Avantor, Inc. (AVTR) Earnings Call Transcript & Summary

All right. Good afternoon. It's our pleasure to welcome Michael Stubblefield from Avantor to the Cowen conference. Avantor is one of our top picks for 2020. Michael and the team have done a tremendous job, improving the growth profile and revenue mix of the business since the VWR LBO. The outlook for cash flow yield is amongst the best in the group, and we view the outlook as quite resilient. And frankly, we just don't think that's captured in the current valuation. So we're excited to have Michael here to unpack this a little bit. Thanks for being here with us today. We have a little bit of an ambitious agenda to get through. So if you have any opening remarks, that's great; if not, maybe we'll just jump into it.

Yes. No. Thanks, Doug, excited to be here. Appreciate the opportunity to us to interact and happy to jump right in.

All right. So why don't we -- I don't know if anyone could hear us, but we were talking about different things that different companies are doing with COVID-19. Maybe just using that as a segue to what we're asking a lot of companies, again, what's going on with your business, when it comes to COVID-19. I know this goes beyond China. But right now, China is most impacted, and we would note that less than 2% of sales are in China, and you source, I think, only 2% to 3% from China. That being said, not a lot of revenue exposure, but what about proprietary or third-party supply chain risk?

Right. Doug, I think you've done a pretty good job in kind of bucketing our exposure to date, which has been relatively muted. Less than 5% of our revenue comes out of Asia, less than $100 million of revenue in China itself. And then we're going to source a couple of hundred million dollars for our supply chains in Europe and the U.S. And I would say outside kind of the personal protective equipment value chains, we've seen relatively limited disruption to date. And obviously, it's something we're monitoring pretty closely. We had relatively good inventories heading into the Lunar New Year which has allowed us to kind of buoy some of the congestion at ports and some logistical constraints that are out there. And as we think about various scenarios as they play out, we kind of look at it in terms of when the preponderance of manufacturing capacity in China comes back online and would that happen by the end of March? Would that happen by the end of June? And I think our view is as long as, at least as it pertains to China, we see more and more of that coming online every day and I think we feel reasonably good about where we're at, where our customers have been over the last couple of months, and we haven't really seen much of an impact one way or another as we sit here today. Obviously, as the virus spreads to the U.S. and Europe, we're keeping a close eye on that. Obviously, way too early to tell what impacts that we might have there. And hopefully, as it plays out here in March, we'll be able to give you some sense of that. Aside from looking after our customers and monitoring our supply chains, obviously a lot of focus on keeping our associates safe, and we'll continue to place a significant emphasis on that.

And then just not sure there's a lot more to unpack there. But in terms of just other countries where maybe you have higher risk within as a percentage of sales in Asia, are you a little higher risk in -- I'm sorry, a little higher exposed as a percentage of sales in Korea and then in Europe, similar question on Italy?

Yes. So staying within Europe -- or Asia, excuse me, roughly 5% of our revenue is in the region, and it's going to be split amongst kind of 5 demand centers. We've talked about China, India, Middle East, Africa, 2 other additional areas for us to focus. Our core business is really centered around Southeast Asia and Singapore and in South Korea, and that's primarily bioproduction focused. And to date, we've seen no interruption to those supply chains.

Okay. And I have, thus far, asked mostly about COVID-19 in the context of risk. What role -- I hate to position this as an opportunity, but I imagine there are certain product areas where there's increased demand for Avantor products. So in terms of the opportunity, maybe more importantly, the role that your company is playing in trying to help us get a vaccine and maybe some treatments.

I'd say a couple of things. One, through our channel business, we have a pretty important role to play in supplying garments and masks and other personal protective equipment into the clean rooms of the customers that we service and clearly have seen a pickup in demand, particularly in China, but we also see it in other parts of the world as well. Our biopharma customers need these garments and other items in order to be able to produce. And we've obviously taken great care to ensure that we can provide continuity of supply into those customers. We're obviously deeply embedded in supporting the space broadly, whether that be through our clinical trial support businesses or through the materials that we supply on to therapies. And I think there's a pretty significant list of companies that are working on either therapies or treatments for the virus or for vaccines, many of which we serve as well.

