They messed up and left... Part V

A fanciful story inspired by events observed in different companies in the contract manufacturing market and could happen again in the future in other companies in the same industry.

Connection to Parts 1 to 4

The family owned CDMO became PE owned. The 5-year BP shows quadrupled EBITDA. Profitability improvement is expected to come exclusively from discontinuing “unprofitable business” and from Price increases and Recharges. The word “Contribution” was forbitten and any new RFQ was reviewed in terms of EBITDA even if not clear how EBITDA could be calculated in RFQs. New corporate positions were created, increasing the general overheads. But sales were still to come. Manufacturing sites were given full responsibility on their P&L and thus the other functions, like Business Development, become supporting functions. RFQ process became more complicated requiring several authorization levels. Changes in managing customers and customer service were implemented.

Part 9: F**k the contracts

It is common practice in companies that every new business deal is accompanied by a contract. There are clauses in the contracts that protect both parties or they give them the right to claim something if the cooperation goes wrong.

This CDMO had over 100 customers most of them being in its portfolio for years and the contacts signed with them had the signature of the previous owners; the family. The family, in its attempt to make the next step and grow more and more its business, decided to open the door to some big pharmaceutical companies. And when you are small fish you have to play the game with the rules of the big fish, so in order to produce for the big pharma, the CDMO provided lower prices than the market average, but at the same time trying to keep the costs down as much as possible. The second thing that the family decided to do in order to put the big players in their house, was to sign contracts with big pharmaceutical companies with terms more favorable to them rather to the CDMO. ?

For example many contracts signed under the old regime included a re-pricing clause mentioning that if material costs increase up to 3% per year, then the CDMO has to absorb this cost. If the material cost increase is higher, the CDMO should bring evidence and then the cost could pass to the customer. And when it came to conversion cost (the cost related to the production process) the CDMO should be restricted to increase this part of the price according to inflation or labour index of the country where the product was produced. So all these years, annual price increases were kept to minimum also because it was the case that the CDMO did not always meet all its targets mentioned in the contracts related to delivery performance or quality performance. So both parties avoided usually asking for claims either in terms of pricing from the CDMO perspective or in terms of penalties related to performance from the customer perspective.

When the regime changed this practice had to stop. “Combining performance with pricing discussions is wrong” were the words of the CEO. “Its one thing asking for price increases and another one discussing about delivery performance. We should ask customers for price increases regardless of not performing according to their expectations” And next to him the CFO added that “no matter what the contracts say there is no way that we can absorb any cost increase or to keep negative or low profitability levels. So no matter what the contracts say we should ask the customers to pay for the increased cost and for our profitability improvement.”

When a middle level manager asked what if it is our fault that the material cost goes up because of our own inventory initiative which makes us order lower quantities of raw materials? Will we also pass this to the customers? The answer was of course yes. “We should ask every cost increase no matter the reason and no matter what these old contracts mention. We are not in the position to eat the cost.”

It was September or October of the year before the end, when one of the toughest discussions around this topic took place. It was a teleconference where the CFO, the Commercial Director, the Procurement Director, the Supply Chain Director and some middle level managers participated. The topic in the agenda was to discuss “why we have not yet asked our customers the price increases that the re-pricing exercise, that we did during the summer, suggested”. During the summer, a huge exercise took place where all SKUs of the CDMO portfolio were examined. And after procurement’s feedback about the expectations of materials price levels for the following year, there was a new price for each SKU that the CDMO should communicate to their customers.

“And this should not be part of any negotiation. You should just inform the customers about the new prices and you should update your systems in order to invoice the new prices, arising from cost increases. And then as a second step, you should negotiate further price increases not related to cost increases but they will help us improve our profitability levels”. So the expectation of the CFO was to ask customers two waves of price increases. One wave because the CDMO’s cost were up and a second wave due to the fact that profitability level of the CDMO needed improvement.

“I cannot do this without having evidence behind the reasons of material increases” the Commercial Director dared to say. “I have made my own market research which does not suggest that material price levels will increase next year. On the contrary, my research says that there is a negative trend in the market. So before I go back to customers asking for price increases I need evidence that prove these increases”.?

