West Pharmaceutical Services Inc (WST) — Q1 2022 Transcript

Thank you, Didi. Good morning and welcome to West’s first quarter 2022 conference call. We issued our financial results this morning and the release has been posted in the Investors section on the company’s website located at westpharma.com. This morning, CEO, Eric Green; and CFO, Bernard Birkett will review our financial results, provide an update on our business, and present an update on our financial outlook for the full year 2022. There is a slide presentation that accompanies today’s call and a copy of that presentation is available on the Investors section of our website. On slide four is our Safe Harbor statement. Statements made by the management on this call and in the accompanying presentation contain forward-looking statements within the meaning of US federal securities law. These statements are based on our beliefs and assumptions, current expectations, estimates, and forecasts. The company’s future results are influenced by many factors beyond the control of the company. Actual results could differ materially from past results, as well as those expressed or implied in any forward-looking statement made here. Please refer to today’s press release, as well as any other disclosures made by the company regarding the risk to which it is subject, including our 10-K, 10-Q, and 8-K reports. During today’s call, management will make reference to non-GAAP financial measures, including organic sales growth, 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’ll now turn the call over to West’s CEO and President, Eric Green. Eric?

Thank you, Quintin, and good morning. Thanks for joining us today. We will start on slide five. I'm pleased to report that we delivered a strong first quarter. This is driven by double-digit organic sales growth with increasing demand for our high-value products. Our confirmed order book for the rest of 2022 and into 2023 remains as strong as ever, primarily driven by non-COVID based business. And to provide you more color, over half of the order book is coming from biologics demand. These results were delivered despite several macroeconomic challenges that are impacting all companies and sectors. We've taken proactive measures to mitigate the risk of these challenges and ensure the continuity of critical components to our customers. For example, with inflation, we're adjusting our pricing strategy and have enacted surcharges as a pass-through to offset increasing costs of raw materials, energy, and transportation. Regarding the supply chain, our raw material and proprietary medical device components are sourced from across the globe. We have increased our inventory of these key raw materials to minimize any supply disruption. We continue to execute and monitor our business continuity plans with respect to these issues, including the war in Ukraine and the recent pandemic surge in China. Turning to slide six, our team members across the globe continue to demonstrate their passion to improve patient lives as they remain focused on our strategic initiatives of execute, innovate, and grow. Starting with the first pillar of execute, we continue to deliver the key drivers of growth in Q1 with strong customer demand for HVP components, including NovaPure and Weststar. There was solid demand in the quarter across all market units and a positive outlook remains for the rest of the year, particularly for our biologics market segment, which is now greater than 42% of our total sales. We see both existing and new customers continue to specify our highest level of components by West or our partner Daikyo for sensitive molecules. Our capital spending investments through expansions and optimizing productivity across the global operations remain on track. To-date, almost all of our 2020 expansion phases have been installed, validated, and in production, and we're making good progress on the 2021 capital expansion plans, some of which will come online in the second half of 2022 and throughout 2023. With the accelerated biologics demand for NovaPure, we have executed digital support for NovaPure future demand as well as other HVP finishing capabilities. Expansion construction is underway and will be online towards the back half of this year with commercial production and 2023. Shifting into the West team of scientific and technical experts, we continue to educate and share insights in biologics, combination products, and container closure integrity, which are priority areas in pharmaceutical packaging. At the recent PDA Annual Meeting, several of our West experts were recipients of prestigious awards. Now, to innovate, we need to feel innovation to develop future products, solutions, and services that connect the dots across science and technology to create customer value. We're doing so by investing in external opportunities that complement our current business needs, such as our partnership with Tekion to create a research center of excellence in combination with West Scientific expertise. The Corning collaboration as we expand our HVP value proposition to lead the industry from components to a truly integrated system of elastomer and glass. And building technologies like the recent collaboration with Numa Systems to develop a family of fluid flow technologies for drug delivery. I'm pleased with the progress our R&D team is making around innovation. Moving to the final pillar of growth, which includes uses of cash. We're working from a position of strength as we believe we have a long horizon of continued strong organic sales growth and margin expansion. As we have demonstrated over the past two years, we have increased our capital spending for capacity expansion at existing sites across our global network to support our organic growth initiatives. In addition, we have made inorganic investments, such as partnerships with Corning. Our continued focus within these three strategic pillars; execute, innovate, and grow, allows us to be more responsive, leverage our assets more effectively, and support the trends that are happening in the industry today. This was most evident from our recent site visits in Dublin and Waterford, Ireland. For example, in Dublin, I saw firsthand how the digitalization of our manufacturing technologies is providing real-time data, enabling our team to raise the bar in operational performance with higher yields and efficiencies. At Waterford, the capital investments over the last year and a half have significantly increased capacity with additional lines producing HVP product to meet increased demand. We're seeing early success with our next-generation fully integrated automation that we believe will scale and transfer across the network for a combined benefit of higher quality production and higher manufacturing throughput. Lastly, and proudly, the hard work of our Waterford team was acknowledged by the Ireland-U.S. Council as we received the Global Public Service Award for our commitment during the pandemic. Now, I'll turn it over to our CFO, Bernard Birkett, who will provide more detail on our financial performance.

