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

All right. Good afternoon, everyone. My name is Tejas Savant, and I'm the life science tools and diagnostics analyst at Morgan Stanley. It's my pleasure to host Avantor this afternoon. And with me is Michael Stubblefield. In the audience, we have Tom Szlosek, and CJ is out there somewhere as well. So welcome, guys, and thanks for doing this. Before we get started, just a quick disclaimer that I need to read off over here. For important disclosures, please see the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. And if you have any questions, do reach out to your Morgan Stanley sales rep.

So with that, Michael, it's been a very dynamic year for Avantor with a lot of moving pieces. So as you sit here today, what are some of your reflections on the business performance year-to-date?

Yes. Great place to start, Tejas, and thanks for having us. We're excited here in New York live. If I look back at the year, I think probably the first thing that comes to mind is just the strength of the core business. Our core business has grown about 7%. We've expanded EBITDA margins over 140 basis points, and net income has grown into the teens. And when you put that in the context of our long-term growth algorithm, it's been a pretty good start to the year so far, and the business is performing pretty well, particularly in the context, as you mentioned, just the dynamic environment that we find ourselves operating in. Obviously, the global economy has struggled, high inflation, FX headwinds as well a number of supply chain constraints. So I think when you put the performance of our business in that context and the fact that we continue to run at the high end or outside the high end of our long-term growth algorithm, it's been a good year so far.

Got it. So we'll get sort of deeper into some of the macro dynamics and the backdrop here, Michael. But before we get there, can you just outline what your expectations are for the third quarter and for the full year here?

Yes, we don't normally give too discrete guidance at a quarterly level, but it will probably make some sense just given how the year has developed so far, try to provide at least a little window into how we're seeing the quarter play out. We're a little over 2 months of the way into the quarter now. And as I said on our second quarter call, we would anticipate the third quarter growing sequentially off the second quarter. Probably if I was modeling it, probably 50 to 75 basis points, something like that is probably a good way to think about it. We'll deliver another strong quarter of margin expansion and earnings growth. But when I pivot off of the top line core growth of, call it, 7-ish percent or so, we'll end up with organic growth of, call it, 3% to 4% when you take into account the COVID revenues that we'll generate in the quarter. And then when you factor in FX rates, which have drifted modestly since the second quarter call, together with the M&A revenues that we anticipate generating in the quarter, reported revenue will come in somewhere in the 18 40, 18 50 range, is probably how I think about the quarter shaping up.

Got it. Makes sense. That's helpful. So I want to talk a little bit about pricing. I mean it's an important driver for you this year, about 2/3 of the core growth outlook in '22. And how sustainable do you view these outsized pricing increases? And is that a point where it starts to impact customer demand in '23? And to what extent will your ability to continue to deliver these outsized pricing increases play into your '23 growth and margin expectations?

One of the key tenets of our long-term growth algorithm is our ability to expand organic margins, 50 to 100 basis points, and managing price over COGS is an important element of that, of our approach there. And the team has a great track record of doing that sustainably over a pretty long period of time, including this year in a hyperinflationary environment. To your point, pricing is probably contributing in the 2x level of what we have done historically, given the inflation that we've had to offset. It's too early to tell what kind of an inflationary environment we're going to find ourselves going into next year. We're right in the throes of that process, where suppliers, over the course of the call, the next 30 to 60 days, would be nominating their price increases or price changes for January 1. And I'm not sure where that's going to land, other than to say, I think we've got the commercial flexibility in the system to be able to react appropriately. And we're not trying to push pricing well beyond what the inflationary environment would dictate. So we hope that things can normalize because at least in various end markets where they might be operating on a fixed budget, at some level, it probably does impact demand if you're having to spend more for your materials. And I don't think the types of inflation that we've seen is sustainable long term. So we are anxious for it to normalize, but certainly in a good position, if necessary, to drive pricing at levels similar to what we've seen this year, if that's what the environment calls for.

Got it. On your point on FX, Michael, how are you thinking about sort of the FX headwinds starting to impact customer demand? Is that a dynamic you see especially in pockets within Europe or not really?