Maybe to pivot to talk a little bit about the 2020 margin outlook as well as the longer-term margin outlook. So looking back to Q4, you were able to post 4.3% organic revenue growth in spite of a mid-single-digit decline in equipment and instrument sales, and you had decent margins as well. 2020 EBITDA margin guidance implies a bit less expansion than what we saw in a period where actually growth had slowed a little bit relative to recent trend. So as we think about 2020 margin guidance, you provided helpful color on the components to expansion on the call, including $40 million to $50 million in VWR synergies as well as some incremental growth investments like $20 million in AMEA. How should we character -- long buildup to the question, which is how should we characterize the level of conservatism in your margin guidance? Or maybe put differently, how much risk is there to this target given what we've seen recently from you?

Yes. I think maybe to get to the punchline, I think from where we're at here early in the year, I think the 50 to 60 bps of expansion that we've guided, I think, covers the risks that we see at this point in the year. And as you mentioned, there's a number of levers that we have available to us to drive margin expansion, whether that be managing the relationship of price relative to COGS. Certainly, organic growth drives a certain level of expansion given the operational leverage we have in the P&L. You mentioned the VWR synergies. That was a program that we announced at the time of the acquisition of VWR that was roughly $300 million of EBITDA synergies split roughly 2/3 cost, 1/3 commercial that was to be delivered by 2020. We've just concluded year 2 of that 3-year program and realized roughly $230 million of synergies in the P&L in 2019. We were run rating at somewhere $250 million, $260 million at year-end, so we have a bit of work to do to top that program off but certainly remain confident that we'll be able to deliver against that commitment. But on a year-over-year basis, we're well ahead of the curve through the first 2 years of that program. And so you'll see incrementally a little less impact in 2020 than what we had seen in prior years.

A couple of quick follow-ups. So if end markets were actually to play out, as I think many of us expected coming into the year, putting aside where we started this conversation. If you were actually to generate 5% plus organic revenue growth, is it plausible? Is there a path to 100 basis points of margin expansion?

I think when you look at some of the assumptions we've made around inflation and how we have maybe planned for price relative to COGS to play out, certainly we see an opportunity to perform at the high end of our guidance. We've made certain assumptions around investments that we made. You mentioned some of the work we've been doing in Asia. That's probably an area where, if I roll back the clock a couple of years, we certainly knew that there would be opportunity in the Asia market that we were excited about. I think it's probably a bit more opportunity and coming a bit faster than maybe what we had originally contemplated, so you see us accelerating investments in certain areas, whether that be in GDP distribution capabilities. You saw us inaugurate a new innovation and technology center in Shanghai in December. We announced in January on our earnings call the addition of a new staff member that's specifically driving the growth in that region for us with a specific focus on China. So we're trying to mobilize resources to capture the opportunity that's there while also balancing kind of the cost of the business. So you also see that kind of factoring in as well.

Longer term, I guess really the question is, is the 75 basis points that you're targeting this year in terms of margin expansion, is that sustainable? Is something like that sustainable? And part of the reason I ask is when we think about VWR back in the old days that was one area where they consistently just couldn't get to where they were supposed to get to. You've done better with that. Maybe something to talk about a little bit more is just the success you've had with proprietary mix moving up, which is higher margin. But again, I think the question is how should we think about the sustainability of the type of margin expansion you're targeting this year looking forward?

Yes. We haven't provided any clarity or guidance as to what we see margins expanding beyond this kind of integration period as we would refer to it. But when you look at the drivers of expansion, whether it be price over COGS or organic growth, those are certainly -- you're going to continue well past this year. This point you're making about mix is actually pretty important to understand in our business. So roughly half of our revenue comes from our own branded products and our own proprietary content. Roughly 50% comes from brands that we represent from our third-party partners. Given that our production, our solution for the production environment is primarily proprietary content, that part of our business tends to outgrow the work that we do in the labs with our customers by as much as 2:1 or maybe even in some cases 3:1. And obviously, the margins that we have in our business on our own content is going to trend a little bit higher than the third-party revenue that we generate. The fact that, that piece of our business grows disproportionate to the third-party business will also naturally drive margin expansion over time.

