Wellcome Inc. for the exclusive US marketing, sales, and distribution rights for Ceftin (cefuroxime axetil), an oral cephalosporin antibiotic used in treating acute bacterial respiratory infections. PDI assumed all commercial responsibilities for the drug, including marketing, pricing, contracting, and distribution (for which it has sub-contracted with Livingston Health Care Services, a subsidiary of UPS). The CSO will take ownership of Ceftin inventory purchased from Glaxo and book all domestic wholesale sales as revenues, expensing the cost of inventory, detailing, advertising, and the like.

Last year, Ceftingenerated about $332 million in revenues. PDI officials say they will be able to produce 8% revenue growth in 2001, which should generate a 6.5% pretax profit margin, or the equivalent of about an extra $1 per share for PDI stock. A number of analysts believe that those are achievable numbers.

The Ceftindeal is the first one for PDI's LifeCycle subsidiary, which was launched last year as a vehicle for the risk-sharing side of the business. Among other things, LifeCycle is intended to serve Big Pharma companies with profitable, but maturing, products that have flat or eroding marketshares. For biotechs, LifeCycle offers an alternative to outlicensing for companies seeking to retain control over their products.

One of the most interesting aftereffects of the Ceftinagreements has been the financial market's reaction: since the deal, PDI's share prices have been on a singularly impressive roller coaster ride.

PDI's price had actually made a fairly precipitous jump in the 5 months preceding the Ceftindeal, from around $19 in April to $57 at the end of September. Steve Cotugno, PDI's VP, corporate development, says that the rise simply mirrored the recovery of the health care financial markets, as technology stocks came—or crashed—back to earth.

But that boost was nothing compared to what happened next. Within a week of the Ceftindeal, shares were up $23 to $80; by the end of November the stock was selling at $135.

Then concerns regarding the patent protection for Ceftinbegan to mount. The tablet and suspension formulations have patent coverage through July 2003 and 2008, respectively. Ranbaxy Laboratories Ltd. , however, is seeking approval to sell its generic version of Ceftin as early as this year. And when analysts also began to question the validity of PDI's sales projections, the stock began to fluctuate wildly. On December 8th there was a 40-point swing in price; a week later the stock closed at $72. Analysts have recently expressed confidence that Ceftin should be free of generic competition until 2003, and also generally agreed that the sales goals are attainable. As IN VIVO goes to press, PDI stock is hovering at around $90—still more than six-fold increase over the price last spring.

And that's about where it should be, argues Cotugno. The run-up, he says, reflected "fast money and momentum players who didn't understand the underlying fundamentals and the risks associated with Ceftinand the CSO business in general, and "didn't appreciate the size and complexity of the Ceftin deal." Cotugno says that he and his colleagues "were uncomfortable with $135—it just wasn't supported by the earnings." So far, the deal with Glaxo is the only one for LCV, and at least one analyst expressed concern following a December 2000 guidance call that additional such agreements hadn't been announced. Chris Tama, who heads LCV, and has held senior management positions at Novartis AG and GD Searle & Co. (now part of Pharmacia Corp. ), says that those sorts of expectations are unrealistic.

For one thing, Tama says that it's a positive sign for investors that PDI isn't rushing to put equity into more risk-sharing deals. He adds that PDI has turned down several deals that failed to meet its criteria. Indeed, explains Tama, PDI did an extensive vetting of Ceftinbefore going ahead with the deal.

Using the resources that it gained by purchasing the market research and medical education company, TVG, PDI conducted a series of focus groups. Physicians essentially said, reports Tama, " that Ceftinis a great drug, but we haven't seen any reps lately." That, and additional research, according to Tama, indicated that the drug's sales "are extremely responsive to detailing" and thus an excellent candidate for PDI's services.

Beyond the assessment process, negotiating took time. PDI first began talking with Glaxo in May and didn't conclude the deal until seven months later.

Ramping up to handle the sales and marketing of Ceftinalso consumed considerable amounts of time and resources. Because Glaxo completely handed off the commercialization duties, PDI had to create an infrastructure with all the various commercial components including medical affairs, distribution, and analytics. Taking over distribution in particular was a major—and new kind of—undertaking for PDI, which assumed responsibility for $40 million in inventory.

While PDI was engaged in this Ceftin-related preparation, it wasn't looking for more LCV deals, according to Cotugno. But he says that PDI is once again looking for risk-sharing arrangements, and that he sees completing 2-5 LCV deals over the next 18-24 months. Cotugno emphasizes that those deals may not be of Ceftin's magnitude and may involve a more limited set of services than it is providing in connection with the Glaxo deal.

John Kreger, an analyst with William Blair & Co., agrees that PDI shouldn't rush into additional at-risk deals since there's plenty of growth left in PDI's base business. In the long-run, however, Kreger argues that risk-sharing deals are the way to go for CSOs. In addition to increasing margins, Kreger says that they need such agreements to prepare for when the pharmaceutical industry sales force build-up finally reaches the saturation point. Although the oft-predicted slowdown has yet to occur, Kreger argues that eventually there will be just too many reps for too few physicians, and that the ROI for detailing will diminish. As demand for the contract detailing services goes down, more lucrative, performance-based contracts will become increasingly important.

In fact, Kreger says that he expects to see more risk-sharing deals among the CSOs in general. He contends that while drug industry consolidation may have some disruptive short-term effects, as newly combined companies figure out whose outsourcers to go with, the mergers will ultimately benefit contract sales and marketing companies.

Although it could be argued that some of the M&A activity seems to be at least partially driven by a perceived need to create a critical mass of in-house sales and marketing firepower for promoting blockbusters, Kreger contends that there will always be a demand for help in marketing maturing or mid-range products like Ceftin. "For every approved product, says Kreger, "there will be an older drug that a pharmaceutical company can no longer afford to promote. It's essentially a zero-sum game." Chuck Saldarini, PDI's CEO, concurs: the number of products that fail to meet the promotional thresholds of large drug companies will only grow as consolidation increases the pressure to focus on blockbusters, he believes.

But should the CSOs make a significant foray into at-risk deals, they will necessarily become a different kind of investment than in the past. The post-Ceftinfluctuations may be exceptional, but they also send a message to investors about the changing nature of the promotional outsourcing business. As John Kreger puts it, "The P&L [of CSOs] will begin to look more and more like that of specialty pharmaceutical companies."