So it's not something that I necessarily say we'd attribute any of the demand trends to as of now. It's certainly a factor if you're based in Europe and having to buy materials denominated in U.S. dollars. We tend to transact in local currencies, where that isn't too big of an issue. I think for us, as we look at particularly the end markets around the world, which, to date, have been pretty robust as evidenced by our strong core growth, when we look into a place like Europe, where FX has been an issue, we probably get a little bit more concerned about just the impact of the inflationary environment and what -- however the energy balances transpire as we move into the winter season.

Got it. I want to spend a minute on the Ritter and Masterflex acquisitions. But just at a higher level, you recently lowered your M&A guide for the year, from $500 million to about $450 million, and pointing to FX and supply chain challenges and perhaps improve at headwinds as well, how derisked do you view the new number?

Yes, I think it's -- certainly, we're spending a bit of time on it. I know our investors spend a lot of time looking at these numbers, as do we. And I think, that maybe taking each of the deals on a stand-alone basis here for a second may be helpful. Starting with Masterflex, I think as we're now almost a year into that acquisition, making considerable progress on a pretty collective carve-out. We recently completed probably the most significant milestone in the integration, in getting all the business now on our systems. We went live in the Americas a few weeks ago, and the team did a phenomenal job driving a pretty complex transition there. So we're pretty well through a lot of the key milestones there and really now focused on capturing the commercial synergies and integrating that platform into our single-use portfolio. And I would say the early signs are really positive in terms of the value that our customers place on being able to have a supplier like us provide an end-to-end integrated aseptic fluid transfer solution across the modality needs. And as we think about some of the more novel modalities in cell and gene therapy and mRNA for example, the value of having these solutions in place is significant. And we like the technology that we acquired an awful lot. The peristaltic pumping technology gives us an anchor point pretty early in the process development process. And what I really like about that is it sees a pretty significant amount of consumable demand as customers would then buy the tubing that goes to those pumps and ultimately positions us to move the rest of our portfolio, excipients and process ingredients and the like. So we like that technology and how that integrates into our portfolio an awful lot. As you look into the second quarter, certainly, we were plagued by some of the lockdown issues in China and some of the supply chain constraints, particularly around printed circuit boards for peristaltic pumps, which is a unique issue for our portfolio relative to these pumps. And as I look into the third quarter, probably some of these supply chain constraints have probably become even a bit more pronounced. And we've seen, at least on the tubing side of the business, some weaker demand signals than what we would have anticipated into the quarter. So when I look at Masterflex, for example, if I had to call it today, it's probably somewhere in that $240 million, $260 million of revenue range. And if you unpack some of the COVID contributions that are in that business, the underlying growth rate on that Masterflex business, looks an awful lot like our core single-use business, and I think we're well positioned for good growth there long term. And we're thrilled to have that technology in the lineup. Had some recent innovation launches off that platform to expand the portfolio, and we would have 1 of the 2 leading solutions in the marketplace. And I think we're going to be really happy with that acquisition long-term. Transition to Ritter, that's more on the lab [Audio Gap] high-precision consumables, production capabilities to service life science research in various diagnostic applications. I think we've spent an awful lot of time talking about the work that we have underway there to transform that business model that we acquired, which was principally an OEM-dominated model, predominantly in Europe, to an end market, end customer-driven model. And that's going to take some time. It's a natural transition for us to drive to leverage our channel. We provide a significant amount of content alongside the portfolio already to these customers. So it's a natural drop into our channel, and our teams are excited to be able to add this content to the lineup and to be able to bring additional solutions to our customers. Unfortunately, it has been an extremely challenging year for that business, with as much of the business was exposed to PCR testing for COVID and as quickly as that fell away. It's also plagued then with a pretty considerable level of inventory that's hanging over this space. The products are fungible across COVID or non-COVID diagnostics. And so as folks scaled up to meet the needs for COVID testing, and then as quickly as that fell away, they're able to repurpose inventory they had purchased for their core business. So the conversions are going a little bit slower than what we had imagined or had intended. We've got great customer interest and great customer uptake and in engaging in the qualification work to specify our products. We have many examples where they have qualified their products and said, "Listen, we'll be back to you with orders as soon as our inventories get into line." So it has been quite a challenging year for that as we transition away from some of the COVID revenues that are in the business. Fortunately, we didn't pay for any of those revenues in the way that we structured the deal, but unfortunately, it did come out quite a bit faster than what we had imagined. As we look into the third quarter, I know one of the questions we've been getting a lot of is, do you think you've kind of bracketed that COVID exposure in the business? And it feels like we probably have, just based on how the business has transpired as we've moved into the third quarter. One of the areas though of concern that we see developing in the business is there is a piece of the business that's more industrial-focused in Europe. And back to my earlier comments around just some of the weakening demand signals that we do see in certain parts of the business in Europe, I do have some concerns about how some of the demand is going to hold up in that part of the business as we move through the balance of the year. So if I had to call Ritter, as we sit here today for the balance of the year, it's probably somewhere in the 1 30, 1 50 range. So if you put that together with my commentary on Masterflex, we're probably closer to 400, is probably a better way to think about it as we incorporate some of the dynamics that we've seen as we move through the quarter.

