West Pharmaceutical Services Inc (WST) — Q1 2017 Transcript

Thank you, Takia. Good morning. And welcome to West's first quarter 2017 conference call. We issued our financial results this morning and the release has been posted in the Investor section on the company's website located at www.westpharma.com. This morning, CEO, Eric Green; and CFO, Bill Federici will review our results, give you an update on our business, and provide an updated financial outlook for the full year 2017. There is a slide presentation that accompanies today's conference call and the copy of that presentation is also available on the Investor section of our website. On slide two is the Safe Harbor statement. Statements made by management on this call and in the presentation contain forward-looking statements within the meaning of U.S. federal securities laws. These statements are based on management's beliefs and assumptions, current expectations, estimates and forecasts. There are many factors that can influence the company's future results that are beyond the ability of the company to control or predict. Because of these known or unknown risk or uncertainties, actual results could differ materially from past results and those expressed or implied in any forward-looking statements. For a nonexclusive list of factors which could cause actual results to differ from our expectations, please refer to today’s press release, as well as any further disclosures that the company makes regarding the risks to which it is subject in the company’s 10-K, 10-Q and 8-K reports. In addition, during today's call, management will make reference to non-GAAP financial measures, including sales at constant currency, organic sales, adjusted operating profit, adjusted operating profit margin and adjusted diluted EPS. Reconciliations and limitations of the non-GAAP financial measures to the most comparable financial results prepared in conformity to GAAP are provided in this morning's earnings release. I will now turn the call over to West's CEO and President, Eric Green. Eric?

Great. Thank you, Quintin, and good morning, everyone. We are pleased you could join us today for our Q1 call. We are off to a good start to 2017. In the first quarter, we generated solid organic sales growth of 8.7%, with good contributions from both segments. We expanded growth and operating profit margins in the quarter. We launched new products and increased capacity with our Dublin contract manufacturing expansion, which is now online. And we continue to invest in the future with the first phase at our Waterford Ireland facility on track to be operational and delivering validated customer samples in 2017. We generated a record high diluted earnings per share of $0.81 for the quarter. Excluding the benefit from the new accounting rules for tax deductions related to stock-based compensation expense, we would have grown adjusted diluted EPS by 13%. On slide four, we present organic sales growth over the last five quarters. As you can see, our overall organic sales growth has been in the 8% to 10% range over this period. But when you look at the individual market units, as we previously discussed, there is more quarter-to-quarter variability. Our ability to serve these market groups despite these changes in demand demonstrates the strength of our scale and the depth of our capabilities. In aggregate, the long-term dynamics across our end markets remain robust and we are uniquely positioned to serve these diverse customer groups. Let me review our Q1 performance in the context of our end markets. Our strategy for growth remains focused on increasing the adoption rate of high-value products. We are also working to secure more opportunities for our customers to use multiple West products for each dose delivered and we see customers responding positively to the strategy. In our Pharma market unit, we had strong double-digit sales performance. The growth was a result of very strong high-value product sales, coupled with favorable year-over-year comparison due to inventory adjustments by our customers. There is also some favorable pricing adjustments made in certain regions impacted by inflation. We expect Pharma to return to more typical mid single-digit sales growth resulting in high single-digit growth for the full year. As we saw last quarter, our Generics market unit declined mid-single digits as customers continued to work out safety stock accumulated in the first half of 2016. We have improved lead times for many of our high-value products and in turn our customers have been able to reduce their inventory levels. For Generics, we expect to see increased momentum as the year goes on. We have already seen some large customers place meaningful high-value product orders for second half delivery. We expect Generics to return to high single-digit growth in the latter part of 2017, which will result in mid single-digit growth for the full year. In the Biologics market unit, we saw mid single-digit growth as we recycled against the strongest growth quarter of last year due to inventory builds in support of commercial drug launches. In this quarter, we experienced some destocking by customers, but not at the same level as Generics and we expect to return to double-digit growth in Q2 and for the remainder of the year. Importantly, commercial activity for both SmartDose and CZ remains high. We have multiple SmartDose programs at an early stage and its commercial program is in place for both SmartDose and CZ. Developments for larger volume and preloaded versions of our SmartDose device platform, as well as connectivity features, are raising interest from our customers, especially within our Biologics and emerging biotech customer base. In contract manufacturing, we achieved the second straight quarter of double-digit growth, along with a favorable comparison from last year's first quarter. We are seeing the results as expected from the many tooling projects which support new programs secured in the back half of 2016. Because of the longer lead times of some of these projects, we have good visibility into the back half of the year, which should produce high single-digit growth in this segment. On slide five, this shows our product portfolio and represents the value we bring to our customers with the value of those products and services we provide to West. We recognize that our long-term success depends on our ability to keep our product pipeline full of advanced containment and delivery solutions. The product shown above the arrow represents some of the new products that have recently been launched or will soon be launched. I am pleased with the progress of our global innovation and technology team, and their work to expand our portfolio. We do know it takes time for many of these products to achieve substantial commercial volumes, as our customers make their way through the drug development cycle, but we are pleased with our cadence of new product launches. By working with our customers particularly during Phase 1 or 2, we are able to support them from concept to development to launch. As a result, we have seen a high percentage of FDA-approved injectables using either West or Daikyo components. In fact, we are pleased to report that our products are used in all five of the new biologic medicines approved by the FDA in the first quarter of this year. Most recently, I had a chance to speak with some of our top customers at the March DCAT Conference in New York. It was a great pleasure to get their feedback on how West is successfully partnering with them to get their products to the market. What I heard most frequently was how much they value and appreciate the deep technical insight our teams offer. We also noted the importance of our collaboration to continue to improve so that together we can ensure we deliver the highest quality level every day. It's not just about the products we make. To hear from our customers how much they value our scientific affairs and technical services, as well as our regulatory affairs and assistance with filings, underscores that West is the scientific destination for integrated containment and delivery of injectable medicines. We are striving to provide value at every possible touchpoint we have with our customers as part of our market-led strategy. Turning to slide six, with a good start to the year, we remain focused on delivering critical high-value products to our customers, offering differentiated contract manufacturing services and further developing our growing self-injection platforms. We are maintaining a 7% to 9% organic sales growth guidance for the year and raising our adjusted EPS guidance. I'll now turn over to our CFO, Bill Federici, who will take you through the detailed financial results for the quarter. Bill?