Thank you, Eric, and good morning. Let's review the numbers in more detail. We'll first look at Q1 2022 revenues and profits, where we saw continued strong sales and EPS growth, led by strong revenue performance in our Biologics and Pharma market units. I will take you through the profit growth we saw in the quarter as well as some balance sheet takeaways. And finally, we will provide an update to our 2022 guidance. First up, Q1. Our financial results are summarized on slide seven, and the reconciliation of non-U.S. GAAP measures are described in slides 15 to 18. We recorded net sales of $720 million, representing organic sales growth of 11%. Looking at slide eight, Proprietary Products sales grew organically by 14.4% in the quarter. High-value products, which made up approximately 73% of Proprietary Products sales in the quarter, grew double digits and had solid momentum across Biologics and Pharma market units in Q1. Looking at the performance of the market units, the Biologics market unit delivered strong double-digit growth. We continue to work with many biotech and biopharma customers who are using West and Daikyo high-value product offerings. The Generics market unit experienced mid-single-digit growth, led by sales of FluroTec and Westar components. Our Pharma market unit saw high single-digit growth with sales led by high-value products including Daikyo and NovaPure components. Contract Manufacturing declined 3.8% for the first quarter due to a reduction in sales of components for diagnostic devices. We recorded $284.6 million in gross profit, $12.7 million or 4.7% above Q1 of last year. Our gross profit margin of 39.5% was a 100 basis point decline from the same period last year. We saw improvement in adjusted operating profit with $189.9 million recorded this quarter compared to $179.2 million in the same period last year, or a 6% increase. However, our adjusted operating profit margin of 26.4% was a 30 basis point decrease from the same period last year. Finally, adjusted diluted EPS grew 12% for Q1. Excluding stock-based compensation tax benefit of $0.12 in Q1, EPS grew by approximately 15%. So let's review the drivers in both revenue and profit. On slide nine, we show the contributions to sales growth in the quarter. Volume and mix contributed $49.9 million or 7.4 percentage points of growth. Sales price increases contributed $23.6 million or 3.5 percentage points of growth in the quarter. Looking at margin performance, slide 10 shows our consolidated gross profit margin of 39.5% for Q1 2022, slightly down from 40.5% in Q1 2021. Proprietary Products first quarter gross profit margin of 43.4% was 290 basis points lower than the margin achieved in the first quarter of 2021. The decline in Proprietary Products gross profit margin was caused by several factors, including lower levels of absorption during the early part of the quarter due to short-term labor constraints, increases in raw material and overhead costs. In addition, our 2021 gross profit margin included approximately 150 basis points of benefit in the prior year associated with one-time fees from COVID and other supply agreements, which did not reoccur in the first quarter of 2022. These fees had approximately 160 basis points of benefit on Q1 2021 operating margin. Contract Manufacturing first quarter gross profit margin of 20.1% was 440 basis points above the margin achieved in the first quarter of 2021. The increase in margin is largely attributed to the pass-through of inflationary costs and components in the quarter. Now let's look at our balance sheet and review how we've done in terms of generating more cash for the business. On slide 11, we have listed some key cash flow metrics. Operating cash flow was $151.2 million for the first quarter of 2022, an increase of $62.5 million compared to the same period last year, a 70.5% increase. Our operating cash flow in the period benefited from our working capital performance. Our first quarter 2022 year-to-date capital spending was $65.8 million, $11.1 million higher than the same period last year. Working capital of approximately $1.1 billion at March 31, 2022, decreased slightly by $42.2 million from December 31, 2021, primarily due to the net reduction of our cash, offset by an increase in inventory levels. Our cash balance at March 31 of $667.7 million was $94.9 million lower than our December 2021 balance, with the decrease in cash primarily due to our share repurchase program and higher CapEx, offset by our strong operating results in the period. Turning to guidance, slide 12 provides a high-level summary. We are reaffirming our full year 2022 net sales guidance. We expect net sales to be in a range of $3.05 billion to $3.075 billion. There is an estimated FX headwind of $115 million based on current foreign exchange rates compared to a prior estimated headwind of $70 million. We expect organic sales growth to be in the range of 11% to 12% compared to our prior guidance of approximately 10%. We expect our full year 2022 adjusted diluted EPS guidance to be in a range of $9.30 to $9.45 compared to a prior range of $9.20 to $9.35. This revised guidance includes first quarter $0.12 EPS positive impact of tax benefits from stock-based compensation. Also, our CapEx guidance remains at $380 million for the year. There are some key elements I want to bring your attention to as you review our guidance. Estimated FX headwind on EPS has an increased impact of approximately $0.38 based on current foreign currency exchange rates compared to a prior estimated headwind of $0.21. Our guidance excludes future tax benefits from stock-based compensation. To summarize the key takeaways for the first quarter: strong top line growth in proprietary, growth in operating profit, growth in adjusted diluted EPS, and growth in operating cash flow, delivering in line with our pillars of execute, innovate, and grow. I'd now like to turn the call back over to Eric.