Got it. That's actually really helpful. So Michael, as you step back and think about sort of Masterflex and Ritter and integrating these assets in the midst of the pandemic, is there anything you could have done differently in terms of perhaps either the due diligence process or taking a different approach to integration? Are there any lessons here that could be useful as you evaluate and then execute on future deals?

Yes. So it's lost on us how noisy some of the performance has been here, and nobody is more disappointed than we are with that. And it has -- unfortunately it's masked, the point that I made where we started, around just how strong our core business is running this year. The integrations on all 3 of the deals we did last year have actually gone extremely well. I mentioned the Masterflex acquisition, which was a carve-out. There's probably 35 or 36 TSAs that were in place for the course of about 12 months. And we're just nearing the end of those. And including system transitions and cutovers and such, the team has really done a phenomenal job executing our integration playbook. And that's a playbook that we've honed over a number of years. These aren't our first acquisitions. This is a platform that has been acquisitive over the years. We've done large deals like VWR, and we've done tuck-ins and bolt-ons like these. So doing integrations and acquisitions is something the team is actually quite good at. I'm not sure we've done acquisitions before and certainly in the midst of a pandemic, with some of the demand fundamentals that we've seen here. So that's certainly been unique. And if I think about the Ritter business and trying to look at should we have known more about how much of the business was COVID or not COVID, the challenge we had here really was the products are fungible. And they're used in across all the applications. So we definitely got it wrong. We thought it was more 10% to 15%, and it's proven to be closer to 25% of the business was COVID. But we knew that there was a reasonable amount of COVID in the business and we were concerned about its sustainability. So as I mentioned before, we didn't actually pay for any of those revenues. The way we structured the deal with a pretty sizable earn-out. I think the team did a nice job in the way they approached the transaction. So when I step back and I look at it, despite the noise, none of these acquisitions, and we certainly don't do any acquisition with the intent that the success or failure of that acquisition is measured in the first months or quarters of the deal, I think the long-term fundamentals of all these transactions are certainly in front of us. And I've often said that if I was presented the same opportunity to do these deals again today, I'd be happy to do all 3 of the deals we did.

Got it. Makes sense. Switching gears to bioprocessing. You derisked your COVID vaccine contribution earlier this year. I think you're now calling for about $150 million versus your prior $250 million. Is there any sort of potential for upside here with the CDC recommending the broad rollout of these booster vaccines here? And do you expect any disruptions from the transition of the government purchasing to the private sector at all or not really?

Yes, so maybe just a little context. We did about $400 million of COVID-related revenues in 2021, and that was split across 3 categories, our PPE offering, our testing offering and then the vaccine offering, as you suggest. Coming into the year, we had anticipated roughly a 2% headwind, so maybe somewhere in the $250 million range for revenues. And certainly, across all 3 categories, things decelerated probably a lot faster than what we had contemplated. So as we sit here today, somewhere in the $150 million to $180 million is what we would anticipate doing this year in terms of revenues. With -- by the time we get to the end of this year, pretty much the only COVID tailwind we'll have in the business or COVID-related revenues we would have in the business would be associated with the vaccine. Pretty long lead time for the materials that we supply into the -- into these vaccines, meaning actually quite a few months. And so as we sit here today, our customers that are producing these vaccines would have ordered the materials for the batches they're producing today, probably much earlier in the year, actually. And even though they're maybe switching up and moving from the original variant that they were targeting, to now the covalent variants, including BA.5, the process they're following is exactly the same, which is why they don't need to do updated clinical trials. They're just changing the genetic code of the virus there. And so the materials are virtually identical or are identical to what we would have been supplying before. So we have anticipated the demand. And as we look at how things are playing out here, we've done a little bit of moving around with our customers and moving some of the revenues from Q3 to Q4 to support the timing of their production. But net-net, I don't really see any change or -- in the outlook there compared to how we saw it maybe 90 days ago.