Thank you, Eric, and good morning, everyone. We issued our results this morning reporting first quarter 2017 earnings of $60.9 million or $0.81 per diluted share versus the $0.30 per diluted share we reported in the first quarter of 2016. Those results are summarized on slide seven. Our Q1 2017 reported results include a $15.9 million or $0.21 EPS tax benefit associated with our adoption of the new accounting standards regarding share-based payments. Our Q1 2016 reported results include a restructuring charge and the Venezuelan devaluation charge. Excluding those non-recurring items, our Q1 2016 adjusted diluted EPS was $0.53. Those 2016 non-GAAP measures are described in slides 13 through 16. Turning to sales, slide eight shows the components of our consolidated sales increase. Consolidated first quarter sales were $387.7 million, an increase of 8.7% compared to the first quarter of 2016 sales, excluding translation exchange effects. Proprietary product sales increased 8% versus the same quarter in 2016 excluding unfavorable translation exchange effects. Volume increases contributed 5.7% of the proprietary sales increase. Our high-value product components and system sales increased 8% compared to the prior year first quarter. As expected, the current quarter’s HVP sales were adversely impacted by customer inventory management, especially in our Generics and Biologics market units. The current quarter HVP sales as a percentage of total proprietary sales were constant compared to the prior year quarter and represent more than 50% of our total proprietary product Q1 2017 sales. For the full year 2017, we expect double-digit sales growth in high-value products. CZ and SmartDose sales grew double digits in the current quarter versus the prior year quarter. Contract manufactured products net sales increased by 11.4% compared to the prior quarter, excluding exchange, a favorable mix of products sold, volume increases and pricing drove the increase in Q1 2017 sales. This quarter’s growth was favorably impacted by the ramping up of some customer projects in our Dublin facility. We expect high single-digit sales growth in contract manufacturing for the full year 2017. As provided on slide nine, our consolidated gross profit margin for Q1 2017 was 34.6% versus the 34% margin we achieved in the first quarter of 2016. Proprietary products' first quarter gross margin of 31.2% was 40 basis points higher than the 38.8% achieved in the first quarter of 2016. The increase in gross margin is due to price increases and operational efficiencies offset by a slightly unfavorable mix of products sold and normal inflationary increases in labor and overhead costs. Our Venezuelan operations' favorable currency impact in the current quarter was partially offset by growing currency losses on material purchases and an unfavorable currency translation effect in Europe. Contract manufactured products' first quarter gross margin increased by 160 basis points to 16.3% compared to the prior year quarter. The current quarter's higher gross margin is primarily due to the favorable mix of products sold and operational efficiency, offset by normal material, labor and overhead costs increases. As reflected on slide 10, Q1 2017 consolidated SG&A expense increased by $3.5 million versus the prior year quarter. As a percentage of sales, first quarter 2017 SG&A expense was 15.9% versus 16% in the first quarter of 2016. Pension costs decreased by $1 million in the quarter and were offset by higher compensation expenses, including lower increases and increased IT costs. Foreign exchange had a favorable effect, reducing SG&A expenses by $400,000. Slide 11 shows our key cash flow metrics. Operating cash flow was $20.7 million for the current quarter, $17 million more than the prior year quarter, primarily reflecting the higher net income and the new accounting standards classification of the excess tax benefit on share-based payments as part of operating cash flows. Our capital spending was $37.5 million in the current quarter. We expect to spend approximately $150 million to $175 million in capital in 2017, with more than half of our planned capital spending dedicated to new products and expansion initiatives, including $25 million in Waterford. Slide 11 also provides some summary balance sheet information. Our balance sheet continues to be strong and we are confident that our business will provide the necessary future liquidity. Our cash balance at March 31st of $169 million was $34 million less than our December 15 balance. Approximately $27 million of our cash was used to buy back 325,000 shares of our common stock under the Board authorized share buyback plan, and related to a $20 million voluntary contribution to our pension plan. A large portion of our cash remains invested overseas and is generally not available to repatriate to the U.S. without incurring tax consequences; we continue to pursue repatriation of certain offshore cash where possible. Debt at March 31st of $228 million is essentially the same level as at year-end. Our net debt to total invested capital ratio at quarter-end was 4.8%. Working capital of $396 million at March 31st was $5 million lower than at year-end. The majority of the decrease was due to the reduction in cash and the reclassification of long-term debt to current, offset by increases in inventory and receivables related to our growth in our business. Our committed proprietary product orders of $408 million in March 2017 were 8% higher than at year-end, but 5% lower than the March 2016 orders, excluding exchange. The March 2016 committed orders were impacted by our extended lead times for certain high-value products. Turning to slide 12, we are increasing our full year 2017 EPS guidance range by $0.21 to reflect the Q1 excess tax benefit on stock transactions. We are reaffirming our other annual guidance provided previously. We have based our guidance on an exchange rate of $1.05 per euro, the same rate used in our prior guidance. Our 2017 guidance excludes any additional impact from further currency devaluations, including the Venezuela Bolívar, as the company continues to operate primarily under the official exchange rate. It also excludes the expected additional expense associated with our restructuring program. I would now like to turn the call back over to Eric. Eric?

