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Manufacturing at a crossroads

In some 50 years, Puerto Rico has gone from agriculture to industrialization to high tech and now into a knowledge economy. Such rapid change in a relatively short period of time has indeed transformed Puerto Rico from a once-poor agricultural economy into a high-tech industrial powerhouse.

Today, manufacturing continues to be a major force in Puerto Rico’s economy, responsible for 45.5% of the island’s gross domestic product (GDP) of $95.7 billion in 2009, or close to $44 billion, up from $24.5 billion or 39.7% of the GDP in 2000. (The GDP is the total value of all goods and services produced by a country in a year, including income earned domestically by foreigners but not income earned by domestic residents overseas.)

Manufacturing companies paid $1.4 billion in income taxes in 2009, or 57.9% of all corporate income-tax collections, according to the Puerto Rico Manufacturers Association.

In the latest CARIBBEAN BUSINESS Top 400 local companies, manufacturing firms generated $1.6 billion in revenues in 2009, or about 7% of total revenue generated by all local companies on the list.

Although the industry remains a very important one for Puerto Rico, in reality it has gone through some significant challenges, including the phase-out of U.S. Internal Revenue Service Section 936 in 2006, market-driven transformations in the key pharmaceutical sector, a tortuous permitting process and rising energy- and labor-driven costs.

Close to 31,000 manufacturing jobs have been lost since the beginning of Puerto Rico’s current recession in 2006—from approximately 120,000 four years ago to 89,400 as of September 2010, according to the commonwealth Labor Department’s Non-Farm Employment Survey. Some 39%, or 34,600, of these remaining jobs were involved in the manufacture of durable goods, including computer and electronic products and appliances, as well as cement, concrete and fabricated metal products. The manufacture of nondurable goods involved 54,800 jobs, including 22,700 jobs in chemical manufacturing, largely in pharmaceutical operations. Companies specializing in medical equipment and supplies employed another 11,500 people in September 2010 under the nondurable goods category.

Operational costs high

The local manufacturing industry continues to be plagued by rising operational costs such as electricity and water. With the industrial cost per kilowatt-hour (kWh) at approximately 16 cents, it is not unusual for manufacturers on the island to have energy costs that are 17%-to-20% of their entire operating budget. The high operational costs have forced manufacturers to implement so-called Six Sigma and Lean manufacturing cost-reduction and efficiency systems. However, there comes a point where a company reaches its limit in terms of cost reduction and efficiency. As a result, many plants have been forced to close shop and leave the island.

Pharmaceutical Industry

Despite shedding thousands of jobs in the past five years, the pharmaceutical industry continues to lead local manufacturing in the value of goods produced. Approximately 25.7% of Puerto Rico’s GDP was generated by the pharmaceutical and biotechnology sectors in 2009, up slightly from 24.8% in 2007, according to commonwealth Planning Board figures.

Puerto Rico is the fifth largest area in the world for pharmaceutical manufacturing with more than 80 plants, the third-largest biotechnology manufacturer with more than two million square feet and the seventh-largest medical-device exporter with more than 50 plants. The pharmaceutical companies originally came to Puerto Rico in the late 1960s and ’70s to take advantage of a now-expired federal tax incentive known as Section 936, which at one point allowed U.S.-based manufacturers to send all profits from local plants to stateside parent plants without having to pay any federal taxes. Over the years, and because of 936, Puerto Rico turned into a worldwide pharmaceutical hub that currently produces 16 of the top 20-selling drugs in the mainland U.S.

It is a top-notch labor force—hard working, dedicated and intelligent—that is Puerto Rico’s No. 1 asset in the manufacturing sector and continues to be one of the main reasons companies continue operating locally and are drawn to the island. Compared with the U.S. mainland, the average cost of a Puerto Rican worker in manufacturing is about 65%-to-70% of what a company would have to pay there. The U.S. Department of Labor (USDL) indicates the manufacturing worker in the U.S. mainland earns an average of $16.14 per hour compared with an average cost in Puerto Rico of about $11 per hour, or roughly 68%. For the quality you get from the Puerto Rican workforce, the price is considered one of the best deals in this hemisphere.

However, the future of the pharmaceutical manufacturing industry in Puerto Rico faces many challenges as many companies have patents on their products that already have or will soon expire, and the number of new drugs in the pipeline are not enough to replace those with expired patents. One dynamic now at play in the industry is the consolidation and purchasing of companies with promising medicines and patents that will help strengthen a company’s overall product pipeline. In addition, local pharmaceutical companies are increasingly turning toward the outsourcing of certain products to India and China to help reduce costs.

In fact, the number of jobs in the pharmaceutical sector has steadily declined in the past five years to 19,725 in August 2010, down from 28,567 in 2005, according to the U.S. Bureau of Labor Statistics Establishment Survey. Such employment was as high as 29,100 in 2004. The pharmaceutical sector generates another 90,000 indirect jobs, according to the Puerto Rico Pharmaceutical Industry Association (PIA).