Got it. And then on the base business, is 20% sort of core growth in bioproduction still a safe bet for the back half of the year? Obviously, the non-COVID work didn't provide a full offset to the COVID declines in 2Q. To your comments on fungibility, I mean, was there something else around raw material constraints? Or is it just taking longer to transition for some of these modalities from COVID to non-COVID work?

Yes. The bioproduction part of our business is obviously an important part of our growth story and an area that gets a significant amount of our attention. We divert a disproportionate share of our R&D dollars as well as our capital investments to support the growth into that area. And it's somewhere where we're pretty well-positioned and have a pretty optimistic outlook for how things will develop longer term. Just given how intimately we touch all of these therapy areas, we're well positioned within monoclonals as well as have a great offering to support cell and gene therapy as well as mRNA. And so the attractive way that we play this space, I think, is we're going to be lined up behind nearly every therapy that's out there without really having the binary risk of does the therapy work or not work as we're likely going to be on most all of the therapies that ultimately get launched. So we spend a lot of time here, and we're investing aggressively. When I look at the growth we've driven this year, as you suggest, we're 20%, I think it continues the theme of -- certainly over the last 7, 8 years that I've run the platform, where we see us -- see ourselves outgrowing the broader market by probably 200 to 300 basis points, owing, I think, to the breadth of our portfolio, we are the leading materials provider into this space. As well as our global footprint, we will have -- we do have GMP capabilities in all 3 major regions of the world, and we're continuing to invest to ensure that we have the capacity and capabilities to continue to support really, really strong growth. I'm excited about a new GMP facility that's coming up in Singapore here over the next few months. It's just one of dozens of examples of investments that we've made this year to continue to support a pretty robust outlook that we have for that space. I think it's important to understand, that on a daily basis, actually, in most of our assets, we're probably moving back and forth multiple times a day between satisfying COVID demand and non-COVID demand. So we get to prove and test this theory that it's fungible on a real-time basis consistently. So it's not a theoretical exercise and thinking about can you repurpose the capacity. We do, do this every day of the week. As I think about transitioning away from some of the vaccine production, one of the things that will do for us is allow us to use more of our capacity to address a pretty impressive backlog for these products and to restore service levels to a more normalized level. I'm not happy with the lead times that we have to quote to our customers on a lot of our core products. And one of the signs of, I think, things improving and some of the investments that we're putting in place starting to come online here is for actually several hundred products here over the last month or 2, we've been able to start to meaningfully improve the lead times that we're quoting to our customers. And so we got a ways to go there, but certainly, the trajectory is positive.

Got it. Makes sense. A couple of questions on the funding environment. We'll start with pharma. I believe SMID cap biotech, I think you said, was low single-digit percent of your pharma exposure, so 1% of overall sales. But even so, are you seeing any sort of elongated decision time lines or cautious sort of purchasing patterns in that sort of customer constituency?

So it is in a really important customer grouping, if you just look at the number of molecules that, that group is collectively developing. And so it is strategic to us. Even though it is a relatively small overall percentage of our revenue, it is a space that we pay a fair bit of attention to. And I think we're uniquely positioned with our channel and our supply chain to be able to service that group and have some privileged relationships that have us well positioned to service the demand that is there for us. Most of that demand is going to be in the lab. A lot of these small biotechs, as they move through clinicals and show -- start to show promise on the therapies, probably end up partnering and having somebody else take the molecule to market, where the real volumes for us come into play as part of a production platform. So the exposure that we would have on a real-time basis to these programs would be in the research environment. And there's going to be a wide range of exposures there. There's going to be programs that we're supporting that are mid- to late stage, with having shown pretty good promise and have all their funding sewn up, and that continues. And then on the other end, there's definitely going to be the early-stage biotechs. They're looking for funding or just recently got funding and getting off the ground. And this is where you worry a little bit about things like the inflation, and the impact that having to use more of their dollars towards price, does it cause them to optimize how they think about doing their experiments and do they phase these a bit. And there's probably some early evidence that some of that is occurring. Just given the exposure we have there, it's not significant, but there is some early signs that is having somewhat of a modest impact on some of these customers on how they think about running their programs.

