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

All right. Good morning, everyone, to day 2 of the Morgan Stanley Healthcare Conference. My name is Tejas Savant, and I'm the life science tools and diagnostics analyst here at MS. It's my pleasure to host Avantor this morning. And on behalf of the company, we have Michael Stubblefield, CEO. Thank you for joining us, Michael. Before we get started, just some important disclosures, please use the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. If you have any questions, do reach out to your sales rep.

So Michael, maybe just to kick things off, Avantor has seen its pressure of challenges with the COVID headwinds, the inventory destock, softer demand in pharma, semis, et cetera. But just at this stage, could you talk about how '23 has played out so far versus your initial expectations at the start of the year? And what are you sort of most proud about in terms of how you've navigated through these sort of choppy macro times?

Yes. First, Tejas, thanks for having us. Really happy to be here in New York to kick things off here at the conference. It has been a challenging year. The industry is seeing a number of unprecedented headwinds and certainly, the year hasn't played out as we would have anticipated with destocking persisting through the balance of the year; the COVID headwinds have played out about as we would have expected; but some of the funding constraints in biotech; certainly, the slowdown that we've seen in mid to large pharma has impacted the business; you mentioned the inventory corrections that are underway in the semiconductor market have provided a headwind to the business. But these are all temporal. There's nothing structural about what we're seeing here. And so I think the thing that we think about internally within Avantor is just staying focused on the strategy. The business is well positioned in the end markets that we're in. We're in some great end markets. This is the golden age of science. There's never been a more exciting time to be part of the biopharma space. There's some really cool therapies being developed, and we're right at the heart of that. And certainly, I'm really proud of the role that Avantor plays in helping bring these new therapies to life.

Got it. So let's begin, perhaps starting with the biopharma end market. On the last earnings call, you called out stabilization in the biotech customer base. While sales were actually large and mid-cap pharma declined a little bit, can you just give us a little bit more detail on what you're seeing here of late? And has that divergence sort of held up?

Yes. So if we take each of those separately. Biotech for us is -- our exposure there is going to be primarily in the R&D space. And at the enterprise level, it's low single-digit percentage of our total revenues. So not over-indexed there. But it is an important customer segment for us just given the science that they're developing. And we first started to see some of the funding constraints play out as things started to slow down in the back half of last year. That headwind accelerated further into Q1. The business was off about 15% to 20%, high teens, something like that. And in the second quarter, to your point, we saw it stabilize at those levels, which makes it perhaps feel like we've caught the bottom. I think there's some good data out there that suggests funding into that space has certainly stabilized, maybe some -- a bit of a tick up here of late. And as we've moved into the third quarter here, I think we see certainly that trend stability continue. The divergence you're talking about really was mid to large cap moving away from us in the second quarter. I think that space has -- in trying to deal with the realities of a number of challenges to their top line, whether it be COVID revenues rolling off, patent cliffs challenging some of their revenue models, certainly concerns around IRA and interest rates and such, and it has created a more conservative backdrop for our customers. And we see them tightening their belts and conserving cash, driving for efficiencies in productivity and we certainly see that playing out in the second quarter. And the way we've guided the year is that we see that trend continuing through the balance of the year and through the early days here of the third quarter, I think we certainly see that occurring.

Got it. And then switching to bioproduction, where do your customers stand today in terms of bioproduction inventory versus normalized levels? And based on current demand, what percent would you say get to normalization by year-end? Or could this have been sort of persisting to 2024 as well?

Yes. So the dynamic we're seeing in bioproduction is really one of inventory destocking. The end-market demand continues to be very robust. Despite all the discussions around all the other modalities, cell and gene therapy and mRNA, the market is still dominated by monoclonal antibody therapies that are on the market today. There's been a number of really high-profile launches. The pipelines have been good. Certainly, patient demand is there. And so the end-market fundamentals are certainly there, but we are working through the destocking dynamics that we talked about in previous forums. For us, that's primarily in the single-use categories that are within our portfolio, and there's still a reasonable amount of inventory in the chain. It is improving as we engage with our customers. We're sitting on an order book that's still well above historical levels. And so certainly, the demand is there. But they're being a little bit more prudent about how they manage the working capital, particularly in this environment. And the guidance that we have out there would contemplate these headwinds persisting through the end of the year. We'll have the benefit of a couple of quarters to see how that plays out before we look into 2024.

