Issue:January 2013

MANAGEMENT INSIGHT – Pharming Infertile Fields: Three Strategies for Growth in a Going-Nowhere Economy


In a healthy growing economy, you and I are both business oracles. We plow investments into fertile fields and they grow. Success is a ripe apple in arm’s reach.

It’s been a long time since we’ve seen such crops, and with the Conference Board forecasting GDP growth of 1.4% next quarter, we are still in this interminable drought. Investments grow slowly, languishing, their limbs drooping, and their fruit pale and tasteless. Others wither and die in the fields.

In this climate, you must scrutinize not only our own investment choices, but also those of the people you do business with. If you choose the wrong vendor, you may unwittingly tie your own fortunes to another’s dying horse. This month’s column is your guide to analyzing the growth strategies of the companies around you.

There are really only three ways to grow a business. First, you may build from the ground up – a new plant, new people, and new equipment. Second, you may borrow new capabilities from others – by contracting or allying with another company. Lastly, you can buy another business, and then carefully stitch it into your existing business. Ultimately, the decision of whether to build, borrow, or buy a new capability is as important as the decision to adopt the new capability itself, and the choice can make or break the business.

How do you choose? Capron and Mitchell, authors of Build, Borrow, or Buy: Solving the Growth Dilemma, have spent decades developing a framework to answer this question. Their insightful book is the new bible of business growth; a go-to place to analyze and understand business decision-making and forecast business growth. If I were to summarize their book in a nutshell, it would be this: Build if you can. If you can’t build, borrow. If you can’t borrow, buy.

BUILD

Build if you can. If you build, your new capability will be custom-designed to meet your clients’ needs. Your new capability will be a product of your own genes. You will love it unconditionally, because it’s your own. At the risk of overstating things, you and your management team will experience the warm glow that comes after giving birth. Of course, not everyone can build a new capability, as Capron and Mitchell aptly point out. To build, you must already have in-house the knowledge, processes, and incentive systems you’re going to need.

Eli Lilly developed Zyprexa in its own labs. The new drug was a natural fit because it built on the existing knowledge base Eli Lilly had used to develop Prozac. It was also a strong organizational fit because Zyprexa used existing technical expertise in central nervous system therapies, both in development and in clinical trials. It also had a market similar to that of prior products, and used compatible regulatory and marketing procedures and familiar evaluation techniques.

Just because a company has the in house capabilities, however, doesn’t necessarily mean a build strategy is called for. If, for example, your current staff gets all cloak and dagger when they see the new people coming in, your strategy is doomed. Insiders can be expected to put up a fight when their culture or processes are threatened, and when they are faced with obsolescence, expect the gloves to come off.

Take the example of Schering Plough, used in Build, Borrow, or Buy. Schering Plough only ever used the build strategy. After the blockbuster success of Claritin, the company needed to fill the pipeline. Company scientists struggled and failed to come up with their own successor. When a desperate management team began to put forward outside alternatives, the organization vehemently resisted. Management waited too long before forcing the issue, and a formidable inner battle ensued. When the dust cleared, the old team found itself not only under new management but also in an unlikely alliance with competitor Merck, working on an anti-cholesterol drug. Even this drastic measure resulted in only lackluster sales, so when it failed, the gig was up. With no pipeline, Merck acquired Schering Plough in 2009.

Ironically, Merck itself had suffered a similar tumult a decade earlier because of internal resistance to outside intrusion. Management eventually forced the in-house labs to accept external sourcing, and the company later earned a reputation for adeptness in sourcing from contracts, alliances, and small purchases.

In my own company, Xcelience, we use the build strategy most often. Sometimes the choice is simple. Sometimes it’s not. We recently added new equipment capabilities, including a GeoPyc Envelope Density Analyzer and AccuPyc Gas Pycnometer to support our existing roller compactor work. Micromeritics’ Geopyc is an ideal tool for the determination of the bulk density of roller compactions and the ribbon created during the process. And the Gas pycnometer is a perfect match for measuring the density (really the volume) of almost any type of solid. In 2012, we added extrusion and spheronization capabilities to produce pellets, and that has been very successful. We might have partnered with another to add these capabilities, but we chose to bring them in-house. We were honest with our first client about our limited experience with the technologies, but we made it work, and we’ve since developed the requisite experience. Obviously, these new capabilities did not threaten our internal resources. We also learned what we didn’t know and recently hired another formulator to support us in that. Easy implementation.