Great. Thank you, Bill. In conclusion, we delivered a solid set of results for the first quarter of 2017. We are driving high-value product growth in our proprietary products segment and expanding our contract manufacturing services. Our global operations are driving more efficient production, higher quality and better service, delivering significant value for our customers and patients that we serve. And our innovation and technology team continues to fill our product pipeline with exciting new developments in primary containment and delivery. We are off to a good start and I look forward to making additional progress and executing our market-led strategy in 2017. Takia, we are ready to take questions. Thank you.

Hi. Good morning.

Good morning, Derik.

Good morning, Derik.

Great. So, I have just a few housekeeping questions and I got a bigger one. Bill, tax guidance for 2017 is bulk of the benefit in the first quarter. How does the rest of the quarter pace out? What’s the guidance for the full year tax rate?

Full tax rate is right around 29%.

Okay.

It excludes that tax benefit that we picked up from the share-based payments without the net new accounting announcement.

Got you. Okay. Great. And the topline impact from FX, you are looking for this now?

Well, FX is, right now we are guidance to $1.05 per euro.

Yeah.

Right now obviously it’s a little higher than that, but we put a stake in the ground and we will continue to monitor that and report on a quarterly basis. Right now it’s a headwind for us from the euro.

Got it. Okay. Share count?

Share count, we are hoping that remains relatively flat because we have that share buyback plan that the Board authorized and we put in place, so hoping to keep it relatively flat.

Great. Second question now, could you just walk a little bit about the Biologics? I mean, you had a tough comp and you’ve also seen some drawdown, you saw some drawdown in inventory, it sounds like, just talk about what you are seeing that in market and then how, where, is any out there in terms of where your customers are adopting Crystal Zenith, and I will shut up?