The nearly 20,000 jobs in the pharmaceutical industry made up 22.4% of the island’s 89,400 manufacturing jobs and 2.2% of the total 921,500 nonagricultural salaried jobs, according to commonwealth Labor Department figures issued in September 2010.

Tax incentives and the commonwealth fiscal crisis

Tax incentives have been the main draw for corporations to Puerto Rico for more than 30 years. The local government has been unable to find additional federal tax benefits to substitute sections 936/30A of the Internal Revenue Code, which were phased out in 2006. In the last few years, different New Progressive Party (NPP) and Popular Democratic Party (PDP) administrations have, instead, focused on improving local tax incentives to try to offset the lack of federal tax breaks, beginning with the Industrial Tax Incentives Act of 1998 (Law 135), which expired 10 years later and was replaced by the Puerto Rico Economic Development Incentives Act of 2008 (Law 73). The law, forged between an NPP-dominated Legislature and then-Gov. Aníbal Acevedo Vilá of the PDP, allows exempt companies to pay a tax rate between 4% and 8%, depending on the royalty fees. It also grants companies credits for energy consumption and allows more small- and medium-sized local businesses to take part in the incentives.

However, while tax incentives do serve a purpose, companies have become less concerned with them because of high operating costs that have eroded profits, in many cases resulting in bottom-line losses that have rendered tax exemptions useless. That may be why the incentives law has not been very effective in attracting new manufacturing operations to the island amid one of the worst recessions in Puerto Rico’s history.

In fact, NPP Gov. Fortuño, who took office in January 2009, has taken drastic actions, including the layoff of between 20,000 and 30,000 commonwealth workers, to cover a $3.2-billion deficit inherited from the previous administration that was largely caused by diminishing revenues during the recession. This has forced the governor to find new sources of revenue, especially to pay for pledged tax relief for salaried workers and local businesses.

In October 2010, he enacted Law 154, which levies a temporary excise tax on the offshore purchase of locally produced goods and services between affiliated companies when such transactions surpass $75 million annually and certain other conditions are met. The tax, slated to take effect Jan. 1, 2011, is set at 4% of such purchases for the first two years, then falls incrementally to 1% in its sixth and final year.

While the governor highlighted the temporal nature of the excise tax, administration officials have not discussed plans regarding Law 154’s new taxing authority beyond the excise tax under the “Source Rule,” which allows the government to levy permanently the normal 39% corporate income tax on offshore affiliates with sales below $75 million on income from Puerto Rico. The Source Rule also will apply to the larger firms once the excise tax expires.

The pharmaceutical industry, as well as large business groups including the U.S. Chamber of Commerce, have denounced the excise tax, approved without legislative hearings, as “discriminatory” and “punitive,” and have asserted that it would damage the commonwealth’s credibility and put tens of thousands of manufacturing jobs at risk. However, industry executives have lately toned down their criticism after the governor began a series of meetings with industry executives to “validate” data used by the administration to levy the tax. The PIA has asked for the tax to be postponed a year so that the industry can draw up alternatives to increase Treasury revenues.

PIA President Daneris Fernández has acknowledged that pharmaceutical multinationals have not yet decided to close or modify operations on the island due to the tax, but told CARIBBEAN BUSINESS (CB Nov. 18, 2010) that “company executives will ponder the situation and make very careful decisions.”

The expiration of $91 billion in drug patents by 2013 will pose challenges for the pharmaceutical industry, particularly in Puerto Rico, where many of the blockbuster drugs used the world over are made.

The U.S. Food & Drug Administration (FDA) also has cited local manufacturing plants for irregularities concerning quality-control management, leading to several drug recalls over the last few years. The most dramatic case involved the GlaxoSmithKline (GSK) plant in Cidra, the global drugmaker’s largest, which closed in September 2009, laying off more than 900 workers, due to declining sales of drugs, including the diabetes treatment Avandia, whose sales were hurt after a New England Journal of Medicine article in May 2007 reported the drug raised the risk of heart attack by 43%. The plant was closed even after GSK invested millions to upgrade the plant to meet FDA compliance rules.

The FDA had cited the facility for being unsanitary and lacking adequate quality control. Federal officials seized factory records in 2003 and 2005, and raided the factory in 2005 to seize its supply of antidepressant Paxil and Avandamet, a diabetes drug that uses Avandia as an ingredient. The company agreed in July 2010 to shell out $750 million to settle civil and criminal charges related to production problems at the Cidra plant—the fourth-largest amount ever paid by a pharmaceutical firm for such a settlement.

In November 2010, members of the U.S. House Committee on Oversight & Government Reform sent a letter to FDA Commissioner Margaret Hamburg requesting a range of records related to the federal agency’s work in Puerto Rico.

