West Pharmaceutical Services Inc (WST) — Q2 2017 Transcript

Thank you, Leanne. Good morning, and welcome to West's Second 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 a 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 law. 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 risks or uncertainties, actual results could differ materially from past results and those expressed or implied in any forward-looking statement. 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 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 in 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 now turn the call over to West's CEO and President, Eric Green.

Thank you, Quintin, and good morning, everyone. Following a strong start to the year, our second quarter performance fell short of expectations. While we delivered 4% organic sales growth, with strong performance in Contract Manufacturing and Pharma, unexpected softness in Generics and Biologics caused an unfavorable sales mix, which resulted in a drop in the gross margin for the quarter. While we have taken several actions, including increased customer interactions, to better forecast their demand patterns and have put in place increased cost controls over our processes, we remain confident that the fundamentals of our markets, our products, and our strategy are solid. Our long-term outlook remains unchanged and we believe that our growth profile will improve in Q4 of this year. I will focus my comments on the details of our sales performance in the quarter. First, at a high level, two areas of our business, Contract Manufacturing and the Pharma market unit, which account for approximately 55% of our total sales, performed well and were at or above our expectations. On the other hand, the Generics and Biologics market units, approximately 45% of our total sales and accounting for 70% of total high-value product sales, were softer than expected due to a variety of customer issues, including continued customer inventory management, drug-launch delays, and customer-related regulatory issues. I will go into more detail in a moment. Turning to slide four. We have laid out our organic sales performance over the last 5 quarters and show our updated full year guidance for each market unit and the Contract Manufacturing segment. I want to take some time to go through each of the businesses in detail regarding the second quarter and talk about the outlook for the balance of 2017. As we expected, Pharma grew mid-single digits after strong double-digit growth in Q1. For the first half of the year, we are very pleased Pharma's growth coming in at high-single digits. Thanks to the realignment of our customer commercial organization, which is helping our team better focus on value creation, we are finding more of our large pharma customers seeking higher quality containment and delivery systems and are converting to high-value products. In fact, I had the opportunity to meet with the senior leaders of a major customer at our Jersey Shore, Pennsylvania facility a few weeks ago, and they reaffirmed their commitment to move from standard products to high-value products, commencing later this year. They believe that doing so will aid in their initiative to drive towards zero particulates and defects, which ultimately has a positive impact on patient care. This is a trend we are seeing throughout our customer base and we're well positioned to address the market needs. We expect continued growth in both standard and high-value product sales in this market unit, resulting in healthy high-single digit organic sales growth for the full year. Turning our attention to the Generics market unit. We experienced a continued trend of customer inventory management that began in late Q4 of last year. We've talked about this issue on past calls. In 2016, when our capacities were constrained, our lead times became extended, and as a result, our customers built up inventories to make sure they had sufficient safety stock to cover manufacturing requirements. Our global operations team is successfully reducing lead times for key high-value products, and our customers are responding as we would have expected them to do by reducing their safety stock. More importantly, the increased confidence by our customers in our ability to supply on time is opening up discussions for converting even more of the drug portfolio to West high-value product offerings. This