That was it. The CFO would have kicked probably the commercial director in the face or maybe also in the balls, if they were in the same meeting room. ?And this is when he said the words “You are bul***ing the company right now” mentioned in previous parts of the story.

“But we have contracts signed”.?“F**K the contracts” was the response.

Probably singed contracts was a detail to him…

?

Chapter 10: This shitty team should go out and sell

It was mid of November of the year before the end. It was the time that the budget for the following year was almost ready and it was discussed between the functions of the company, the CEO and CFO. In the headquarters of the CDMO, in a big rectangle meeting room, the Commercial Director, the CFO, the CEO together with some middle level managers were gathered around a big table. You could feel the tension in the air even before the beginning of the meeting. The participants were prepared for a difficult discussion, as it is the case for all such budget meetings, since the role of the Top Management is to challenge the figures of each function and make them prepare a final version with better results.

Only one week before, the Commercial Director together with one of the middle level managers of his team who was there to support him with the figures, were in the same meeting room participating in the budget meetings of the manufacturing sites and the top management. So they were prepared to be challenged. They were prepared because the CEO in every single meeting with the manufacturing sites was asking the same question again and again. “Why there are no NPIs included in the budget”. NPI stands for New Product Introduction. ?And he was asking this question to the Commercial Director who was in charge of business development and was responsible for bringing in new business to the company. ?After several meetings, the CEO clearly frustrated, finger pointed the Commercial Director and told him “next week, in the business development budget meeting be prepared to explain yourself, it is unacceptable that there is no NPI in the budget”. The commercial director agreed and over the course of the following days, with the support of his middle level manager spent hours and hours preparing several charts, diagrams and dozens of slides that would be sufficient to explain and to justify the absence of NPIs.

In the CDMO business, bringing growth through new products is not like any other business. If for example you sell carrots, the customer buys the carrots and the revenue is pocketed the same moment. If you sell pharmaceutical product dossiers, you sell the dossier to the customer and the revenue is in your books the next month, at least a good part of it. But if you are a CDMO and you sell your capacity, it does not work exactly the same way.

In order to give an offer to the customer you need to receive the relevant documentation for the product that you are about to quote for, prepare your offer and then wait for the customer’s feedback that may take several weeks or even months. And then if the customer accepts your offer, until you see the manufacturing revenue of the new product in your P&L, it may take another couple of years. And the reason is that transferring the production of a pharmaceutical product to another manufacturing site, has many steps. So before you are ready to start the production of the new product, first you need to validate it with the equipment of your sites. Then you need to register the new manufacturing sites to the health authorities and also wait for the stability studies to finish. This means that you make some pilot batches and you wait to see how the product will respond to the new environment that was produced. This takes several months. So in reality from the moment that you agree a new business with a customer it may take two years before you can produce it in full.

But probably these were details…

In practice what all these meant was that in order for the CEO and the CFO to see new business in the budget of the following year, these new business should have been agreed with customers two years before. This is the nature of business development in the CDMO business. All the work that is done now, bears it fruits in the future. And the particular CDMO, two or three years ago, was under a very difficult period where ownership was changing from family to capital equity. And this created uncertainty to its customers also because of the rumors behind the reasons of this transition. It was spread around the pharma world that this CDMO was under financial difficulties and needed restructuring. No matter if this was true or not, the result of this was that customers were reluctant to award new business to the CDMO until the situation was stabilized. Therefore the absence of new agreements during this period, resulted in no new business in the latest budget. This was it and could not change, it was inevitable. It’s like you want to sell carrots in summer but not plant them in spring. If you don’t plant them in spring, there is no way that you could sell them in summer.

The Commercial Director even if he was not in the company for many years, knew that this excuse would not be enough. So he asked his middle level manager to prepare something more, showing what new business has been agreed in the previous year and would bring revenue in 2020 and 2021. And as a matter of fact the amount of new business agreed over the previous year was quite significant, given the circumastances. So his story would be that we may not be able to change the growth of 2019 anymore but we have prepared the growth of 2020 and 2021. And that almost every manufacturing site would have new business in 2020 and 2021 because we have made a such great job last year! But it was not that easy to calm down a CEO and a CFO under enormous pressure for immediate results.