Yes, that's a good question, Derik. We're observing the Biologics segment similar to last year, where there was a period that was slightly less than the other three quarters. We're experiencing something similar this year in 2017, and from a unit volume perspective, the markets are still showing mid to high single-digit growth. We expect to exceed that growth rate, but we're working closely with our customers on inventory management. This emphasis on high-value products is helping us reduce cycle times. Notably, we've seen approximately a 20% reduction in some of our plants that focus mainly on high-value products, which is positively impacting our customers as they are starting to pull back on their inventories. We've been clear that we anticipate an increase in growth rates over the previous year, returning to double digits starting from this quarter, Q2, and moving forward. We're optimistic about this. Regarding Crystal Zenith, we’ve noted a slight increase in interest as we prepare for launch in the relevant categories. While it does take time and depends on approvals and customer readiness, we remain confident about that portfolio at this time.

Great. Thank you.

Thank you, Derik.

Hi. This is Sarah Akers on for Tim. I have a margin question for you. You guys had pretty solid margin gains in the quarter and I like it came from the components. You guys call out about 100 basis points on efficiency gains but then volume and mix was bout a 30 basis points headwind. Can you guys talk about kind of what exactly you are doing to gain the efficiencies and then also talk about why volume and mix was a negative contributor, so this is kind of reversal also historically speaking?

Yes, Sarah. Good morning. Let me start with the efficiencies. Last year, we began to shift our focus on operations. We globalized our approach from both a site and regional perspective, and although it had an impact at that time, we are moving towards a more global strategy. We have introduced leadership within the organization, and we are starting to see positive results as we assess how to transfer production of certain products across regions and locations more effectively to balance the load. In terms of operations, we are concentrating on four key areas. First, we are already achieving a high level of quality but aim to improve it even further. Second, we are focused on enhancing service, particularly by reducing lead times to acceptable levels for our customers. Third, our global lean initiatives are beginning to take hold as we implement global operations and lean principles, and we are seeing early signs of progress. The fourth area may require more time: it involves our global manufacturing strategy, which entails exploring capacity opportunities and leveraging scale. We are investing significantly in capital expenditures and are seeking ways to more effectively utilize our assets through this global approach. Bill, would you like to discuss the mix effect?

Sure. So mix was very slightly negative and slightly unfavorable and it’s directly tied to the lower growth rate in both Biologics and Generics.

Okay. So we encourage you to think that next year can be a positive contributor to margin?

Exactly. So, let me say that Biologics is expected to return to double-digit growth in the second quarter, and we also anticipate that Generics will see an increase by the end of the year. All of this will positively impact our mix moving forward.

Okay. Great. And then just a quick follow up on the CZ question. You guys talked about $27 million in CZ and SmartDose last year. Do you guys expect that line to grow materially this year?

Yeah. We expect that to grow in the double digits.

Okay. Great. Thanks for my question.

Great. Thank you, Sarah.

Good morning. Thanks, guys.

Good morning, Larry.

Bunch of moving parts, obviously, with timing and what not and just curious, I know we expect a little bit more of a backend loaded year. Is most the difference there just a little bit of the pull forward on the contract manufacturing side or what's sort of is there or is the quarter maybe a little bit better than your internal outside the timing?

Yeah. I think what we are going to see in the back half this year is more the ramp up on the Generics space. As recall that we have a few large customers in that space that really move the needle quickly.

Right.

And so, again, I am very pleased with their operations really driving down cycle times, therefore value to build confidence, but the demand in the Generics is still rather robust, so we are pretty confident there. In the Biologics, again, that’s more of a ramp up back to double digits in Q2 and beyond, so we have that effect of those two, which is about 50% of our business and most of that is our high-value product portfolio. The contract manufacturing, just a quick comment, low double digits in the last two quarters, we anticipate a similar type of growth going forward. However, when you look at Q4, as far as the growth percentage is going to get a very high comp, so you should look at the contract manufacturing as a very stable predictable revenue run rate for that business, especially after investing in the facilities in Dublin.

Okay. On the contract manufacturing side, I wanted to provide a brief overview. I noticed that the gross margin for this segment increased quite significantly year-over-year. I suspect this may be related to the timing in Q1, which is typically lower, and it likely remains below your full year forecast. There's been a decent rebound in growth. Are there any other factors that might impact this as the year goes on?

Yeah. So, Larry, as you remember, we had a bunch of tooling stuff going on in the fourth quarter that has actually now produced usable capacity and that capacity is filled by our customers, so that’s obviously helped to achieve the increase in the margin. And there is also some good operational efficiency going on in there as well. So those things we continue to, as I have said, we continue to think that that’s going to continue to build for the year.