includes our new AccelTRA program developed specifically for our Generics customers. We are experiencing a positive response from this program. And with a number of customers currently testing their drugs for stability with the AccelTRA components, we expect to commence commercial production by early 2018. Additionally, as the quarter progressed, we gained visibility to order pattern changes from some customers, who have been impacted by FDA regulatory actions unrelated to our products. These customers, who purchase both standard and high-value products, have experienced impact to their operations. As a result, these actions depressed their growth over the quarter. Our revised guidance assumes a similar trend in Q3 and to a lesser extent in Q4. Our visibility around the corrective actions these customers are taking is limited. While it is difficult at this time to predict when order volume will return to normal levels, we do have new orders with our largest generic customers, who for the last three quarters, have been running down their safety stock. Therefore, we believe that by Q4, we should see more normal order volumes return. In Biologics, we also experienced some customer inventory management issues in the quarter, but to a lesser extent than in Generics. This did, however, push growth in the market unit down to the mid-single digits. The inventory management activities are related to product launch builds in prior quarters, some customer product launch delays and adjustments associated with conversions to high-value products. I want to reiterate, we are the clear market leader in the growing Biologics market. In fact, our products are on 100% of the newly approved biologic drugs in the U.S. so far in 2017. This, combined with our improving visibility to demand with committed orders gives us the confidence to believe our Biologics units will finish out the year strong. As far as our Crystal Zenith and SmartDose platform sales, we had strong double-digit growth in the quarter. Our customers are adopting CZ for applications where traditional glass falls short of meeting their needs. CZ is well characterized and the recent FDA approvals using CZ containers have brought more customers to West to begin stability studies for future products. Also, the commercial success of our SmartDose technology has resulted in new customer interest and opportunities to West. To that point, in Q2, we signed development agreements with two large global customers for the use of SmartDose with their drug candidates. Our contract manufacturing business had its third consecutive quarter of double-digit organic sales growth. All the hard work in 2016 is paying off in 2017, and we're proud to be critical partners to our customers that are bringing new drug delivery and diagnostic devices to the market. Our Dublin facility is currently ramping up and we are on track to hit our expectations for the full year. I want to spend a minute on the progress of our newly created global operation and supply chain organization. The team is focused on driving safety, quality, service, and cost. And on all accounts, the team is making good progress. As an example of this progress, I am pleased to share that our customer, Bristol-Myers Squibb recently named West as the 2017 supplier of the year in quality. I also have an update for you on a major investment we're making to ensure our ability to meet customer demand in the years to come. The Waterford, Ireland, investment is tracking under budget and on time. We are currently partnering with customers to validate the critical insulin sheeting production line, and we expect to start commercial production in the first half of 2018. In Phase II of Waterford, we plan to have high-value product finishing capabilities up and running in late 2018. On slide five, we have revised our sales outlook to reflect the Q2 results in our second half outlook. We are reducing our sales guidance. We now expect full year 2017 to be at the lower end of our long term 6% to 8% organic sales growth target. Our 2017 adjusted diluted EPS guidance takes into account the margin impact from lowered high-value product sales growth related to Generics and Biologics, and is offset by cost controls and favorable tax benefits from stock-based compensation expense. I'll now turn it over to our CFO, Bill Federici, who will take you through our detailed financial results for the quarter.

