What Can a CRO do to Deal with the Cancellation Bugaboo?
1: the act or an instance of canceling
2: something (as a hotel room or a ticket) made available by the canceling of an arrangement
3: a mark made to cancel something (as a postage stamp)
4: a cruel act by the drug development gods when they decide to inflict pain on Clinical Research Organizations
Okay, so maybe item 4 didn’t come from Merriam-Webster, but it sure does feel that way sometimes. The euphoria of a high margin, fast burning trial can be quickly extinguished by its cancellation. Anyone who has spent a good portion of their career in clinical research has likely had their fair share of cancellation experiences. Cancellations are adversity and navigating adversity is a key CRO management challenge. Managing and mitigating cancellations can really make or break a CRO.
Cancellations Quantified
The volume of backlog cancelled on an annually basis is staggering when you think about it - especially when reading the quarterly reports of the large CROs. For example, Parexel announced $305M of Q1 '16 cancellations (or a 5.7% cancellation rate). It’s not uncommon for a large CRO to have $1B+ of cancellations annually. Using public CRO backlog data, estimated market share data and an assumed industry average of 4% of beginning backlog cancelled every quarter, I calculate that over $12.5B of backlog is cancelled annually.
Large CROs tend to have sophisticated planning tools established that take cancellations into consideration - cancellations are part of their business model. So while large CROs will feel the adverse financial and operational impacts of cancellations, their financial stability and scale enable them to weather the storm. Many small and mid-size CROs do not have luxury of scale to cushion the impact of a large cancellation. What do you do when you wake up and find out 15-20% of your backlog went away overnight? How do you mitigate the impact? There is no one perfect solution, but I wanted to share my thoughts on the topic (as an FYI, using cancellations as a water cooler topic probably won’t make you the most popular person in the office).
Proper Planning
Drug development cancellations are inevitable. Cancellations will happen on good days, they will happen when you least expect them, and worst of all they will happen again. Cancellations are painful and never fun – but hoping you get lucky isn’t a good plan. When building your budget or forecast, always be sure to assume that 3-5% of each quarter’s beginning backlog will get cancelled. Also be sure to factor in a revenue hit due to cancellations – just decreasing backlog isn’t enough. I like to take a little less than my total backlog study duration and assume that revenue will go away.
Don't assume that if your cancellation dips to less than the norm one year that it will stay at the level. Be conservative and forecast an industry norm cancellation rate (unless of course you have a lot of historical data suggesting a lower rate for your business), as long-term the cancellation rate usually regresses to the mean.
Assess the Impact
Cancellations will have adverse financial and operational consequences – understanding these consequences will inform you with data to develop a mitigation plan. Try to find out the following as quickly as possible:
How much total revenue will be lost? Over what time period?
Will there be a revenue generating wind down period? How long and how much revenue?
What staff are impacted? Where are they?
Are new trials commencing where staff from the cancelled trial can be placed?
Is there now excess labor capacity?
There can be many more questions depending on the CRO. Answers will help operations determine if existing staff can be redeployed or if employee recruitment plans need to be curtailed. Additionally, finance can determine if the damage is a minor profitability blip or heavy financial losses with a looming cash crunch. Getting the details enables management to do what they get paid to do: Manage.
Understand your Sales Pipeline
Future sales are almost always the first place a CRO will look to fill revenue gaps created by cancellations. A majority of the time “selling your way” out of a cancellation isn’t a strategy but more like hopeful optimism. However, a strong pipeline combined with an aggressive business development strategy can help mitigate the challenges created by a cancellation. Focusing on near term opportunities with short durations can really help fill the void (here's where performing a detailed pipeline analysis can help). I’m not a big fan of making large price concessions for short-term gains – I feel it cheapens the value of services provided and adversely impacts future pricing. However, if a CRO is in dire financial straits due to a cancellation, then aggressive price cuts may be warranted.
Turn Lemons In to Lemonade
While I was CFO at Theorem Clinical Research, our largest customer (representing almost 20% of total revenue) let us know they would be moving all of their work to a large CRO (of course this communication happened a few weeks after a 6 month Masters Service Agreement negotiation period). Obviously, this was (at least we thought) a big blow to the organization – the type of cancellation that can set a small to mid-size CRO back several years. Fortunately, staff on that particular project were in high demand. The leader of that group, was able to redeploy that staff to new customers at higher gross margins, resulting in a big win for Theorem. We were able to reduce customer concentration and get out of the cycle of annually losing margin (due to the sponsor's negotiating leverage) on this contract. This cancellation created quite a bit anxiety at first, it ultimately became a big game changer for Theorem.
Cost Reductions
The worst cancellation I experienced was while I was Finance Director at MDS Pharma’s Late Phase Business Unit - almost $40M (or 25%) of backlog was cancelled overnight. Financially it was very damaging as it was a fully staffed global trial where the drug failed. We tried for several months to fill the gap via sales, but unfortunately were unsuccessful and had to restructure our business. Reducing headcount at a service business is always the last option for the following reasons:
People are the greatest asset for any service business - heavy reductions can only weaken the organization
Staff reductions typically result in lower morale
Word spreads quickly in the industry when headcount reductions occur - possibly making it more difficult to win new business
Unfortunately, many small to mid-size CROs need to reduce costs due to a lack of financial resources. When faced with this challenge, I go through a multiple step process:
Reduce Non-Labor Costs First - It’s always surprises me the amount of cost reductions that come from facilities, travel, recruiting and of course the always mysterious miscellaneous expense account.
Reduce Consultants - Whenever possible swap out consultants with employees – obviously it preserves jobs, helps morale and is more cost effective (no severance needed). Total win-win scenario.
Restructure Poor Performers - Obviously, you don't not want to eliminate “A” players – especially excellent operations staff that are customer facing. Poor performers can adversely impact the morale of strong performers by having to compensate for their poor performance. Rarely are there easy decisions when reducing costs across an organization, but "ring-fencing" top performers during challenging times is a no-brainer.
Last Resort - No one ever wants to deal with a cancellation that put the financial health of the entire organization at risk. Quite often quick decisions are made just to stop the bleeding. Be methodical and thoughtful. Non billable management costs would be the first grouping and then operational staff (by geography and function) where the cancellation hit the hardest. Hopefully, it never gets to this point.
Other measures can be taken as well. For example, if a cancellation results in a CRO tripping their debt covenants, then renegotiating the debt agreement may be more advantageous than a restructuring. Always try to preserve the organization as best as possible.
Wrap Up
When I interview new staff, I always let them know that the clinical research industry isn’t for the faint of heart. However, if you are quick on your feet, enjoy working in a dynamic industry and don’t mind a little (okay a lot) of volatility than clinical research could be a perfect match. While cancellations are a normal part of life at a CRO, I must admit, it’s a lot more fun and a lot less stressful focusing on growth plans rather than cancellation issues.
If anyone has a cancellation strategy or a cancellation war story, I’d love to hear it (and learn from it). Please shoot me a note at jmpivotalfinancial@gmail.com.
Jason Monteleone is President at Pivotal Financial Consulting, LLC. A Strategic Financial Consulting Firm serving the Clinical Research Industry. Jason can be reached at jmpivotalfinancial@gmail.com.