The pressure for results was huge and part of it had to do with the figures included in the business plan for 2019.?The utopic business plan assumed that in 2019 the overall EBITDA of the company would be double than 2017, before its peak in 2021 where minimum triple and maximum quadrable EBITDA should be expected. The actual EBITDA result of 2018 was expected to be more than 10 million euros.

Imagine the frustration of the CEO and CFO in the first version of the budget, in the beginning of November, where the manufacturing sites provided an overall EBITDA result of zero! This was crazy of course. How it is possible to expect more than 10 million of EBITDA for 2018 and zero for 2019? So the Top Management urged the sites and functions to revise their budget and build another one with a targeted result of more than 20 million of EBITDA, in order to be close to the assumptions of the business plan.

What sort of company prepares two versions of budget within the period of 1 month with a variance of 20 million euros? Because this is what happened at the end. The budget was revised and its final version presented to the board assumed that 2019 would bring more than 20 million of EBITDA. How this happened and zero turned to more than 20 is not a mystery. It was the result of the manufacturing sites planting in unrealistic assumptions in their budget just to calm down the Top Management. And of course no one reduced the expenses. They increased their figures by assuming increased prices, new business not yet agreed, better efficiencies and output of their lines and all the easy things that do not require tough decisions related to cost cuts. No matter what figure was correct, the zero or the 20 plus million EBITDA, it was clear that something was not going right in the company. It was clear to middle level managers looking at the xls sheets and the assumptions of the new budget, that only some months within 2019, the company would be far behind the budget target. But nobody was listening. There was no way that the Top Management would go to the board and admit that the assumptions of the business plan were unrealistic. So they preferred to win some time by presenting a budget that would be acceptable by the board.?

Maybe this is why during the business development budget meeting in the big meeting room of the headquarters, when a middle level manager told to the CEO that “don’t expect to have new business in 2019, because we could not plant the carrots in advance, but we have planted many of them in 2018 and in 2020 and 2021 we will sell them” the response of the CEO was very clear. “I don’t care about 2020 and 2021, I want to see results now, otherwise we will not be here in 2021”. Not many people predicted how fast this would happen, but the truth is that very soon, the top management would not be part of the company anymore.

In this meeting, apart from the participants physically attended, there were also some participants attending through teleconference. The most important of them were the 3 directors of the business development team, each one of them overviewing a team of several business development managers. The business development department constituted of three teams. One team of 4-5 people in charge of the Key accounts, the most important customers of the group, another team of more people responsible for customers marketing pharmaceutical products and a third team with less people responsible for customers marketing cosmetic and OTC products. Growth was expected to come mainly from one or two key accounts and also from the two other teams. This is what the business plan had assumed.

What business plan did not consider was the fact that this CDMO had only one manufacturing site fully dedicated to produce cosmetic products and some parts of other sites that apart from pharmaceutical they could also produce cosmetic grades. In the pharma industry, areas where pharmaceutical products are produced should be separated by the production of cosmetic grades. So in fact, the BD team in charge of bringing growth through cosmetic and OTC products did not have many alternatives than to promote the capabilities of one or two manufacturing sites mainly. The advantage with cosmetic products is that they don’t require so long transfer in timelines as pharma products, because the regulations are not so strict. So, in theory you can be awarded with a new product now and in some months you may be able to produce it.

Some more details however made it more difficult for this specific BD team to bring in new business. The main manufacturing site able to produce cosmetics was almost full apart from the lines that were so old that in reality were not reliable to take in new products. So the free capacity that could be promoted was limited. Also the fact that this manufacturing site was part of a company producing mainly pharmaceutical and not cosmetic products did not help. And this was because its cost structure was similar to pharmaceutical sites, a disadvantage compared to competitors that focused on producing this kind of products. And the other concern was that the main capabilities of this old site were restricted in old fashioned products like creams and shampoos. There was no real capability of producing fancy cosmetic products that customers of the CDMO would be happy to promote to their market.