Thank you, Eric, and good morning, everyone. We issued our second quarter results this morning, reporting net income of $38.8 million or $0.51 per diluted share. Our reported results this quarter include a $0.15 per share charge for the deconsolidation of our operations in Venezuela. Excluding this charge, our Q2 2017 adjusted diluted EPS was $0.66 as compared to adjusted diluted earnings of $0.59 in Q2 of 2016. As a reminder, 2017 reported earnings include tax benefits on option exercises due to an accounting change that took effect in 2017. Our Q2 2017 reported earnings includes a $0.13 per diluted share tax benefit related to stock option exercises. A reconciliation of non-GAAP measures is included at slides 12 through 15 in the presentation that accompanies this call. Turning to sales, slide seven shows the components of our consolidated sales increase. Our consolidated second quarter sales of $397.6 million increased by 2.5% versus our second quarter 2016 sales. Excluding the $5.6 million adverse currency effect, our Q2 2017 sales increased by 3.9%. Proprietary net sales increased by 2.2% versus the same quarter in 2016 excluding exchange. Sales price increases were marginal. Higher sales of CZ and SmartDose, as well as gains in tooling and development revenues, contributed the majority of these sales increases. Sales of our high-value products rose just 2.2% versus the prior year second quarter. Current quarter HVP sales as a percentage of total proprietary product sales were unchanged versus a year ago. Both Q2 2016 and the first half of 2016 saw significant growth in HVPs, up 16.6% and 19.6%, respectively. The combined Q2 revenues from CZ and SmartDose of approximately $10 million were $6 million more than the combined 2016 Q2 sales, reflecting strong customer demand. Contract manufactured net sales increased by 10.5% versus the prior year quarter, driven by the ramp up of diabetes customer activity in our newly completed Dublin facility as well as our Arizona facilities. As provided on slide eight, our consolidated gross profit margin for Q2 2017 was 31.4% versus the 34.4% margin we achieved in the second quarter of '16. Proprietary second quarter gross margin of 35.4% was 3.1 margin points lower than the 38.5% achieved in the second quarter of '16. The decrease in gross margin is primarily due to the unfavorable mix of sales, volume decreases, higher raw material costs and normal inflationary increases in labor and overhead costs. We sold a higher percentage of Contract-Manufactured Products, standard components, CZ and SmartDose devices, and tooling and development revenues, all of which carry lower margins than our high-value product components. HVP sales lag as customers, specifically in the Generics market segment, delayed orders as a result of regulatory actions, which impacted their operations, as well as certain Biologics and Generic customers working off high levels of inventory acquired as part of product launches and/or other inventory management initiatives. To dimension the high-value product sales impact on margins, in Q2 2016, high-value product sales increased by 16.6%. This favorable sales mix added 1.4 margin points to our proprietary gross margin. As contrasted to the current quarter's 2.2% growth in HVPs, which yielded an unfavorable mix impact of 1 margin point to proprietary gross profit margin. Contract-Manufactured second quarter gross margin decreased by 0.8 of a margin point to 16.8%. A favorable mix of products sold was more than offset by higher labor and increased overhead costs associated with new capabilities supporting Contract Manufacturing, customer programs, especially in our new Dublin facility. As reflected on slide nine, Q2 2017 consolidated SG&A expense decreased by $1.9 million versus the prior year quarter. Merit and headcount increases in compensation costs were offset by lower incentive comp costs. As a percentage of sales, second quarter 2017 SG&A expense was 15.2% versus 16.1% in the second quarter of '16. Slide 10 shows our key cash flow and balance sheet metrics. Our year-to-date operating cash flow is $26.8 million above what we generated in the first six months of '16, due primarily to our higher operating earnings and the impact of the accounting change with tax benefits associated with stock option exercises, net of higher current year pension plan funding. Our capital spending was $67 million for the first 6 months of '17, approximately $7 million less than at this time in 2016. We expect to spend up to $150 million in capital in 2017. Approximately 60% of our planned capital spending is dedicated to new products and expansion initiatives, including approximately $20 million for the construction of our new Waterford facility. Our balance sheet continues to be strong and we're confident that our business will provide necessary future liquidity. Our cash balance currently of $226 million was $23 million more than our December 2016 balance, due primarily to the higher operating cash flows. Approximately $69 million of our cash balances are held by U.S. subsidiaries. Debt at June 30 of $229.5 million was $1 million more than at year-end. Our net debt to total invested capital ratio at quarter-end was 0.2%. Working capital of approximately $429 million at June 30 was $28 million higher than at year-end. The majority of the increase is due to increases in our July cash balances, accounts receivable and inventory balances, partially offset by higher accounts payable and the reclassification to current liabilities of our headquarter building note that matures in January of 2018. Looking ahead, our committed proprietary product orders were $382 million at June 2017, 7% lower than at June 2016 excluding exchange. As expected, due to operational gains resulting in lower lead times in our plants, customers do not need to place orders as far in advance, which has the effect of lowering committed orders on hand. We revised our full year 2017 guidance as reflected on slide 11, based on our year-to-date 2017 results and our analysis of the orders on hand. We believe our remaining 2017 quarterly results will follow historical seasonality, wherein Q3 results are traditionally lower than the results achieved in the first and second quarters due to customer and our planned summer shutdowns for preventive maintenance. We expect Q3 2017 EPS to be flat to the prior year. However, we expect a strong Q4, with a return to more normal customer order patterns. We now expect full year adjusted diluted EPS to be in the range of $2.66 to $2.73, which includes the $0.34 of tax benefits from stock option exercises. We have based our guidance on an exchange rate of $1.14 per euro versus $1.05 per euro rate used in our prior guidance.