The decision to add clinical packaging to our capabilities was much more complex. Using the Build, Borrow, or Buy template, which I was already a fan of when we made the decision to add clinical packaging about a year ago, we began with some knowledge questions.

The first question was, did we already have – or could we easily hire – the in-house knowledge and expertise to master clinical packaging? The answer was yes. We didn’t already have clinical packaging expertise, but we were willing and able to bring industryleading expertise on board.

The second question was, would the new people fit our current system of incentives and culture? The answer was again, a resounding, yes. The idea met with no sense of internal competition or feelings of cannibalization, as might happen for example if a commercial packager were to try to get into clinical packaging. You may recall Sharp, a commercial packager, recently purchased Bilcare, a clinical packager. This was not an impulse buy – Sharp had tried for a couple of years to build a clinical packaging unit in-house, but finally decided that it would have to buy. Commercial and clinical packaging are strange bedfellows; they are destined to compete for resources, and the larger, more lucrative commercial packaging department will always win.

With positive answers to the key questions, the build strategy was a fit for Xcelience. In addition, we had a client who was willing to commit to our new venture, and granted us high-level access to their own staff to help us set up the right systems. With our own people and the client’s expertise specifications, we had the foundation to build a new, 25,000-sq-ft, purpose-built facility devoted entirely to clinical packaging, which we opened in September. To this combination of in-house industry experts and client support, we sprinkled a liberal dose of specialized clinical packaging consultants, and we were able to create a new capability in-house, and to a higher level of quality than any of our competition.

It wasn’t easy. Building is costly and takes time, and any small company has to struggle to free the resources to pour into a new venture. We were careful to make sure that the whole organization bore their share of the burden. But for Xcelience, the changes necessary to bring about this new capability internally were relatively minor. Had they not been, we would have moved down the ladder to the next possible strategy: borrowing.

BORROW

Far less threatening to your internal organization is the option of borrowing. Borrowing means either contracting with another organization for a certain capability, or forming a less formal alliance with the same goal. Like renting a vacation home, a car, or a bike, there can be advantages over building or buying. In fact, according to Mitchell and Capron, most businesses undervalue this strategy. They believe they need to have complete control over the capability, when in fact they don’t. Moreover, borrowing often gives them more control than they expected.

For one thing, borrowing can work faster than any other strategy. Let’s say your company decides it needs a new software technology to win that milliondollar contract that will be awarded next month. Building would take months. Even buying a company, with all its incumbent ritual negotiation dances, deals to secure capital, due diligences, and so forth, takes far too long. But if you could contract with a known supplier, there’s a reasonable chance you might be able to make it happen with two afternoon meetings and one threecourse dinner (your tab, most likely). A drug product company looking to backwardly integrate into APIs would be a great candidate for borrowing.

Building your own API company is rarely an option; the capital required for API development is huge, as are the risks, but more than that, the chances of an organizational fit are infinitesimal. API companies are led and managed from top to bottom by organic chemists. The ways of thinking are different. A drug company would be far better off contracting, forming an alliance or a joint venture with an API company.

Borrowing can also be a better choice when your organizational knowledge base is weak. Mitchell and Capron use the example of Abbott Lab’s expansion into India. Even though Abbott has great strengths in marketing and regulatory systems and has put them into practice successfully in North America, Europe, and beyond, they knew enough to know that they didn’t know India.