Pivoting to the biopharmaceutical end market, so this is important for you guys. It's roughly 50% of sales. It grew as a whole about 10% in 2019. It's been a high single-digit grower for most of the group over the past 5 years, aided by strong bioproduction growth, which, for you, represents about 20% of your biopharmaceutical sales. Obviously, easy math, about 10% of total sales. You guided us to assume high single-digit or low double-digit biopharma growth in 2020. Can you break down the components of that and how you get there this year?

We're pretty excited about the momentum that's in that part of our business. As you indicated, that represents roughly half of our revenue is linked to biopharma, and we have a unique model in that we're going to service our customers all the way from early phase discovery out through their commercialized drug platforms. We internally refer to that as beaker-to-bulk. Probably 2/3 to maybe close to 70% of our revenue in biopharma will come in the workflows, in the laboratory environment, working to support our customers' research into next-generation therapy platforms. Roughly 1/3 of what we do is then going to be supporting their activities at commercial scale, providing ingredients and excipients, chromatography resins, single-use solutions to help facilitate the production of the therapies that make their way into the marketplace. You see a little bit lower-growth dynamics in the lab environment, think low to mid single-digit type growth. And then the production environment is going to grow in and around double-digit levels. We've probably done a little bit better than that more recently. And certainly, some of the trends we see for our customers to move towards more single-use manufacturing certainly speaks to a portfolio like ours that has a pretty considerable amount of single-use content in its portfolio. That part of the business tends to grow even into the 20-plus percent range. So we ended up at a 10% total growth rate for biopharma, which reflects kind of double-digit growth on the production side of things and more mid single-digit growth in the lab.

That all sounds -- recognizing you're not providing long-term growth targets there, I mean, and nothing you described sounds like it's expected to be temporary. It seems like you feel like some of the drivers to growth are pretty sustainable at this point.

So we think the long-term fundamentals in the biopharma space are really solid, and I think the proof points that you look to there that give you that kind of confidence are the number of funding sources and the frothiness of funding sources around the world to fund these exciting therapies. And you see the explosion of start-up companies that are driving the investment in these new therapies that are going after indications that we've never been able to treat before. The other thing that's exciting for our team is, as we see the biologic technology play out, clearly, the bulk of the revenue is generated from the monoclonal antibody platforms, and we don't see that changing over the next 3 to 5 years. But what we do see, though, is the emergence of kind of maybe the next generation of biologics in the form of cell and gene therapy now starting to take hold in the marketplace. We don't think that's going to generate a significant amount of revenue in the near term. But as you start to look forward over the next 3 to 5 years, the number of therapies that are moving their way through the pipelines, we've started to see some of the first approvals of these drugs even last year, that will, I think, drive kind of the next wave of innovation and growth for our business that will extend for an extended period of time. So funding as well as just the science and the breakthroughs that we're realizing on some of the next-generation technologies give us a lot of confidence.

And increasingly, you're moving into areas of biopharma where you get locked in and you have even more visibility.

So the charm of the biologics business obviously is the opportunity to earn a specification and become part of the regulatory filings. It makes for a very resilient sticky business. Our inputs to these platforms are significant. They're part of our customers' regulatory approvals. And although you never want to take it for granted, it's quite an onerous exercise for our customers to try to change a material specification once the drug has made it past a certain phase of the clinical trials. And we've even been surprised as we've come up with innovations, as we've gone back to certain customers and to point out to them what we could do for the platform that we already expect on if we would maybe implement the new technologies, even seeing resistance on those kinds of things and saying, "No. Let's apply that to the next generation." We don't want to reopen the regulatory filings.

Okay. That's really helpful. Pivoting to your other end markets. So obviously, if biopharma is roughly 50%, everything else is roughly 50% as well. If we do the basic math on biopharma and say, "Okay, that's going to grow, yes, about 10%." You multiply that by about 50%. That alone gets you to about 4% to 5% total company growth. Your guidance for the year is 4% to 6%, so you're not assuming a whole lot of growth for everything else. Why is that? I mean I think that implies a little bit of a deceleration versus trend. I mean how much of this is conservatism versus seeing something that gives you for -- a reason for pause when it comes to the growth outlook in these other areas?