Thank you, Bill. In closing, we remain confident that the fundamentals of our markets, our products and our strategy are solid. We are maintaining our leadership position with customers. We are expanding our customer portfolio with emerging Biotech and small pharmas as the number of new therapies based on injectable drugs continues to grow. The regulatory hurdles for quality and reliability continue to rise, and our global customer base is increasingly looking to West for worldwide availability, scientific expertise, innovative new components and injection devices, and deep technical service, which we continue to deliver. I want to be clear, we see no change in the fundamental growth drivers and no change in long-term sales growth expectations of 6% to 8% per annum with approximately 100 basis points of operating profit margin expansion per year. Leanne, we're ready to take questions. Thank you.

This is Sara on for Tim. I have a question on cost. I was wondering what levers can you guys pull to manage costs during the delays. I think you mentioned earlier on the call you're implementing some cost controls. And then, as a related question, how should we be thinking about operating margin expansion this year given the headwinds?

So when we were looking at our opportunities, what levers we have available to our business on a short term, it's more around typical cost measures around how we are deploying our resources in our plants. It's also looking at ways to reduce our SG&A or maintain our SG&A as a percentage of sales around that 15% to 15.5%, which we're currently at. This is more around the discretionary spend that we have here at West. Fundamentally, we look at our infrastructure and you look at where we have our operations and our plants and the capacity we have available. There is demand. We expected demand to continue to pick up later in this year. We are ready to take that on. So that's the lever we're looking at, which is more around the discretionary.

And just to answer your question directly on the operating profit margin expansion. We do expect about a 100 basis points increase based on our current forecast versus prior year.

And then in terms of visibility, what are you guys doing to gain better visibility with your clients? I don't know how much you can share with us, but are you able to provide, kind of, any narrative of what changed between now and last quarter and what you're, kind of, doing to address that?

Yes, so what we're doing with our global operations team in our commercial organization is that we have a very robust supply chain group that is actually being tied to our customers and started looking at demand patterns, not just historic but also forward-looking. And so these are the initiatives that we have put in place. But it is really around the overall demand planning, not insular but actually working side-by-side with our customers. Just to reiterate, I mentioned earlier that I had a meeting, several of us had a meeting with the key leaders of a major Pharma company up in Jersey Shore, and that was one of the key deliverables from that discussion is integrating our group with their group to actually build forecast and demand short-term and more long-term.

Bill, can you provide more details about the financial outlook for the second half? Specifically, 3Q usually sees lower activity due to factory retooling, so I’d like to understand the revenue trends better. Also, you mentioned a 100 basis point increase in margins. Will this primarily occur in 4Q, given the flat EPS? Please provide additional insights on the model.

We have indicated in our release and are reiterating here that Q3 will remain flat compared to the previous year’s EPS. We will continue to experience the impact of softness in both the Generics and Bio segments. Looking ahead to the fourth quarter, we anticipate a return to a more typical ordering pattern from our customers in these areas. Therefore, while Q3 sales are expected to be less robust than usual, we foresee higher growth rates in the fourth quarter.

And then, Eric, maybe just you highlighted the double-digit growth in CZ and SmartDose and called out a couple of new customer wins. Could you just give us a sense of the growth you're seeing? Is that coming from the products that have recently been approved commercially, or are you seeing stronger growth from clinical trial and stability trial work?

Yes, the increase in CZ and SmartDose that we anticipated this year is largely due to commercial launches. Our mention of additional development activities around SmartDose indicates that we are building a pipeline for future opportunities. The growth we are experiencing now is primarily related to these commercial launches.

I was wondering if you could provide more insight into why your proprietary orders have declined by 7%. I understand this is influenced by several positive factors, such as reduced lead times and improved throughput and capacity expansion. However, is this year-over-year decline of 7% also affected by a slowdown that you have mentioned, beyond just inventory management?