Borrowing is relatively risk-free, but relatively risk-free is not the same as risk- free. Borrower beware, as Toys “R” Us would certainly warn you. Toys “R” Us made a larger-than-life-sized mistake in committing to a long-running play date with online retailer Amazon, according to Mitchell and Capron. In making the deal, Toys “R” Us saw nothing more than the opening of a new channel to sell toys. Amazon, however, saw the opportunity to learn a new industry, and so it did. It learned it so well that shortly thereafter Amazon purchased its own line of competing toys to sell on the site. Toys “R” Us had unwittingly created a new competitor for itself, and a really, really good one at that. In 2004, Toys “R” Us sued Amazon claiming that Amazon had taken advantage of their relationship, and the judge agreed with a settlement of $51 million to Toys “R” Us. It was still nowhere near enough to compensate for the creation of a new superhero-powered toy retailer. In hindsight, if Toys “R” Us had set up a simple contract to sell goods, things might have gone differently. It was the decision to partner with them, sharing info about sourcing and product management that led to irreparable harm. In this case, it would have been better to keep their contracts simple and share only what they must.

Lastly, don’t borrow if you don’t need it. Every year, I consider bringing micro or USP compendial testing inhouse. It would be – well – tidy to possess this capability. And every year I decide against it. This is so easy and inexpensive to outsource, there is plenty of capacity in the US for raw material testing, and bringing it in-house would never be a deciding factor for a client choosing to use Xcelience’s services. Better to let someone else do it.

BUY

Buying is enticing. Why take the time to build, with that “buy it now” button beckoning from the corner of the screen? Company shareholders want results yesterday; building takes time. Borrowing means having to play nicely in the sandbox with a partner; buying offers complete control.

But buying a company is significantly different than buying on Amazon. Where will the money come from? If you have the money in-house, so much the easier, but unless your last name is Cook (or formerly Jobs), you probably don’t have millions lying around. And buying is expensive. It’s not like buying a car, where you are buying just the metal and screws and glass, the labor, and a profit margin for the factory and dealer. You must pay not only for the bricks and mortar and inventory that you would also pay for if you were building, but also for a multiple of the company’s future earnings. An existing company has a track record and if it’s a good one, it’s going to cost you. A lot. Five to ten times the company’s profit in the current year is a reasonable price to pay. Let’s be perfectly clear: you are paying for profits not yet generated, and there’s no guarantee that those profits will continue to flow under new management.

If you don’t have the cash on hand, you will need banks or private equity. Banks are fine, but their lending potential is limited, and your balanced books may or may not be to their liking. Private Equity (PE) capitalists are better equipped to listen to the unique intricacies of a particularly exciting buying opportunity, and they offer a wealth of experience to temper your buying impulses and guide you in cutting a good deal. But they, too, have their own agendas, which include delivering three times returns to their investors within a three to five-year timeframe. These goals may conflict with your own long-term growth goals.

Buying a company is not unlike the dating scene. Many companies will flirt with you, if they know you are on the market and you’ve been building your books. Then, one day, you meet the perfect purchase. You think you are logical and rational, but your heart races, and your eyes begin to cloud. She is nothing less than perfect. You line up your financing, and make your intentions known. She has other offers on the table, and you play the game, upping your offer and adjusting your terms to secure her affections. She offers you the deal. Your heart soars, and your thoughts turn to integration.

Not so fast, young man. The first step in the deal is a LOI (Letter of Intent). That means that for 60 days (or similar), she will not entertain any other offers. In that time, you may perform a due diligence. A due diligence is when she opens her files and all the interested parties in the deal swarm over her to ascertain if everything she said in the flirting stages is as it was said to be. Unexpected things will come to light; they always do. Many of the income streams that she said were ongoing may turn out to be one-time sources of income that are going off patent. You may still love her and be determined that two can live cheaper than one, but your PE is turned off. As the nascent deal collapses, you must, with trembling hands and broken heart, break up and return to the dating scene.

Still, at the risk of being trite, it is better to have loved and lost”¦ and if buying is your best choice, you must get out there again until you find your soul mate.

Patheon’s purchase of Banner Pharmacaps was an excellent match that will make Patheon one of the largest soft gel companies in the world. Patheon had tried for years to build its own soft gel business called P-gels, advertising heavily to support the fledgling brand. It was a good strategy for a commercial firm. Soft gels are hard to make and never a good choice for early clinical development. It’s hard to say why P-gels didn’t take off – it might have been internal competition for resources, lack of internal expertise in making them, or even lack of marketing prowess in the face of Catalent’s market dominance. Internal build wasn’t cutting it. Then, in what appeared to be a last-ditch effort to save the strategy, they purchased Banner, and Patheon was catapulted into a position of market leadership. I give this purchase two thumbs up.