Got it. I want to ask you about engineering growing activity. That was an interesting leading indicator you pointed to. How has that trended off late as far as actually your assemblies are concerned? And then in terms of that order book and the backlog normalization dynamic, has the rate of decline sort of slowed sequentially?

Yes. So we're all looking for kind of the green shoots of those bright spots that would indicate that the market is on the verge of an inflection point. And so for us, we look at a whole host of leading indicators in our business. And in the single-use business for us, or the single-use platform, which has been one of the areas that we've encountered some of these headwinds, the earliest activity that we would see that would indicate that things are starting to pick up would be engaging with customers on what we refer to as engineering drawings. And we have talked a bit about this. That's the first step in the process. They'll bring a concept to my team. My team will engage pretty intimately with them, translate that into a drawing, ultimately probably a prototype, will go back and forth to get the design set. And then presuming that the program is going to move forward, they'll translate that into an order. And of course, that will kick off our production process. So it probably front-runs our revenue by anywhere from 4 to 6 months, that type of activity. We did see a market turn up in the second quarter. We've seen really good activity continue through the third quarter. And we're anxious to see that ultimately translate into an uptick in the order book.

Got it. One of the questions we've gotten of late, speaking about sort of high-profile launches, is how big the GLP-1 opportunity could be for your bioproduction business and could this switch to perform down the road, drive incremental demand for your resins versus the injectable format?

Yes. So this is a really great example of what I was mentioning earlier around just the promise of science, the number of new therapies and modalities that are out there. It really is an exciting time to be in this space and GLP-1, for good reason, is getting a lot of headlines. And it is a space that will be important to our platform, but no more important than anything else that we do. One of the things I like about our platform is that we're not over-indexed to any single therapy and collectively, we serve all the spaces. We're going to be ubiquitous in terms of the modalities as well as the therapies that are commercialized. We're in more than 85% of these commercialized therapies. And so GLP-1 will be one of those. We have a pretty compelling offering. Whether you're in the fermentation route or the chemical synthesis route, our process ingredients, buffer, solvents will be used throughout those workflows. And so it is an area that we're excited about. I think we're a little bit cautious at the moment, just looking to see what approvals and what it gets extended to, what indications that it gets approved for as well as what the reimbursement models end up looking like. And then to your point, the dosage form will be important for us as well. So early innings, clearly, but it is a good example of just the momentum that's in the biopharma space, and it's great to see some of these things coming through.

Got it. What percent -- I mean, speaking of new modalities, what percent of your bioproduction backlog is selling gene therapies and is that mostly on the research side? And I think you called out double-digit growth in some of those workflows in the second quarter. Do you see that strength sort of sustaining here?

Yes. So interestingly, when you think about bioproduction, as I mentioned earlier, it's still predominantly driven by monoclonal antibodies, and we're certainly seeing some of the headwinds play out in that space. I would contrast that, though, with cell and gene therapy. Unfortunately, we're working off a fairly modest baseline as an industry, and that's true for us as well. But boy, it sure is growing rapidly. We're well into the double digits with growth. There's no headwinds that are playing out in that space at the moment. We've had a terrific year on that platform. Our content is extremely relevant. And we've got a very rich R&D pipeline that's focused on bringing new materials into the market to be able to satisfy our customers' requirements in this area. So it's a space that we like an awful lot. It's in the early days. But we'll continue to invest in that. So in terms of the backlog and our order book and such, I mean, it still does mimic kind of the split within the end market itself and which is to say that most of it's still going to be monoclonals, but the cell and gene therapy workflow is growing rapidly this year. It is diverging from what we see in some of the other applications.

Got it. Before we move to the other segments, Michael, I want to talk about the margins in your bioproduction business relative to corporate average. Obviously, negative operating leverage seems to have hurt you on the way down, but it feels like a recovery could really translate into solid momentum on the margin line into 2024.

Tejas, you're exactly right. When we think about the margin algorithm in Avantor, there's 3 or 4 key drivers that yield the margins that we print each quarter. And one of the most important indicators of margin in our business is the mix. We have a mix of business within the portfolio of proprietary products, which carry a margin that's probably 1.5 to 2x that of our third-party products in our own portfolio. And in normal times, just given the workflows that our products are spec-ed into, our proprietary products will grow disproportionately faster than our third-party products. And that yields just structurally a nice lift to our margins. And so where we see some of the headwinds this year, the COVID revenues that are rolling off were very rich in margin; the destocking that we see occurring in biopharma as well as in the lab, again, pretty margin-rich categories; the electronic materials headwinds that we're seeing, that's all proprietary content with very rich margins. And so we see that in the P&L, and we're certainly working hard to offset that in other ways. But to your point, as the volume returns, which it will, the margins will come back with that. And so whether that's at the end of this year, at some point in next year, there will be a margin tailwind that comes when the volumes normalize and this ratio of kind of third-party to proprietary returns to normal.