Yes, Larry, that's a very good question and I appreciate you bringing it up. When we look at our high-value products in our backlog today, I'm very pleased with the progress our operations teams have achieved over the past 12 to 18 months. Our high-value product portfolio is roughly around 17%, the same percentage as last year, of the total units produced at West. Notably, one of the key products in this portfolio historically has been Westar, which accounts for about a third of it. Two years ago, we were averaging over 30 weeks for lead times with customers, which was not acceptable. Now, thanks to our efforts, we have reduced that lead time to less than a third. This reduction has directly impacted our customers' confidence and has resulted in fewer large bulk orders that we previously received due to long lead times. Additionally, despite Westar showing a double-digit decline last quarter, other parts of the high-value product portfolio, particularly new commercial drugs and opportunities, are experiencing strong growth. For example, the self-injection products, along with NovaPure and the Envision line, are all showing robust double-digit growth. Although they come from a smaller base, this growth supports our strategy of continuously expanding our pipeline with new, higher-quality products to meet customer needs. Therefore, the current backlog is directly tied to the reduction in lead times, especially concerning Westar processing in the generics space.

Could you elaborate on the slowdown observed this quarter in both Biologics and Generics? Specifically, regarding Biologics, is the inventory management contributing to the delayed ramps that some of these customers are experiencing? Is this change in their plans due to their own decisions, or is it more related to regulatory delays in approvals?

Yes, Larry, most of this is in the Biologics space, driven largely by our customers' new commercial launches. There was some impact from a similar situation in Generics, but to a much lesser extent. It's primarily about the delayed drug products entering the market that we can see. I won't go into details about any specific customer, but based on our conversations, we anticipate that in the latter part of this year, we will start to see these developments translate into commercial revenue for West and our customers.

It appears that the timing of customer decisions is more of a factor. There hasn't been an indication that the approval forecasts were overly optimistic or that the overall forecasts were too aggressive.

No, Larry, many of our customers, when they are about to launch new molecules, purchase supplies in advance to prepare for the launch. If there is a delay in the launch, it can create some issues with the flow of new orders. I want to emphasize that in terms of Biologics, we do not have any visibility of lost sales. What I monitor daily is whether we are involved with the new molecules coming through the pipeline, and I can confidently say yes, particularly in the Biologics area, it looks very positive. For example, a significant customer has a major biosimilar that has just been recommended for approval, and I am excited that our NovaPure line is part of that. This is another win for West, but more importantly, it's a win for our customers and ultimately for the patients.

On the Generics side, there have been some recent regulatory issues that have impacted production. It seems you don’t have clear visibility on this for the next few quarters. Production may decline in Q3, but you do have some insight into the timing of other orders, which could help offset the weakness. Can you provide a high-level overview of what these regulatory issues entail? Have there been any changes in standards, or is it more about coincidental timing where various regulatory issues have come together, leading to a noticeable slowdown?

Yes, Larry, that's a great question. Let me clarify this for you. Currently, the Generics business is experiencing a decline, which we estimate to be in the mid-single digits for Q3. Last quarter, we expressed our confidence in the large Generic players, which represent about 40% of the Generics market. We have good visibility regarding orders on hand and how they will impact the rest of the year. However, we did not anticipate that a significant portion of this decline—about half—would come primarily from our customers in India. We are observing that multiple customers have undergone audits and have encountered delays due to issues with the materials supplied for production. We recognize that if they don't implement the necessary corrective actions and get them approved, those drugs will need to be sourced from elsewhere. Based on discussions with customers and data from the marketplace, we estimate there may be a transition period of three to six months before we see any changes. This half of the decline we noted specifically stems from our customers in India.

And that's where the regulatory issues have obviously appeared then?

Correct.

And then just one last question about the euro. The average is now $1.14 compared to a previous $1.05, which is a difference of $0.09. Does the historical exchange rate of $0.01 still apply?

Yes, Larry, it's slightly less than that due to some other currencies affecting us in Asia and Europe, including South America. We anticipate that about $0.03 in the second half of the year will be the benefit if the rate remains at $1.14 for the rest of the year.

Instead of the 4.5 you get a little offset on the Asian currencies so it's about $0.03. So that's great. I appreciate that.

