The fast-track custom chemical business is taking a short breather to reorganize and restructure for what many believe will be a headlong rush toward new growth driven by pharmaceutical demand and product innovation. Growth of 5-7% is forecast for this year, down from the heady days before 2001, but still well ahead of growth in the gross domestic product. Suppliers are moving out of businesses that have been whipsawed by energy prices and weak intermediate pricing, and moving into single-customer niches more focused on adding value.

Important lessons for buyers in 2002:

• Stay ahead of new technologies. Biotechnology is creating new routes in chemical synthesis. Another hot technology area at this year's Informex show in New Orleans was chiral chemistry.
• Keep a supplier scorecard. Companies are reshuffling assets, looking for the right mix. Bayer is closing three plants and recently sold ChemDesign of Fitchburg, Mass., to an investment group anxious to grow the business.
• Develop ironclad contracts with outsourcing partners. The dip in the economy created a glut of chemical manufacturing capacity. Many new contract manufacturers have emerged. "Make sure you know where you stand on your suppliers' priority list," said one buying maven at the NAPM Chemical Group meeting in Las Vegas in February. A sudden uptick in demand could leave you at the bottom of the food chain overnight.

Much of the restructuring in chemicals is aimed at focusing more on custom synthesis and less on commodities.

"As part of the continual restructuring of the Fine Chemical Business Unit, we are separating ourselves consequently from commodities in other areas," says Rudolf Hanko, head of Bayer's Fine Chemicals Business Unit in Leverkusen, Germany. The plants that are being closed and divested could only be upgraded to cGMP with major investment. "The upside of this pruning is that it frees tied-up capital to focus on the custom synthesis for the life sciences aspect of our business," says Hanko. The acronym cGMP is one of the hot buttons in custom chemicals today. It stands for current good manufacturing practices and means a set of scientifically sound methods, practices or principles that are implemented and documented during product development and production to ensure consistent manufacture of safe, pure and potent products.

Hanko declines to identify the commodities involved in the shut-down, but tells PURCHASING they involve multicustomer plants.

An example of Bayer's investment direction is Novochem, a contract manufacturer that operates under a Bayer license in Murcia, Spain. It's a cGMP plant with approximately 28,000-gallon reactor capacity that provides manufacturing flexibility. Within the plant are glass-lined, stainless and Hatelloy vessels ranging from 500-2,000 gallons. Five lines are aimed at distillation of solids and one for hydrogenations and distillations. The reactors use quick coupling systems and flexible lines to allow for rapid configuration between products.

"The beauty of this approach is that we will soon have fast and highly variable capacity covering a wide range of volumes and chemistries," says Hanko. "At the same time all the manufacturing is governed by the cGMP quality system."

Another company repositioning to be a bigger player in the custom chemicals market segment is Dow Chemical. At Informex, Dow unveiled two new contract development and manufacturing service organizations that will focus on the pharmaceutical, biopharmaceutical and specialty and fine chemical businesses.

"The formation of these businesses are part of our five-year plan to become a major player in outsourcing," George Blitz, Dow's new vice president for custom and fine chemicals, said in an interview with PURCHASING at Informex.

The new Pharmaceuticals Services unit comprises personnel and assets from Dow's custom manufacturing services unit with those from the recently acquired Ascot Chirotech Technology Ltd. and Mitchell Cotts companies. Also included are assets from the Dow Biopharmaceutical Contract Manufacturing Services as well as other pharmaceutical services. The business operates research, process development and manufacturing facilities in North America and Europe.

The second new business unit, called Dow Haltermann Custom Processing, is aimed at companies in the specialty and fine chemicals businesses and polymer industries that want to outsource process development and manufacturing. It comprises assets from Dow CMS, Haltermann Custom Processing, Hampshire Chemical, and the nonpharma elements of Mitchell Cotts. "With resources around the world, we can help any company looking to change their sourcing strategy, start up a new business, introduce a new product, or enter a new geographic market with greater speed and lower cost," says Simon Upfill-Brown, global business director of Dow Haltermann Custom Processing, which was acquired by Dow last year.

Another sign of the large-scale restructuring underway came from Swiss-based Clariant, which reported a 72% drop in net income in 2001 and a 7% decline in sales. Ten plants have been closed or sold and payroll employees declined 3,500. Part of its strategy was to divest businesses that were highly dependent on raw materials costs and oil. And buyers there say outsourcing will play an increasingly important role in custom chemicals.

Sounding the new mantra in custom chemicals is Nick Hyde, vice president of Avecia Pharmaceuticals, Manchester, England, who says that new technologies and other additions to the "value chain" are key priorities. "Increasingly, our focus at early phase is on the technologies that can help to get drugs launched faster—because that's where we can add the greatest value."

For their part, custom chemicals buyers say the slowdown in the economy is affecting sourcing strategies.

"The ability to use custom suppliers has given us additional flexibility by switching products in and out of our plants," says Tony Verheggen, buyer of custom chemicals and environmental services at Air Products and Chemicals, Allentown, Pa. Verheggen says he seeks toll manufacturers that align closely with Air Products' chemistries. They are used to aid in product development and avoid capital expenditures. He typically has more than 40 projects annually. New toll arrangements are set up using a formal work process and internal team approach. When selecting tollers, he puts strong emphasis on safety, health and environmental impacts.

Overall, business at the industrial gas company is down, but expected to improve. "We certainly have seen a reduction in the marketplace," Verheggen says. "We think we've seen the bottom, and we think the electronics market will improve early. We're hoping for an uptick in the third quarter."

Joseph R. Colleluori, director of strategic outsourcing at Merck, sees another tough year ahead for custom chemical manufacturers. "We have seen a slowdown due to the reduced rate of new product introductions and there's a lot of excess capacity." Additionally, many big pharmaceutical companies are facing patent expirations on blockbuster drugs. He also says that federal government pressure for reduced drug costs is putting pressure on pharmaceutical suppliers to reduce costs. As director of strategic outsourcing, Colleluori is responsible for transfer of Merck commercialized technology to outside companies.

Patricia Halle, director of purchasing for Ungerer & Co., Lincoln Park, N.J., agrees with Colleluori's outlook. "The flavors and fragrances business is incredibly competitive and I don't see that changing until the end of the year."

The biggest issue affecting specialty agricultural chemicals has been profitability. "Our volumes have grown, but what has really plagued us has been eroding margins," says Jim Sweetman, global purchasing manager for Dow Agrosciences in Indianapolis, Ind. Another big factor has been consolidation, resulting in fewer, but much bigger players. The big wild card, though, is biotechnology. A tremendous number of agricultural chemicals are coming off patent, creating a big opportunity for biochemicals. It's still unclear, though, where they fit in terms of price, quality and quantities.

Colleluori and other buyers say they are taking a close look at potential Chinese manufacturers. Transfer of proprietary manufacturing technology to China is problematic, however, because of inadequate protection for intellectual property, Colleluori says. Dow is very active in India and doing some outsourcing in China. "We see sourcing in the developing economies as very much of an opportunity," says Sweetman.

About 10% of buyers' chemical requirements in late 2001 were sourced from custom manufacturers, according to a new study by PURCHASING Magazine. Buyers say the role of custom manufacturers will grow only fractionally over the next two years. Biggest growth will come in food and beverage, agriculture, pulp and paper markets. (see chart on 16C2).