Yes. When I think when we look at the trends in our other end markets, which are principally education and government, health care, and then we have kind of a catch-all that we refer to as advanced technologies and applied materials as kind of our applied markets. When we look at those end markets, roughly flattish environment for most of those end markets the second half of last year. And so as we think about moving into 2020 here, we forecasted kind of high single digits or close to 10% growth in biopharma and essentially a continuation of the trends that we had seen in the second half of the year and the rest of those end markets. And so when you look at some of the drivers that could push you to the upper end of our guidance, that would certainly be one of those. That if you saw any improvement in the health of any of those other end markets, you should certainly see a bit of a move towards the upper end of our guidance. And I think, for us, starting out here early in the year, we're kind of a wait and see. We'd like to see some evidence of some traction in some of these end markets before we start getting too optimistic about that, but we haven't assumed much for the other half of our business. And historically, when you look at those end markets, they're never going to be the high single -- or double-digit growers that we see in biopharma. But if you just look at the historical growth rates of those end markets, they're kind of low single-digit levels, 2%, 3%. So you can see what that could do to our overall growth rate, if they would just return to their historical performance.

Yes. So the -- I mean the upside scenarios are in education and government. You have a good funding environment in the U.S. There's uncertainty in Asia and Europe. I guess the hope would be maybe that gets a little bit better against easy comps, but we'll see.

Yes. Education and government for us is more of a U.S. and Europe topic than it is for Asia. And by order of magnitude, certainly the education piece is going to be larger than government, and I would say the U.S. is probably a little bit more oriented to those end markets than even in Europe. But we haven't got much out of the European market there in actually quite some years. The funding and the government sector has been pretty weak for multiple years, and we don't really see that changing much this year. For us, obviously, we're going to have exposure to some of the national labs in the Americas region. Probably 2/3 to 3/4 of our business in Canada is going to have some link to government funding. All of the education system in Canada, obviously being government-funded and hit a little bit of a soft spot in 2019. Probably the primary end market or submarket, if you will, for us in that sector is going to be the higher ed market in the U.S., where we're quite well positioned. We've actually had a pretty nice run over the last couple of years, and we're off to a good start in that market this year.

Maybe just quickly to touch on industrial/applied, which is just over 1/4 of your total sales. There's a lot of submarkets there, none of which account for more than 10% of total sales. There's I would think some upside, at least relative to how you've guided on the flip side if the economy were to slow at some point for a pronounced period of time. How risky is this end market? And the reason I ask that is we know with stand-alone VWR, yes, if we go back to '08, '09, revenue only declined 3% to 4% in this end market. How did the legacy Avantor business do during this period?

Yes. So if you look at that part of our business, it is kind of a catch-all for a lot of applied markets, whether that be semiconductor, aerospace and defense, oil and gas, food and beverage. And I don't think there's any one of those that are more than 2% or 3% of our total revenue. We're going to play that space in 1 of 2 ways. In something like oil and gas or petchem, we're probably supplying materials, consumables, chemicals, equipment and instruments into QA/QC labs. And so it's very highly correlated to production levels and is going to probably follow the health of those end markets. In the semiconductor space and aerospace and defense, you see the other way that we play some of these markets, which is with our customized proprietary solutions that are specked into the production platforms of our customers and exhibit a little bit different resilience and don't necessarily track the GDP, for example. And so last year, when you see some of these markets being off mid- to high single digits, we had other markets like aerospace and defense for us that's actually pretty good last year, enabling us to kind of come in roughly flattish on that part of our business. In a normalized environment, you should expect that part of our business to grow low to mid-single digits. You referenced the last major market disruption that was experienced back in '08, '09. The VWR business actually was quite resilient. And I think when you look at how much of our business is recurring today, which is more than 85%, the specifications that we have on our business, it is quite a resilient, sticky business. The one piece of the business that probably took 80% of the hit in that time period was the 15% of our business that's equipment and instruments which can be a bit more discretionary, a bit more driven by CapEx cycles. Also, as you saw in the fourth quarter, subject to kind of the year-end budget flush, either the good and the bad of that side of it. But it is quite a resilient business, and I think that '08, '09 time period bore that out. Difficult to probably give you too many insights into how the legacy Avantor business performed during that time. It was a much different business at that time than what we have today. The mix of the business was dramatically different than where we sit today. But I would tell you on the legacy Avantor side of the business, as it's constituted today or as it influences our current portfolio, very production oriented, very specification driven and highly recurring in nature. Almost everything that we do is consumed. And as long as drugs are being produced or medical devices are being produced, they're going to have a need for our materials. So it also exhibits much of the same resiliency as the VWR portfolio.