This is Jared Meggison on for Dave, this morning. I have one quick question. Regarding high-value products, so we've had a little bit slower growth in 1Q and 2Q, now. And I'm just wondering, how are you guys doing the switch up the value chain for high-value products? Is there still demand from customers to move from Westar and FluroTec all the way up to NovaPure? Or given kind of the slower environment here, is there maybe a slowdown in that shift up the chain?

That's a great question, thank you. When examining our high-value product portfolio, particularly the Westar entry point, we have noticed a decline, especially among customers in the Generic space. NovaPure and Envision are also showing growth, but starting from a smaller base. Westar's sales are greater than the combined sales of self-injection CZ administration systems for NovaPure and Envision. However, both of those product lines are growing significantly in the double digits. We are observing a continued shift towards the high Quality by Design of NovaPure, along with increased inspection requirements for Envision, particularly in the Biologics sector and now expanding into Generics. We are confident in our trajectory up the value chain as we enhance the quality of these new products. It's important to note that high-value products accounted for about 17% of our total units produced last year, and we anticipate that this will increase by 100 to 150 basis points each year.

I'm pleasantly surprised to hear that you're still talking about a 100 basis points of margin expansion this year, that's certainly better than we had on our first pass at the model. Could you just sort of talk about how much of that is sort of like currency rate versus operational, just like that, could you just sort of walk it, what's on the underlying op margin for guide?

Yes, currency will not significantly impact the margin percentage. It does affect EPS by $0.03, but the margin remains largely unaffected. As Eric mentioned, we are engaging in operational improvements that should slightly reduce operating costs. We are also focusing on cost controls around SG&A. Additionally, we anticipate an increase in HVPs in the latter half of the year, which I noted in my prepared remarks; the growth in HVPs significantly influences the mix shift and our margins. Therefore, we expect a return to normal order patterns in Q4. With effective cost controls and operational efficiencies, we believe we can achieve approximately 100 basis points.

This raises the question that I've heard from a few people this morning. We've seen similar issues before, especially with the HVPs. If you look back to 2011-14, there was a comparable situation. Can you discuss how this current scenario relates to past experiences and how long it typically took to recover from previous delays?

Absolutely, we have encountered similar situations in the first quarter of 2014, as well as in 2011, and even back in 2008 and 2009. The core fundamentals of our business indicate that as long as our products remain available in the market and there is no loss of market share, we will see those units return when conditions improve. Much of what we are experiencing now is influenced by our operational efficiency and customer inventory management challenges. This kind of fluctuation is not unusual and tends to occur periodically, but we are confident in our continued growth. The demand for our high-value products stems from the need for superior quality, greater purity, and higher standards, which our customers expect. We hold a significant market share in the Biologic segment and have not lost any business, indicating that no fundamental changes have occurred. We anticipate that order patterns will normalize. It's also important to note that we experienced significant growth in high-value products during the first half of 2016, with growth rates in the high-teens. This is above our expected range, which typically falls in the high single digits to low double digits. Therefore, we are observing a reversion to the mean, and we believe that the demand is still present. The products are available, and we expect this demand to rebound in the coming quarters.

And that was, sort of, the question on basically nothing to shake your long term outlook?

Absolutely nothing.

No, Dave, no change.

Regarding the issue with Generics and the quality concerns, it seems you encountered some problems with Generics customers in Q4 and Q1. Are the issues that arose this quarter the same as those, or are they new ones? I'm trying to understand your visibility on the situation—are these lingering issues, or is it more like new problems are continually emerging?

Yes, from our perspective, working with our customers, there are newer issues that are being faced with our customers, specifically in India. While there are some issues that are outside India. They've been going on for some time now. This is specifically, more than a handful, I would say, in India.

Well, I'll just tell you, in the back half of the year, it'll be approximately $20 million.

Thanks, Leanne. Thank you for joining us on today's conference call. An online archive of the broadcast will be available on our website at www.westpharma.com in the Investors section. Additionally, you can get a telephone replay through Thursday, August 3rd, by dialing the numbers and conference ID provided at the end of today's earnings release. That concludes this call. Have a nice day.