Got it. And then on the education and government side of things, Michael, any early signs there that some of these energy relief initiatives governments are undertaking around the world, especially in Europe, are starting to crowd out research funding at all or not really?

Funding is -- overall, has been good. And I think we're encouraged by some of the actions that various governments have taken that really, I think, promote and underpin the prominence or importance of science in society. But particularly in a government or an academic setting, what I mentioned earlier around kind of fixed budgets, you probably see some of the pain in those end markets coming through a little bit more prominently than maybe a more of a private sector market like the biopharma space, where they may be looking to stretch their dollars a little bit further. So for us, academia isn't that big of a market for us. It's probably 10% of our overall revenues. And you add to that maybe another 5% for government. So it's not the main driver for our business. In the second quarter, it was still modestly below kind of pre-pandemic levels. And there's still room to grow here, I think, as things recover and labs return to kind of full staffing and full operations, but to how we see that one shaping up.

Got it. Switching gears to China. I mean, obviously, you saw -- I think it was a modest 50 bps headwind in the region. It's small geographically for you, but the weakness there certainly came as a surprise, I think, even to you guys. How are you thinking about the back half of this year? Is there enough conservatism there given some of the recent lockdowns in Chengdu and Shenzhen? Is that something that's sort of adequately baked into your forecast?

Yes. So China, or Asia broadly for us, is about 5% of our revenues, and China is a subset of that. You're correct, we don't typically talk a lot about China, just given the scale. Although we are investing there and growing our capabilities as we do see that's going to be an important biopharma market long-term. And it's important to have our materials there and well positioned as a lot of the early phase trials are underway and a lot of the development work is underway. So we'll continue to focus on that as an end market that we think is going to be important long-term. The lockdowns were pretty extreme in the second quarter. And I think the piece we probably got wrong is we had anticipated that the markets would open up in early June. They didn't. That seemed to take more into the July time period. I don't anticipate talking about China when we have our third quarter call. Asia, for us broadly, is having a strong quarter. And I'm sure there will be episodic lockdowns just given the 0 tolerance policy that they have. But hopefully, we don't see something that go back as Draconian as what we saw in the second quarter.

Got it. Fair enough. As we look to '23, Michael, I know you probably don't want to guide just yet given all the moving pieces on FX, macro, inflation, et cetera. But as you think about sort of growth in that 5.5% to 6% range, do you think that's a reasonable base case estimate given what we know today? And as you think about sort of operating margins, you've talked about, I think, 50 to 100 bps is a reasonable sort of expectation for the base business ex-M&A. Just walk us through how you're sort of qualitatively thinking about those?

Yes, you're right in that -- probably it's a little bit early to be talking about guidance for next year, but we always start with our long-term algorithm of 4% to 6% and 50 to 100 basis points of margin expansion. As we think about looking at the various puts and takes off of that, we're really anxious to see how the inflation environment evolves over the next 3 to 4 months to help guide what level of contribution we're going to need to drive from pricing. Europe held up well for us in the second quarter, kind of mid-single digits. At least for the first 2 months, I think it's been pretty strong. But as I mentioned earlier, there is some ring clouds perhaps on the horizon there as we think about particularly some of the industrial demand of some of the applied markets and how they're reacting to potential energy allocations and certainly in certain pockets, just energy pricing starting to cause some problems. So although it hasn't necessarily impacted demand as of yet, it's something we're watching pretty closely. And I'm sure as we move through the balance of the year, we'll be a lot smarter as to how that is going to play out. And then I think, from a COVID standpoint, we talked earlier about $150 million to $180 million of revenues in the business this year. Most of what we'll end the year with will be vaccine-related, and I'm anxious to see the uptake of these booster shots. And we're going to need to factor in what we see from a vaccine demand perspective next year. So still a few variables moving around. We're early in the process. Should be back to -- in our normal cadence there early in the year with an outlook for the year.

Got it. This was a fantastic overview, Michael. So thanks so much for spending the time with us.

Tejas, thanks for having us.

Yes, of course.

Thank you.