Thank you, Bernard. To summarize on slide 13, our execution in Q1 has positioned us well for the year ahead. We continue to have a strong base business despite the current macro environment in which we operate. We remain well-positioned with the right market-led strategy around execute, innovate, and grow. We have a robust book of committed orders with momentum in 2022 and continuing into 2023. We continue to realize the benefits of our global operating model, and we're continuing to accelerate capital spending across our operations to meet current and anticipated future growth. With great pride, we realize the criticality of our products for health care across the globe, which is why our purpose to improve patient lives propels us each and every day. Didi, we're ready to take questions. Thank you.

Great. Good morning. Did you provide the COVID-related sales number? Did I miss that?

We didn't call it out, but it was approximately $110 million, which shows growth over Q1 2021.

Got it. So, there's no change to this year's outlook for that, it sounds like. Okay. Just on the cost side, clearly, everyone is dealing with varying degrees of inflation and supply chain issues, and you guys have done a fantastic job offsetting many of them, I think. But obviously, you can only offset so much. I'm just curious about the surcharges you implemented today; weren't you already kind of addressing this? Is this just speeding up increases to keep up with the rapidly changing situation regarding rising costs? I know that normally you include some adjustments in your contracts. Is this a broader and more aggressive response to these inflationary pressures?

Yes, Larry, there are two aspects to consider. Regarding the Contract Manufacturing segment of our business, which represents just under 20%, we are mostly passing on inflationary costs to our customers through our agreements, including those related to raw materials. On the proprietary side, this is a more recent development. There are two components to this. One is that we are revisiting our pricing strategy, which we began implementing last year in preparation for this year. As a result, we are now incorporating a longer-term pricing strategy focused on value capture. Additionally, in the proprietary business, we have introduced surcharges primarily related to transportation and increases in raw material costs. These are the two actions we've taken. I want to emphasize that our underlying base price increase strategy is being integrated into the ongoing business.

Was this implemented at the beginning of this year? I assume there's some type of lag. Margins were down a little bit, and I understand there was a $12 million one-time payment that affected the margins. Even looking sequentially, margins are still down a bit. Is this primarily due to higher costs that you can't fully offset? Hopefully, there will be some improvement as you start to implement these surcharges.

It's partly a result of costs and the delay in passing them on, so it's not always immediate within the quarter. When we encounter pricing or cost increases, we collaborate with our customers to gradually integrate that over time, and that has been our approach. Additionally, we did notice some reduced absorption levels, particularly in the first half of the quarter due to labor supply issues at two of our plants. This was a temporary setback, and we've observed that absorption levels have returned to normal in the latter half of the quarter. However, this situation does have a short-term impact on margins.

That was kind of my next question. Other than the cost impact and the temporary labor issue you mentioned, are you experiencing any significant or worsening challenges in retaining staff or dealing with supply chain problems, or have you managed to handle these issues even though the situation isn't improving?

I wouldn't think there's increasing problems retaining labor. It has been challenging, I think, for everybody, but we haven't seen any spike in that. So we have a number of initiatives with our HR teams to make sure we have the labor in the right places. So it wasn't really around retention problems. Long term, that's not a big issue for us. And then if you look at the implied guidance, we are forecasting operating margin expansion. To do that, we have to be able to do gross margin expansion at the same time to feed into it. We believe some of these short-term impacts we saw in the early part of the year are now behind us.