Got it. And how does that translate into the bioproduction business, Michael? I mean is that also largely sort of skewed towards proprietary and the higher side of the margin sort of category?

Yes, just a little context there. So bioproduction for us would be everything that we supply to our customers that are producing commercialized therapies. So anything pre-commercial is going to be captured in our R&D activities. And within that bioproduction space, as we define it, it's nearly 100% proprietary content. There is a bit of third-party content in there, but it is overwhelmingly proprietary content, which is going to carry margins, GM margins that are probably 1.5 to 2x that of the third-party portfolios.

Got it.

It's an important area from a growth standpoint, clearly, but it also influences our margins.

Got it. That's helpful. Switching to ATM. In the past, you've called your exposure to petrochem and food and beverage there as cyclical and the other 1/2, which is semis, aerospace and defense is not -- it's not exactly how it's played out this year with the semis headwinds you're seeing there. But -- so I think it's really helpful to look at it on an end-market basis, right? So how much of ATM is semis? And can you quantify the other end markets as well, roughly in terms of revenue contributions?

Yes. So at Avantor, we serve 4 end markets. Biopharma is the largest. It's roughly 55% of it. Health care and education and government are in that 10% to 15% range. And then you get into the applied markets, which is about 25% of our revenues. And within the applied markets, which is where your question is at, we serve a whole host of end markets, many of those that you name there, with the largest of those being the semiconductor space. And it's roughly 2% to 3% of our group revenues. And the business model there is actually very similar to what we see in the life sciences space, which is to say, we'll engage with our customers in their early phase development and discovery processes. We'll customize the formulation. It'll get spec-ed into the process, and then we'll scale with that as it becomes commercial. And when I look at the dynamics that are underway here in the semiconductor market, that end market went through a lot of the same disruption that the life sciences end markets went through, with a rapid increase of demand during COVID, supply chains became very constrained and now on the back end of that, is that supply chain is normalizing, you see inventory corrections and things occurring. And so we've seen a very deep cut in demand this year as our customers are aggressively bringing down their own inventories. And that seemed to have bottomed out in the second quarter. We've seen some incremental improvements in the third quarter. We'd expect to see that continue into the fourth quarter. So it feels like that's a good example of a headwind that we seem to be working our way out of. Now it's a space where I don't think the fundamentals of the end market are in question. When you look at what's going on from an AI standpoint or the Internet of Things, the digitization of virtually everything, all the investment that's going in around the world to build capacity, it will be an important driver. So I think we like the end-market fundamentals. We've gone through a bit of a painful correction here as customers have very aggressively taken down the inventories of their finished products to reset post-COVID, but it feels like we're coming out the other end of that one.

Got it. And so would it be fair to say that the NTM forecasts you're getting from them are sort of gradually improving into July and August versus what you have embedded in the guide?

Yes. So maybe back to the guidance, the visibility in our business is a challenge. And so given some of the headwinds that we were facing and some of the murkiness that's out there in some of these end markets, the approach we took to our guidance was to try to simulate the end-market conditions that we saw in the second quarter and project those through the balance of the year. And so that's what's in there for all of our production platforms, including the semiconductor platform. I think it's going to be incrementally better than probably what we have in there. I wouldn't get too carried away with baking in a lot of upside or a material level of upside, but we have caught the bottom. The forecasts are improving. We're starting to turn up our production units again. And I think we're definitely heading in the right direction there.

Got it. [ Overhit a plan] education and government, you highlighted a big win there with the E&I consortium. I think it was over 5,000 educational institutions. Was that sort of a renewal or a new contract? And how sort of needle moving is the impact from that to education and government?