I want to close by talking a little bit about capital deployment, cash flow and CapEx. So just to frame this, net debt should be down to 4x or maybe less exiting 2020. On the Q4 earnings call, you announced the hiring of Marc Centrella to help build out your -- and lead your M&A capabilities. How should we be thinking about your appetite for M&A, especially looking ahead to 2021?

Right. The cash part of our story is a really important part and I think maybe a piece of our story that's not as well understood is probably one of the more unique aspects of the story here at Avantor. At the time that we did the deal with VWR, we were roughly 9x levered. By the time we entered last year, we were 7x levered through the IPO, as well as just the organic operation of the business. We were able to exit last year at 4.6x. And with the organic deleveraging that we have ahead of us, this year, we'll exit the year at less than 4x. We're delevering organically at nearly a turn a year. The business generates a significant amount of cash, and we have a really unique refinancing opportunity in our business later this year that will further accelerate the deleveraging of the business. We have roughly $2 billion of unsecured bonds priced at 9%. We have $1.5 billion secured bonds priced at 6%, both with a make-whole provision that expires in -- early in the fourth quarter that will allow us to step in and recapitalize our balance sheet and given where those bonds are trading at today would certainly give us confidence that we should be able to take a meaningful chunk of interest expense off the P&L, which will give us more flexibility, obviously, to focus on an additional lever to grow this business that we're really excited about in the form of M&A. Both legacy platforms, historically, have been quite acquisitive. And given the access that we have to our customers and the number of workflows that we support, you have a pretty broad purview in order to -- on where you can look for opportunities to grow this business inorganically. So as we're sitting here in 2020, our primary objective remains deleveraging this balance sheet. We are committed to running this business in a range of kind of 2 to 4x, but M&A just doesn't happen always on your own time line. And as we head into this year, we felt that it was important to start to rebuild some of the muscle and some of the capability. So as you mentioned, we hired a head of M&A in December, and we're building some of the processes and even just simple things like cadence with the Board and DOA with the Board and how you set up your templates and your metrics and what's going to be your model, starting to build the pipeline of targets that you want to go after. And so I would say we're definitely in a build phase at the moment. We've been involved in a number of conversations and certainly learned a lot through those things, and we'll continue to be active throughout the year. I wouldn't necessarily say that 4x is necessarily a bright line for the right deal with the right structure. We could potentially do something earlier, but we remain committed to getting into that sub-4x levered range.

If you're in that leverage range and you're not seeing the right deals, is there any preference for buybacks or dividends? Or would the priority be further deleveraging, at least in the near term?

I think as we look at it today, deleveraging is going to be important. And as we drift closer to that 2x, it obviously changes the size of deal that you might be able to invest in. And certainly, transformative M&A will be part of the playbook. We've got a great track record of doing both bolt-ons and tuck-ins. And as evidenced by the VWR deal, we've obviously got the capabilities to do these larger deals. So I think we can create a tremendous amount of value through this M&A and would hope that we have enough opportunities ahead of us to deploy capital in that area.

Last one. Free cash flow versus adjusted net income was about 81% in 2019. Guidance for this year gets you into the 90% to 100% range. Do you think that's a sustainable level of conversion moving forward?

Yes. We should run in that range on a sustainable basis. I think as we move past some of the restructuring charges that have burdened the business over the last couple of years as we've run the integration and capture these synergies, as that starts to tail off. I think you'll see us move comfortably into that range, Doug.

Okay. All right. We are out of time. Thank you very much for spending the time with us, very interesting.

Thank you, everyone.