Got it. And then, just lastly, it sounds like you guys are receiving through your throughput and your capacity over the last three quarters, which is, I think, like a confidence in your customers, and that’s led to some slowdown in orders, which were probably a little bit ahead of the gain last year? Do you think what sort of gain closer to, I guess, on that equilibrium, but less volatility in the order line going forward?

Yeah. I would say, at this point we are going to see less volatility. I think we are in a more stable state, but I will keep on challenging the applications to finally to even improve the cycle times so that it’s uniquely in a new space. So as we go forward you will see that reflected in our committed orders. We do want to continue to push the cycle times down to be more aligned with our customer expectations.

Got it. Great. Thanks guys. Appreciate it.

Thanks, Larry.

Hi, guys. This is Jerry Megason on for Dave this morning.

Hi, Jerry.

I just had a couple quick ones. Can you guys elaborate a little bit more on Waterford and kind of the impact you guys expect there in 2018? I know I don't want to jump forward too much, but just curious what kind of impact this could have kind of long-term basis?

Yeah. Well, we are in the process of completing validation by the end of this year. We will be working with our customers, especially in the insulin space on validating samples. Unless the validation process has been completed, we can start moving into commercial revenues. But as you know, in this space in this business it does take a lot of ramp-up, so I would argue that 2018 while we will see a ramp-up in commercials will be really significant. It’s going to be in line with our expectations, but in fact, it will create a significant hit to our topline in ’18.

Got you. And then just real quickly on the customer inventory management. I'm just curious about your guys' visibility on that and kind of ability to forecast?

Well, one of the, you ask me correct, and one of the reasons why we realigned our organization to the market-led. So our Generics team is just focused on the Generics customers. They are having discussions day in and day out and they are working with their operations to translate that into capacity and utilization of our facilities. We are getting better at it. To improve, I think, we can. But I would say we would be in better visibility. Some of it is a little bit of variability of our customers as they move in and out of ability to produce. Unfortunately, some of our customers are going through difficult times with the FDA but that translates into another location. So there are some moving parts for that business, but we are getting better visibility. I do believe we have some room for improvement.

Great. Thanks guys.

Thank you.

Thanks.

Hey, guys. This is Bill on for Paul Knight. How you guys doing?

Good. How are you doing?

Thanks, Bill.

So first question just on the Generics business, obviously, customers have been working off of backlog over the past couple quarters. With the backlog also kind of flat year-over-year, are you starting to see more customers interested in high-value products and so some of them are maybe burning off standard products to upgrade, just what are you seeing from that customer segment?

I wouldn't directly link that to the shift from standard to high-value products. There is a change happening, and we can identify specific instances. However, we're noticing an increase in new committed orders coming in, which is adding to the current backlog. As you may remember, there was about an 8% increase by the end of last year. Last year also saw a reduction in inventory, particularly towards the end. We discussed this in October, June, and December, and we anticipated it would take about six months to resolve. Q1 fell right in the middle of that timeline. Thus, I would attribute this situation to both the transition from standard to high-value products and the destocking process with some of our larger customers.

Got it. And on CZ and SmartDose, could you just give us an update on the number of trials that are currently utilizing those two products?

Yeah. So I mentioned earlier, we are trying to get with the exact number every time, but I would say that, when we are talking about CZ, there is a slight increase. SmartDose is relatively the same as last quarter we talked about, but there are more conversations. In fact, quite a bit more discussions happening right now around DAs and around sampling of discussions about variations of the product to support various drug therapies. So it’s certainly better than what we talked about last quarter.

Got it. And just one quick one for Bill, Bill over the past six quarters or so return on invested capital has really been moving up about 400 basis points, 500 basis points. Could you just maybe highlight what's driving that?

The growth of our high-value products over the past several quarters, and indeed the last couple of years, has been very strong, which contributes to a favorable mix shift. We are effectively managing operational efficiencies and leveraging other areas of the business. While we continue to invest, which impacts our return on invested capital, we are focused on improving our investments in high-value product capacity to sustain our growth rates. Overall, the main drivers are the growth of high-value products and our operational efficiency.

Great. Thanks guys. Have a good one.

Thank you, Bill.

Thank you, Bill.

Thank you, Takia. Thank you for joining us on today's conference call. An online archive of the broadcast will be available on our website at westpharma.com in the Investor section. Additionally, you may access a telephone replay through Thursday, May 4, by dialing the numbers and conference ID provided at the end of today's earnings release. That concludes this call. Thanks and have a good day.