So the education and government sector for us is about 15% of our revenue. And in the U.S., one of the most important ways that we serve that space is through this E&I consortium. As you mentioned, there's roughly 5,000 member institutions that buy across that platform. And this relationship that we've had for quite some time with E&I gives us exclusive access to those partners and really a ready-made format for us to be able to transact with these customers. So it was an important extension for the business. And this is an area that I would say is a bright spot for our business in the midst of a lot of different headwinds we see in other areas. Our education platform has grown pretty meaningfully in the first half of the year, and we see that continuing in the third quarter. And I think it really reflects, one, just our positioning in this contract and this relationship is an important aspect of that. It also, I think, is a demonstration of our relevance as well as I think we've really been leaning in hard here from a commercial intensity standpoint. We've done some things around realigning our commercial activities over the last couple of years to better serve that space. And you see it playing out. I mean we grew that platform in the U.S. double digits in the second quarter and we'll continue to drive hard into that space. Beyond the contract, we have had some other wins in the space that's brought business into our portfolio. Obviously, it's not a space that we generally rely on for outsized levels of growth. It's classically more of a low single-digit growth space. We like it a lot, though, because of what the insights that we get into where science is heading and what our customers are working on. And in many cases, it's also the scientists' first exposure to our products. And so it's a strategic area for us, and we spend a lot of time on it. I think we really like the positioning and how the year is playing out there.

Got it. Turning to geographies. You have relatively small exposure to China, but it's a huge focus area for everybody. What are you seeing on the ground in terms of some of the pretty drastic sort of weakness called out by some of your peers? Do you see any impact from the anticorruption crackdown there? I think you'd said in the past it's like 2% to 3% of total revenue for Avantor. So just any color on China?

Yes. So maybe taking in reverse order there, you've got the exposure about right. Asia for us is about 5% of our total revenues, and China is a subset of that. So it's in that. 2% to 3% of our total revenues is China. We're seeing the same things that everybody else in our space is seeing. Demand is quite weak. They're sitting on a lot of inventories. It's really not clear how soon it's going to turn around. I certainly don't have any hope for a turnaround there anytime soon. But it is -- at this stage, it's a pretty modest impact to our business. We still think that the -- and believe in the long-term fundamentals of that space. There's a lot of activity there, particularly in the cell and gene therapy area. But even in tech transferring in a lot of monoclonal antibodies, we are strategically investing in that region, whether it be through our R&D center that we have there, we've established a manufacturing footprint there. And I think the key for us there is just to continue to localize capabilities to service what we think is going to be long term, an exciting growth opportunity. But structurally, I think that economy has some things to work through, and I don't think it's going to turn around anytime soon from what I can tell.

Fair enough. And then just shifting over to Europe. Do you see -- what do you see across the end markets there? I think it called out pharma and academic government weakness in the region. And are you starting to see any fallout from China and some of these export-oriented European economies?

Yes. So Europe for us has been pretty resilient so far this year. I think we were off, on a core basis, a couple of points in the second quarter, but there is certainly stress in the system in Europe. You see some of the countries already in recession. Germany is a good example of that. And I think these countries like Germany who have the significant industrial exposure to a country like China are certainly starting to feel some of the challenges associated with that exposure. And so there are certainly some challenges that are building within the region. But for us, I think probably more of it has been just around biopharma, similar funding constraints in biotech, large pharma taking a more cautious approach. That's probably been a bigger headwind for us in Europe this year than maybe some of the applied end markets.

Got it. Services and specialty procurement, I think it's low double digit as a percent of total sales, held up reasonably well for you this year. Can you just remind us of the puts and takes in that part of the portfolio and the sustainability of growth in the second half?

So services for us is a strategic part of our portfolio. As you mentioned, it's just a bit under 15% of our total revenues. And it's a platform that's been growing roughly double digits for a number of years. And strategically, it's an area that we lean in hard on because it really gives us more intimate access to our customers. It enables us to get a better view into the challenges that they're working on. And where we have significant services relationships with our customers, we also see a disproportionate growth of our other product categories. And so this is an area that we're quite focused on. And to your point, this year, not unlike other years, has been another strong year for our services platform. They're actually pretty close to their plan this year despite all of the headwinds, and I think it does further validate the positioning of our platform, the access that we have to our customers. And in these categories where you don't have a surplus of inventories and some of these dynamics, our business continues to be quite strong and that services platform is a good example of that.

Got it. Switching to pricing and margin, really, I mean, how is the pricing environment holding up? Have you seen any sort of shifting share dynamics there? And I think you'd called out slipping a pretty large account earlier this year. How has that started to sort of show up in the numbers yet? Give us a sense at a high level, Michael, of when a customer decides to choose a distributor like you versus a Fisher or Sigma to meet their needs. What exactly drives kind of like that win-loss rate dynamic?