Okay, great. Just one last question regarding COVID. It's a quickly changing situation. However, it seems that for you, we've discussed, it's not about the overall volume but rather the shift in life cycle management. Have you noticed any additional evidence that this is happening? Any updates or thoughts on that?

What we can share is that we are observing a shift in the forecasting for later in 2022 from larger vial configurations to smaller vial configurations. However, this change has not yet impacted our operations as of now; it remains a forecast. We are collaborating with our customers throughout the year.

Right. Okay, great. Thanks guys. Appreciate it.

Thank you.

Hi, good morning. Thank you for taking my questions. I guess Repligen came out yesterday and saw COVID vaccine cancellations, and orders have been pushed to 2023, at least some of them. I guess what are you seeing in your order books? And if you could share your outlook for COVID, both short-term and long-term, that would be great.

Well, two ways to look at it. One is, if we think about for 2022, our confirmed order book for the balance of the year, as we mentioned earlier, is much stronger than it was the same time period as last year. But if you split that out, the COVID ratio within that larger order book is relatively the same as it was last year. Really, the expansion of that order book is really heavy around the HVP, and also due to over half of it is due to the success of various drug launches in our biologics space. So there are some COVID-19 customers that are adjusting their forecasts, but overall, we're seeing a steady flow throughout the balance of the year.

Got it. So you're currently not sort of changing your outlook for 2023, it sounds like?

No, we're not changing our outlook based on our current conversations with customers.

Got it. And I think your margins, both gross and operating, came slightly below The Street. Can you help us think through how much of that is product mix versus currency versus supply chain headwinds? I think gross profit is a bit lower than you're used to seeing, but some of that is offset by lower SG&A spend as well.

On the gross margin, as I mentioned earlier in response to Larry's question, part of the issue was due to lower levels of absorption we experienced in the first half of the quarter, which was more of a one-time occurrence. If we examine our operating margin on a normalized basis and exclude the one-time take-or-pay from Q1 2021, we would see an operating margin expansion of approximately 130 basis points. This one-time event had a 160 basis point effect on our operating margin. Looking ahead for the rest of the year, we anticipate continued expansion in our operating margin.

That’s it for me. Thank you very much.

Thank you.

Hi Eric, your $380 million of CapEx clearly indicates a strong building book for biologics outside of COVID. Can you discuss how 42% of your sales are biologics this year compared to last year? Also, can you share what factors are contributing to your CapEx levels?

Yes. When you look at it, Paul, it's less than 40%, and we're seeing biologics becoming a larger share, being the largest unit today with the highest growth even when excluding COVID. Our current investments are largely growth-oriented, with over 70% of our capital focused on this area, compared to about 50% historically. This is particularly around NovaPure and FluroTec, especially plungers and stoppers. The capital we've been spending over the last couple of years was already included in our five-year plan, and we're just accelerating it to support COVID vaccines. However, demand for biologics continues to increase and accelerate. Looking at our confirmed order book details, over half consists of drug molecules in the market that are ramping up or accelerating in adoption. This is not limited to just one molecule; it's many. We're experiencing an increased volume pull from the West to support the ongoing supply of these drugs. We're very excited about the focus on biologics and the high success rate of new biologics license applications and new molecular entities. Our participation remains very high, and this is the impact we are observing.

Regarding the Corning joint venture, I understand that you've mentioned a capital expenditure of $15 million, but what is your perspective on the multi-year timeline for that joint venture?

Well, the investments are more in the next couple of years. I mean it's a very long-term arrangement. We will have various launches over the next couple of years, starting this year, 2022, of new solutions to customers. But these investments will take place on the capital side over the next couple of years to increase capacity, particularly around prefilled syringes.

Yes. So that's going to be a number of years before we see from a revenue and profitability perspective. That's not immediate. It will take time to build that out. In the interim, there are other configurations, as Eric said, that we're putting together, but they won't be overly material on our numbers in the short-term.

Okay. Thank you.

Good morning, and thank you. I have a couple of clarifying questions. Regarding COVID, if I understood you correctly, your revenue expectations for 2022 remain the same. However, has the makeup of those revenues changed? It seems like you might see some additional benefit from a configuration change in the latter part of the year. Can we conclude that the composition of those revenues has shifted from what was previously expected?

No, I think it's pretty consistent. What we're seeing is that when you manage the life cycle and change vial configurations, there will be a shift, mainly in the latter half of the year. However, looking at our current growth orientation and the balance of 2022, the growth from non-COVID areas will surpass the COVID-related growth. As you remember, there was a rapid acceleration last year and the year before due to our market response. Now, it's more steady, though I can't fully call it steady state. It's more on the lower end but still represents overall growth for West. The greater growth in proprietary will mainly come from non-COVID-related areas.