Catalent’s recent purchase of the clinical packaging business Aptuit is more of a head scratcher for me. Catalent already had a build strategy well underway and, according to their most recent quarterly filings, this build was already one of the company’s best performing units, when analyzed completely separate from the Aptuit purchase. Management had done several things right, including selling their commercial packaging to Frazier Healthcare, eliminating the potential for internal conflict for resources. But why then take a build strategy that’s working and add the distraction of a buy, with all the inherent conflict and loss of productivity that comes with any integration? Already they’ve had to close down an entire site to achieve the cost savings synergies that would pay for the deal. It’s possible the purchase will help them achieve economies of scale more quickly as they struggle to catch up to Fisher Clinical, but the deal creates enough friction in a previously smoothly growing operation that I have to wonder, if it wasn’t broke, why’d they fix it?

AAI’s purchase of Celsis Analytical at the beginning of this year is even more puzzling. AAI was already known for its analytical capability, so what was the strategic rationale for adding two more labs and 150 people? If they needed more capacity, then build it. There is no question that they had the in-house capacity as this was not a new capability. By buying these labs, not only did they accept the integration hiccups that go with any purchase, but they paid up-front for profits not yet generated, and not guaranteed. Beyond that, customers of Celsis may have chosen Celsis over AAI for a reason. There is no guarantee that clients will stay once under AAI management. It is possible AAI sees more cost-savings efficiencies from the larger scale, but given they are still in seven separate locations and don’t have the scale to be the largest analytical lab, the potential economies arising from this purchase are limited.

When it comes to bad purchases, I would be remiss if I didn’t mention a purchase that is much in the news lately as one of the worst buys ever: Hewlett Packard’s (HP) purchase of British software maker Autonomy.

In November, HP announced a write-down of $8.8 billion of this $11 billion dollar purchase. Five billion of the write-down was due to what HP called, “serious accounting improprieties, disclosure failures, and outright misrepresentations at Autonomy Corporation that occurred prior to HP’s acquisition of Autonomy and the associated impact of those improprieties, failures, and misrepresentations on the expected future financial performance of the Autonomy business over the longterm.” The rest of the write-down came, as it happens, from the resulting stomach-wrenching plunge in HP’s share price. This, despite HP spending two months pouring over the books, and involving Barclay’s and KPMG, among other highly-reputed firms.

Autonomy, meanwhile, vigorously disputes this assertion, claiming that HP single-handed destroyed England’s most valuable software company by making it a pawn in the management’s own flipflopping strategy changes. Autonomy management said that at one point, HP sales staff were even told not to sell Autonomy software.

The ultimate outcome is far worse than just a write-down and much licking of wounds. Two of the biggest players in the tech world are now fighting a public battle for their reputations in which, arguably every host and parry in the media arena damages both parties. Beyond that, HP, the Autonomy management, and a host of advisors could be up to their eyeballs in litigation for a very long time. Buyer beware!

Derek G. Hennecke is a Founding Member, CEO, and President of Xcelience. He has a long history of growing strong businesses around the world. Blending a scientific and business background, he has nearly 2 decades of international experience in the healthcare industry and a track record as a highly successful international turn-around manager in the global drug development community. Xcelience is the first company Mr. Hennecke has managed as an owner, having launched a management buy-out from MDS Pharma Services in 2006. The newly-formed company immediately embarked on a robust pattern of growth. Before founding Xcelience, Mr. Hennecke spent more than 10 years abroad working for the Dutch-based conglomerate DSM. In Montreal, he was GM of a 250-staff Biologics plant for more than 2 years. In Cairo, Egypt, as GM, he oversaw a turn-around in an anti-infectives plant that had been slated for closure. He spent 2 years in Holland developing new Pharma intermediates, and two years in Mexico as Commercial Director covering Central and South America. He also worked for Roche, both in Canada and Germany. Mr. Hennecke has a BSc in Microbiology from the University of Alberta and an MBA from the Erasmus University in The Netherlands.

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