Sure. So let me try to unpack a few points that you made in there. So this year, pricing, once again. has been outsized relative to historic levels, which is to say it's probably 300 to 400 basis points, something like that. It's been pretty consistent throughout the year. I think it's playing out essentially as we would have anticipated. And back to the comments I made earlier around our margin expansion algorithm, price over COGS is one of those key variables. And I think throughout the pandemic and throughout the last several years, this -- the price relative to COGS dynamic we've been able to drive has yielded, I would say, consistent results, in line with our long-term algorithm. So although we're taking higher price into the market, we're also seeing higher levels of inflation. And that will be an important variable as we move into next year to see where inflation is landing so we can set the pricing. But I think we've had good pricing power this year, and the teams have done a nice job executing that. Relative to customer wins, I'd say we've had another very terrific year. You mentioned a pretty high-profile win and conversion that we're in the midst of driving. Playing out as we would have anticipated. This is a very complex account that you're referring to. And we -- in our -- I would say in line with our plans, which is to say that we'd anticipated that it would ramp as we move throughout the year, as we connect our systems, get our service associates on site, implement the catalogs and drive that conversion. Our teams are very good at this, and we've got a full team that's dedicated to driving that. So it's had -- I would say, through the first 2 quarters, as we've indicated before, it's had a modest impact, but you'll see that impact start to ramp as we move through the back half of the year.

Got it. Couple of quick ones on the numbers. Brent's been in the CFO seat, he's in the audience here, for a little over a month. What are his initial priorities? Should we expect anything sort of markedly different in terms of the way you've been forecasting or guiding? I think the balance sheet sort of rejigging is largely complete. So what sorts of initiatives are on his priority list in his first year?

Yes. So we are really happy to have Brent here. Tom had been a great partner, and you referenced some of the highlights what he did for us, remaking the balance sheet and really changing our tax structures and making that a lot more efficient. So certainly, a lot more -- a lot of really good work that Tom left us with. As we think about bringing Brent in, obviously, in the early days, he's just trying to learn the business and get his arms around a new platform. You mentioned forecasting and visibility. That's a critical area for us. So as you would expect, that's an area that he's spending a tremendous amount of time on. He's engaged with our businesses to kind of unpack the growth strategies and identify opportunities for us to accelerate our growth. And certainly, as we think about doubling down in this environment, not only just to accelerate growth but to control costs, Brent's operational background is going to be pretty important to us as we work through some of these headwinds, and he's leaning in hard there. So thrilled that he's here, and he's coming up to speed quickly.

Got it. So you've got about 125 basis points of EBITDA margin decline embedded in your guide this year. 200 bps from lower volume, weaker mix and then an offset of 75 bps from productivity and cost control. And so my question really is, could we see additional margin benefit from these cost actions in '24, which, in combination with a mix benefit, particularly as some of the proprietary stuff you alluded to earlier comes back, could see a pretty meaningful uplift in margins versus even what The Street has you doing next year?

Yes. So probably helpful to focus a little bit on the guide. If you think about the comment I made earlier about trying to simulate the conditions we saw in the second quarter, in the third and fourth quarters, in the lab part of our business, which is more subject to kind of the number of shipping days in a financial period, you kind of convert that to a daily rate of sales and then translate that through the number of business days. And so on a reported basis, that yields slightly lower revenues in Q3 and Q4 than what we saw in Q2 for the lab part of our business. There's about a 2.5% FX tailwind in our numbers to get you to organic growth numbers of roughly down 8% at the midpoint in Q3 and kind of 5% to 6% down in Q4. And you talk about the margin impact. Certainly, we're seeing the impacts of lower volumes, the shift in mix that we're trying to work through on a temporal basis, offsetting that then with the cost actions that we're taking. Many of these are structural, whether it's footprint realignments around manufacturing centers. We've invested a lot in automation in our distribution network to bring a lot of efficiencies there. These are long-term investments that we've made that will survive these headwinds that we're seeing here. And so it's an important part of our culture. It's in our DNA to drive continuous improvement and we're pulling that lever a little bit harder than we would normally, but it will yield some stronger margins as we move forward.

Great. We're out of time. Lots to chat about. We will be carrying on the conversation at dinner. Thank you, Michael, for joining us. Appreciate it.

All right. Thank you all. Appreciate it.