The letter directed the FDA to provide a list of all inspections conducted by the agency of manufacturing facilities in Puerto Rico in the last 10 years. The congressmen raised concerns about understaffing in the FDA’s office in Puerto Rico in light of a rash of more recent recalls of drugs manufactured on the island by J&J’s McNeil Consumer Healthcare unit, Pfizer and Bristol-Myers Squibb Co.

According to the Bloomberg news agency, drug-manufacturing facilities in Puerto Rico failed inspections 64% of the time in 446 visits from regulators from 1999 to 2010. According to data compiled by the news service, the facilities have failed at more than a 70% rate since 2007, including a 76% rate in 29 inspections this year. The FDA had not verified these figures as of November 2010, and an FDA spokesman told CARIBBEAN BUSINESS it would answer directly to Congress.

PIA’s Fernández has said Puerto Rico has been a big target of FDA monitoring efforts given the island has one of the highest concentrations of pharmaceutical plants in the world. She said the product violations are isolated incidents within local operations that have been generally recognized by the FDA’s counterparts in other countries, including the European Medicines Agency, where drugs produced on the island are shipped.

New technology improves production and quality across sectors

Nevertheless, improvements in manufacturing technology in Puerto Rico have contributed to the increase in exports from $38.5 billion in 2000 to $60.8 billion in 2009. Local assembly lines have benefited from the latest advances to achieve not only production efficiency but product quality and safety as well.

This is the case with the pharmaceutical operations on the island, which make 72% of the products that are exported, including some of the top-selling brands in the world.

Drug companies are reducing assembly-line interruptions to a minimum while making consistently higher-quality products by applying Process Analytical Technology (PAT), established in local operations for newer products since about eight years ago, said Iván Lugo, executive director of the Industry and University Research Consortium (Induniv).

PAT consists of testing products while they are being made, instead of carrying out lab testing when these products have already been warehoused in batches, said Lugo, noting that this allows production problems to be corrected quickly instead of having to wait for lab results. PAT allows operations to reduce warehoused inventory and reduces losses due to recalled batches.

Such tests are done with infrared detectors the size of iPods that give plant chiefs the results needed to determine if the drug elaboration process is being done correctly, he said, noting the FDA-approved process is known as Real-Time Release.

Innovation also has made its mark in the island’s processed food sector, which seeks high-quality standard certifications to export its products successfully to the U. S. mainland and the rest of the world. Companies such as Coca-Cola-owned Century Packing Corp., which makes Carmela-brand small sausages and other foods and beverages, are investing thousands of dollars to obtain the ISO 22000 global food safety standard certification issued by the International Organization for Standardization (ISO), a nongovernmental entity that sets common standards for business, government and society. Companies in 72 countries have implemented ISO 22000 standards.

Moving toward a knowledge economy

The local government and the Puerto Rico Industrial Development Co. (Pridco) have decided to focus primarily on developing a knowledge economy, spearheaded by the life sciences (biotech, pharmaceutical and medical devices), and computers and computer technology. Although biotechnology is not a new industry, it has become the buzzword for the last few years and Pridco is betting this strategy will pay off by leveraging a solid local pharmaceutical industry base, and the highly trained and educated talent available on the island. Pridco also has been proactive in sponsoring educational initiatives aimed at encouraging Puerto Ricans to pursue advanced degrees in the sciences.

Aerospace manufacturing niche opportunity

One niche area that looks bright for the local manufacturing industry is the aerospace industry. Although there are just a handful of aerospace companies established on the island, this is an area which until recently was virtually nonexistent in Puerto Rico. Aerospace companies have found that the high talent base, combined with relatively lower labor costs and the fact that Puerto Rico is a territory of the U.S.—the latter a key element in defense-and-aerospace-related manufacturing requirements—makes the island an ideal manufacturing solution.

‘San Juan Knowledge Corridor’

As part of the development of a knowledge economy that should help increase manufacturing capacity on the island, the island government is embarking on transforming the local landscape into one of world-class science laboratories and facilities. In October 2007, the government of Puerto Rico transferred more than 70 acres of prime land in metropolitan San Juan to the Puerto Rico Science & Technology Research Trust. The Trust was created in 2004 with the intention of implementing public policy and helping to facilitate the creation of infrastructure favorable to the development of a knowledge-based economy in Puerto Rico. Within this structure there will be collaborative efforts among government, academia and the private sector in which the Trust functions as a supervisory entity looking to stimulate each entity, but not replace any one of them.

At an estimated investment of $1.7 billion and development over a 20-year period, the so-called “San Juan Knowledge Corridor” will extend from the area around Centro Médico to the University of Puerto Rico in Río Piedras. The UPR has almost completed construction of the Molecular Sciences building in Cupey, which could house such entities as the Institute for Functional Nanomaterials. No opening date has been set.

 


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