MANAGEMENT INSIGHT - CDMOs Take Flight: Business Lessons From the Airline Industry

I’m writing this article in an airplane. I spend a lot of time up here, and there’s a good chance you do too. Let’s take a moment, then, to reflect on the similarities between the airline business and our own. In my opinion, there is no industry more similar to ours.

It may not seem so on the surface. Most of the planes you fly on cost between $200 and $300 million; an Xcelodose costs $500,000. Most passengers switch airlines constantly based on schedules and routes; a CDMO partners with a client for months or years at a time. And yet, when you scratch a little deeper, our industry flight paths are not so different.

​LACK OF CAPACITY LOSES CUSTOMERS

Like the airline industry, CDMOs suffer from capacity issues. The airline wants to fill every seat, every day. The CDMO wants to run every machine, all day. But neither industry will ever achieve that ideal, because it means turning away customers when capacity is reached. In our industry, more than in the airline industry, a client scorned due to lack of capacity is a client lost. The airlines have compromised with a load factor of about 60%, at which point 7% of flights are full and unavailable. A load factor of 70% would result in 21% being turned away.

Our industry lacks statistics regarding load capacity, and even if such figures existed, they would vary widely based on the equipment and service involved. At Xcelience, we find that in most cases, we can maintain a load around 70% without having to turn any customers away. The  challenge is in anticipating increasing demand because of the long lead times required to increase capacity.

UNUSED CAPACITY EXPIRES

Once a plane takes off, all empty seats are lost potential revenue. The incentive, then, is to fill those seats for any dollar amount. The CDMO industry is no different. An idle machine or lab technician is a lost earnings opportunity. This differs from, for example, the manufacturing industry. A shoe factory can stockpile shoes for a while and slowly adjust capacity to meet demand over time.

Airlines and CDMOs cannot shed capacity with ease. The market for used planes is weak, as is the market for tablet presses and roller compactors during a recession. However, airlines can add capacity more quickly than CDMOs. Planes can be leased. For CDMOs, leasing is less common and, even when possible, time-consuming training and installation procedures must follow.

DEMAND FLUCTUATES

For the most part, neither industry can influence demand. The result is that both industries are sometimes buffeted by the economic winds around them, and must adjust course.

FIXED COSTS ARE HIGH

Because airplanes and terminals don’t come cheap, airlines are incentivized to fly their aircraft as much as possible, even if incremental flying doesn’t produce enough revenue to cover all costs. Routes are optimized to minimize non-full flights, but if a flight is unexpectedly under-booked, it’s better to book as many passengers as possible at any price, if only to cover the variable costs like fuel and peanuts. CDMOs are no different, economically. We are incentivized to use our equipment rather than let it sit idle, even if it’s booked at a rate that doesn’t cover our depreciation and other fixed costs. We don’t offer peanuts, so we have almost no variable costs at all. But whereas the airlines have no reason not to sell that last seat whatever the cost, in our industry, this isn’t completely so. The closer we are to full capacity, the less flexibility we have to meet our existing customers’ sometimes unpredictable needs.

ADDING NEW SERVICES CREATES GEOMETRIC EFFECTS

When an airline adds a new hub, it is, in effect, increasing production. In most industries, increasing production doesn’t really improve your competitive offering, but in the airline and CDMO industries, it does. When an airline adds a new city, it doesn’t just give customers one more buying opportunity, it gives customers access to a new hub with all the flights offered out of that new terminal. A 50% increase in the number of cities added to a network (say 9 to 14) more than doubles the number of city pairs from 45 to 105. Similarly, adding an XPRD makes it more likely at Xcelience that we will sell DSC and TGA work. Having a bi-layer press brings more work for analytical. The effects are geometric, rather than additive.

Here’s an important difference though; when an airline adds a new city, service to that city is the same as service to any other city. When a CDMO adds, for example, toxicology, there is a whole skill set associated with the new capability. The CDMO must take care to offer this new skill set at the same high level as its other capabilities (for the sake of reputation), and must maintain enough business to keep those people busy enough to justify their salaries and to keep their skills honed.

Of course, not all additions will have the desired geometric affect. The capacity added must be the right fit for the CDMOs offerings, and for the times. It’s fashionable right now, for example, to add preformulation to API or drug product suppliers. We did this at Xcelience several years back, and our X-Ray Diffraction and accompanying polymorph screening work is solidly busy. But when we added this capacity, we were filling a vacuum created when Aptuit bought SSCI back in 2008, and Steve Burns and his team subsequently left SSCI. Things are different now. Just because a company can afford the equipment doesn’t mean it will have the expertise or the work to keep a core group of scientists busy enough for their tools to remain sharp. You can’t dip your toes in the same river twice.

Pursuit of the geometric growth effect is what drives the trend toward one-stop shops in the CDMO world. In the current market, this effect is muted by the fact that demand is outstripping supply, but if history proves correct, as the market slows, oversupply will increase. This too mirrors the airline industry, where the saying goes that all new planes are ordered in good times and delivered in the bad.