But these were details…

Details that the top management did not want to listen to, and their response when the right moment came was to say that “we don’t want to listen to excuses, this is a shitty team and their job is to go out and sell. If they can’t, we will fire them all. Don’t take it personal, but your team is a shitty team”. And the same goes for the team of the business development managers in charge of the key accounts. “Why you need 5 people in the team? Probably the director of the department alone would be enough to handle these 6 customers.” And then someone from the top management added that “if you cannot bring growth, and you cannot increase our prices, then you are useless. I’d better have two junior finance people asking for price increases to customers in order to increase the profitability of the company and fire the entire BD team”

“If you tell me that there is no way to bring new business in 2019 and whatever you have done in 2018 has already secured new business in 2020 and 2021, this means that I have banked this success and even if I fire you all, in 2020 we will still have new business. So why to keep you? We will also save the cost of this department, which is significant if you add its annual spent for the next 3 years. Its cost is higher than the EBITDA that it will contribute to the company over the next 2 or 3 years”

As if anyone in the company could calculate EBITDA correctly…

The silence in the room was very loud. And when the middle level manager of business development started to speak and say that BD is a support function and its efforts should be seen as an investment in the pipeline, the response was that this company does not has room for investments right now…

Even if the top management did not believe 100% their words, and they said what they said in order to pass a message, it goes without saying, that the morale of the entire business development team participating in the meeting was not at the highest levels as soon as they walked out of the room.

The message was clear, if we don’t secure the present, there will be no future. So, in the eyes of the top management (and probably rightfully) what would happen in 2 or 3 years’ time was irrelevant. And the reason was that if they could not meet their current targets, if they could not make sure that next year they would be in a position to satisfy their liabilities, then a nice pipeline for the future years would not save the game. The majority of private equities are not so patient.

But it was also clear that these people started to realize that the business plan was unrealistic even though they were not ready to openly admit it. Yet.

Chapter 11: I have to go now. Me too!

All these strategic decisions, this new mentality, all these changes that had to take place so fast could not lead to a happy ending. And within the first two months within 2019, it was no coincidence that people started to jump out of the boat. The CFO and the CEO left the company, the Commercial Director also left after some months and the same happened with the Operations Director. Finally the capital equity fund also left the company which finally collapsed...

So, a company that initially had a low but sustainable EBITDA percentage, collapsed in less than 3 years.

All these chain of events starting from the unrealistic business plan created by non industry experts, one by one brought the company step by step closer to the edge of the cliff. It is at least strange to believe that you can change the rules of the game when the product you sell is sold by so many other players in the market. How you can ask for price increases, discontinue products, kill customer satisfaction, increasing instead of decreasing your costs and expect that all this will work?

That is why it is so important that the people who create the business plan of a pharmaceutical CDMO, are familiar with this very specific industry. It is also very important that capital equity firms that acquire CDMOs manage their expectations when it comes to timelines. Because if they don’t, they will end up in having people in the organization, trying to meet something that cannot be achieved who will eventually start spending more time in politics than working for growing the organization. Because even the best C-level executives cannot do miracles. And in the specific CDMO, top management guys were undoubtedly, capable.

But the private equity behind, believed in something too good to be true. And since they believed it, they wanted it to be materialized. Therefore, pressure was applied to meet something that was more like a wish rather than a plan. So, the CEO, the CFO and the rest of the management team, did not have much of a choice, than to play the game by the rules set by outsiders. And in their effort to meet so strict timelines, they pushed for things to change fast. But changing mentality, culture, way of working, tools and train new comers, takes time and it cannot be done overnight.

Company from company differs, business from business differs, you cannot apply the same rules in every company you go. It’s different if you have invented the super drug and different if you and hundreds of others, produce tablets. In Europe. Where competition is so high and there are at least 200 other European CDMOs producing solid forms.

You cannot afford to apply the same practices, applied in a big pharma, to a CDMO. CDMO business is a special business and as every business it has its own rules. It is easy to blame the old regime and say that we will change everything rapidly from now on, but asking the foxes to take care of the chickens is an experiment. These foxes were so desperate for immediate results and kill whatever belonged to the old regime, that finally together with the chickens they took down the entire chicken house.

In any case this was an experiment that failed, and its main characters left and finally the company collapsed.

They messed up, and left…

------------------------------------------------------------------------------------------------------------

Disclaimer: This is a fanciful story inspired by events observed in different companies in the contract manufacturing market and could happen again in the future in other companies in the same industry. Any similarity to actual persons is coincidental.