Okay, got it. Thanks for that Eric. And Bernard, just on the decline in gross margin sequentially, it sounds like this was largely related to labor and absorption. And if I heard you correct, it sounds like that was the first half of the quarter, and that's been resolved. So is it fair to assume that we should see gross margins kind of bounce back now that that's over with as we think 2Q and beyond?

Yes. And that's implied in the guidance for that to happen. We're confident that, that will take place. As Eric has alluded, we're continuing to see very strong growth within biologics and that mix shift within our business drives a lot of that margin improvement. Also, we expect to pick up various levels of efficiencies throughout our operations. We would expect to see margins continue to improve throughout the year.

That's helpful. For my last question, I want to get to the main point. Eric, you talked about a long-term outlook for organic growth. Can you remind us what percentage of our product units are currently considered high-value? Also, what might that percentage look like in five years?

Yes. Our algorithm indicates that over 70% of our sales come from high-value proprietary products, while the production of high-value product units is around 22% to 23%. A 100 basis point increase in units corresponds to strong double-digit growth in high-value products. As biologics represent a growing part of our portfolio, this growth is distributed across various customers rather than being concentrated on a specific customer or drug. This will lead to increased revenues and profits with only a modest rise in unit production, around 100 or more basis points. We expect this trend to continue as it is the fastest-growing subsegment in the injectable medicine market. Our pipeline remains strong, and we've seen a significant number of new approvals in the last 12 to 18 months, with our participation rate remaining high. All these factors contribute to our confirmed order book for future launches and indicate sustained growth for high-value products over the next five years.

Perfect. I'll leave it there. Thanks for taking the questions.

Thank you.

Hi, good morning everyone.

Good morning, Derik.

I just joined, so I apologize if I repeat anything. Can you discuss the organic revenue growth guidance? Your numbers for the first quarter are a bit lower than ours, yet you are raising the full-year outlook to 1% to 2%, which is surprising given the first quarter. Can you explain your confidence in this increase despite the start?

Yes. When we evaluate the situation, it relates back to my earlier point about the absorption rates we faced in the first half of the year due to some labor constraints primarily linked to Omicron, which affected us at a couple of sites. This was a short-term issue that limited our production capabilities, thereby affecting our revenues in the first quarter. It's important to note that we are not experiencing a decrease in demand; rather, it’s about what we were able to produce and deliver to customers during that quarter, which was slightly below expectations. As Eric mentioned, our order book remains very strong. Earlier this year, we indicated that we anticipated more growth in the latter half of the year compared to the first half, and that trend is still evident. So, there has been no change in our outlook.

Great. That's really helpful, and I didn't catch that. Have you had any clients asking if you can confirm that you're looking for more than 100 basis points of overall operating margin expansion this year?

Yes. And again, that's implied in the guidance. So it will be greater than 100 basis points. Getting back to the point I made earlier, if you look at the fundamentals of the business, if you take that take-or-pay that we had in Q1 2021, if you back that out and then look at the comp on that basis, operating margin would have expanded about 130 basis points. So from a comp point of view, you had that level of challenge here in the first quarter. Looking at that gives me confidence to say we're going to continue to expand that operating margin.

Do you think the production constraints are largely alleviated now?

I’d like to add that, based on the performance over the last few months, I would say yes. There are always challenges in the current environment. The two plants that Bernard mentioned were significantly affected by Omicron, which impacted both absorption and productivity. However, examining the productivity and output from the past few months, we believe we have good control over these aspects and we are building flexibility to ensure we can deliver in the future. It was a short-term setback.

Yes. So we did see improvement as we moved through the quarter. We're forecasting that to continue based on what's in place now.

Great. And I've got some people asking on your China exposure and just sort of any commentary in that region. Has that been a headwind to the business at all?

Yes. So our operations were impacted in the sense that our Qingpu manufacturing facility is within the region of Shanghai and obviously, our offices too. We did have a site closure for a short period of time, and we're working through that now. As far as materiality for West, it's a very low percentage for West coming out of that facility for the local market. But we're keeping an eye on it, making sure that we can pivot and potentially import where necessary versus having materials coming out of that specific site. We do expect to see a recovery in this quarter with the demand, but we need to stay tuned because that's a pretty dynamic environment right now.

Great. Thank you very much.

Thank you.

Thanks Didi. 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 Investors section. Additionally, you may access a replay through Thursday, May 5 by using the dial-in numbers and conference ID provided at the end of today's earnings release. That concludes this call. Have a nice day.