REPUTATION MATTERS

Word of mouth remains a powerful thing in both industries, and even more so for CDMOs. With airlines, people choose primarily based on schedule and price. Frequent flyer points and lounges can stimulate some loyalty, but ultimately, a plane is a plane, and you are only in it for a few hours. It doesn’t matter too much which airline you take, and you can change your mind next time if you aren’t happy this time. A CDMO is a longer-term partnership with higher switching costs. Most importantly, a manager who chooses a CDMO is to some extent putting his/her own career at risk. If the CDMO disappoints, time and API have been lost, and switching requires research, visits, contract negotiations, relationship building, and some re-learning (not all CDMOs operate alike). Reputation trumps price in CDMO selection.

EMPLOYEES ARE THE FACE OF THE COMPANY

You may well argue that safety is job one in the airline industry, and quality in ours. Really, though, both of these are givens as industry regulations make them a barrier to entry. The next most important thing to clients/passengers is the people you deal with. At Xcelience – after technical knowledge – the most important employee attribute we look for is attitude. I believe most of us would agree that the airlines are lousy at this, with one exception, and that is Southwest. Southwest Airlines used to give job candidates a funny photo of the CEO. If the potential hire didn’t laugh, he or she didn’t get an offer.

MARKETS FAVOR CONSERVATIVE GROWTH

Both industries resist growing too quickly. Braniff Airlines once famously added 32 new routes and 16 cities in a 24-hour period. The company added every possible aircraft to the line, including the Concorde. Costs skyrocketed, and it became apparent that there was a reason no other airline had ever offered a direct flight from Buffalo to Orlando. Quality suffered as the company struggled to absorb so many changes at once. It took more than 24 hours to achieve bankruptcy, but the company’s descent from the skies was stomach-dropping just the same. Southwest Airlines, by contrast, took 12 years to go from two aircraft to 50. In the CDMO world, substitute the name of Braniff for Azopharma. Many of us witnessed the famous 2008 AAPS, where 80 new sales reps, fresh from careers selling shoes or cars, cordoned the outside of their booth on freshly combed carpet. Azopharma came out of nowhere in mid-2005, and was gone by Good Friday of 2009.

​ARE WE MISSING THE PLANE?

Any talk of similarities must inevitably lead to talk of unrealized opportunities. What are the airlines doing that we aren’t?

Increasing Demand
I mentioned already that demand in both industries is outside of the industries’ control. Or is it? Southwest proved that the airline passenger pie is not as fixed as everyone said it was. The airline created short, cheap commuter flights that competed for the travel dollars of car drivers, train, and bus passengers. In our industry, price is not going to increase demand the same way. The only way to increase the pie is to encourage large pharma to outsource more development. One way to do this is to co-invest in large pharma customer’s products. Another possibility is to go into a consortium. In this case, the consortium would consist of a group of CDMOs buying a drug or drugs from large pharma in Phase I, bringing them into Phase III, and then selling them back to large pharma.

Add-On Fees
Xcelience has consciously chosen not to use add-on fees, but some people in our industry believe they will inevitably come. The airlines have blazed through the learning curve on add-on fees, and any company considering them would do well to heed their mistakes. Studies have shown that customers feel less betrayed when asked to pay for something they consider a luxury, such as Wi-Fi or entertainment. Being charged for something that used to be free brings much higher levels of resentment, though there are nuances. Paying for legroom that was once standard had a dramatic effect on consumer frustration, as did requiring them to pay for carry-on baggage. But being hit with an extra fee for an oversize bag was not so bad. How would a client feel if hit with a bill for QA work done at the CDMO? Not good, undoubtedly. All of these scenarios involve greater or lesser degrees of negative impact, and thus are not a road to be embarked on without trepidation. Still, from a business perspective, airline add-on fees have been irrefutably successful, earning the industry $5.6 billion in 2011.

Stock Ownerships, Annuity Investments & Profit-Sharing Plans
The only long-term, profitable airline at the moment is Southwest, a fact attributed among other things to CEO Herb Kelleher’s outstanding job of integrating labor and management to build a creative and happy workforce. Not the least among his efforts is Southwest’s employee stock ownership, annuity investments, and profit-sharing plans. While such plans do put employee earnings at risk, they generally offer greater rewards over time, and they impart a sense of ownership that brings employee/management interests together. Xcelience is the only CDMO I’m aware of that moved to an aggressive quarterly bonus pool based on profits and revenue goals. When we did this 3 years ago, we didn’t reduce base salaries. The bonuses were added as a new incentive. Still, the move met with resistance at first. While everyone appreciated the new earnings opportunity, some asked if it could be implemented as a straight, guaranteed salary increase instead. Shared ownership of the company’s success is a culture change, to be sure. Our employees are used to it now. The company and the employees’ interests are more aligned than ever, and this lesson from the airline industry is definitely an engine that is fueling our growth.

To view this issue and all back issues online, please visit www.drug-dev.com.  

Derek G. Hennecke is President and CEO of Xcelience, a CDMO in formulation development and clinical packaging located in Tampa, FL. Mr. Hennecke launched Xcelience as a management buyout in 2006, and the company has more than doubled in size. Prior to starting Xcelience, Mr. Hennecke worked for DSM as a turn-around manager in the global drug development community, managing an anti-infectives plant in Egypt, technical and commercial operations in a JV in Mexico, and a biologics facility in Montreal. He developed the formulation and business strategy of several drug compound introductions such as clavulanic acid, erythromycin derivatives and Tiamulin. A Canadian, he covets the Florida sun, but can’t be kept away from the rink for long. He is an avid fan of the Tampa Bay Lightning.