Embecta Corp. (EMBC) Earnings Call Transcript & Summary

Great. Okay. The time has started. So let's begin. Kallum Titchmarsh from the U.S. Medtech team here at Morgan Stanley. Really pleased today to be joined with the Embecta team. We have Dev, Jake, CEO, CFO, respectively; and Pravesh in the audience as well from IR. Thank you all as well for coming. Before I get started, I need to read some disclaimers. For important disclosures, please see the Morgan Stanley research disclosure website, morganstanley.com/researchdisclosures. Okay. Thank you gents, for coming.

Thank you.

Thank you.

So let's track back in early August. Let's start with the fiscal year Q3 results. Wasn't particularly surprised to see [indiscernible]. But maybe you could give us an overview of what you saw play out through the quarter. I think the biggest beat was below the top line, but it seems there were some one-timers there as well. So maybe level set out what you saw anything surprise you in particular?

Yes. So maybe I can get started here, and then Jake can fill in some more information here. But overall, look, largely aligned with what we expected. This year, in particular, as you know, we've been doing a series of ERP implementations. Along with that, moving distribution network from our former payer in BD to our own and simultaneously standing up shared services, right? So in advance of all of these implementations, which obviously have consumed a lot of time, we've also made sure that we don't have a discontinuity in product supply. And what that has meant is, some inventory stocking with distributors, so that they do have enough inventory to continue to supply patients if we were to have an issue. And so that has led to certain lumpiness in distributor ordering through the year. So this quarter, in particular, from a revenue standpoint was a little bit low from what would have been a normal quarter, but it was something that we had signaled at the Q2 call because we had some pull forward of product ordering in Q2. And then at the gross margin line, there were certainly some one-timers that impacted us favorably in Q3 and then maybe Jake can talk about those.

Yes. So we saw -- because of the large buildup in terms of inventory in advance of the ERP go-lives, we had an amount of profit in inventory that was sort of capitalized on the balance sheet. And then once we ended up selling that product into the end markets, we ended up releasing that profit. Now normally, we recognize PII, smaller amounts in any given quarter. There was a larger bolus that ended up positively impacting us this quarter. You should think of that sort of -- that would have ratably happen normally under more normal circumstances throughout the year, just so happen to impact us favorably in the quarter. But coming back to, I think, something that Dev had said. I think if you look at our business, we thought all along pre-spin that this was going to be a very, very stable business. Now there was a lot of separation work that had to occur over the last 2.5 years in order for us to sort of maintain that stability but that's largely how things played out. On a year-to-date basis, our business, if you put aside the sort of small contract manufacturing revenue of the non-diabetes products that we sell to BD, our core injection business has grown about 0.4% on a constant currency basis. And if you peel that back even a little further, what we're seeing there is, is that our syringe business has been declining, let's call it, double digits, 13% year-over-year for the first 9 months of the year. That's a trend that we have seen happen for the last several years occur. Now more offsetting that is the fact that our pen needle business, which makes up $850 million, give or take, of our $1.1 billion in revenue, has actually been growing 4% on a constant currency basis. In addition, our safety products, whether it's pen needles or syringes, has been growing around 2%. So of the, let's call it, $950 million of our $1.1 billion in revenue, it's actually been growing around 2.3%, 2.5% constant currency year-to-date. It's really this phenomenon with syringe and largely in the U.S. business in syringe that has been causing these declines. And as we move forward here, the amount of U.S. revenue associated with syringe is going to become less and less. So it's going to become less and less of a headwind as we move forward in future years. But the core business, despite having to go through a tremendous amount of separation work, has remained incredibly stable. The higher-margin products that we have within our portfolio have actually been growing, let's call it 2-ish percent. And at some point in the future, those syringe declines are just going to become de minimis in the U.S.

That makes sense. And let's just zoom out a bit on market trends in the core business, less of a debate from the incoming than I get right now. But let us know what you're seeing on the insulin demand side. I think last year, there was a little noise around that, the GLP-1 patch pumps as well. So just let us know what you're seeing?

So the insulin demand in the aggregate level, certainly in the U.S. remain stable. But I think what's interesting is if you parse that insulin demand and say, what's going on with insulin delivered in pens versus insulin delivered in vials, you see a bifurcation. And what I mean by that is insulin delivered in pens is actually stable to maybe even slightly growing. Insulin delivered via vials is declining and has been. And that matches well with what we see internally with what's going on with syringes. That the vial, therefore the syringe usage continues to go down, pens is flat to maybe even slightly growing. And in aggregate, therefore, insulin remains sort of stable. That's something that we've observed for a period of time and continue to observe now. If you go outside the U.S., certainly in emerging markets, our growth rates in emerging markets are well aligned with our expectations. I've often said that we expect sort of low to mid-single-digit growth over there. Again, this year has been a little lumpy as we've been through the CRP implementations but on a year-to-date basis, I think it's fair to say it's well aligned with our expectations. And then if you look at the other developed markets, this all falls somewhere sort of in between.

Got it. And in the U.S. specifically, I think you've been clear historically that price has helped to some degree. From some of our channel checks, there may be some resistance, it seems to continued price hikes looking forward. Is that fair, do you think? And how are you thinking about your pricing power looking ahead?

Yes. So obviously, I wouldn't comment specifically on our forward sort of pricing strategy here. But pricing has been an important factor for us over the last several years in many markets around the world, not just in the U.S., and we'll continue to look for ways to optimize price going forward. Is it possible that there might be increasing resistance to pricing? Entirely possible, right. And certainly, when we gave guidance for the rest of this year, in August, we took all our latest information into account. When it comes to '25 and beyond, we'd certainly talk about that more on Analyst Day, but your broader point being could you see increasing resistance to price in certain markets? Absolutely, that's possible. But again, we'll try to find ways to optimize that around the world. And then the impact on margins, certainly, we're going to try to optimize our cost base as well, right? Because obviously, pricing has been an important factor in us being able, over the last now spend 2.5 years, to deliver on the margins that we've delivered so far.

Great. And maybe we could spend some time talking about international. It's obviously a big part of the business. You mentioned you're seeing trends shifting away from syringes over to pen needles. Maybe touch on some regions in particular that you've seen an acceleration of that trend, which are driving the growth in that part of the business for you guys?

Yes. That trend is most prominent in the United States. And it's not a new trend. I mean, this has been going on for a long period of time. And I think syringes is declining as some people convert over from syringes to pen, even though pens have been available now in the U.S. for decades, but as payer coverage changes, as certain insulin forms become available in pens versus vials, you do get that patient-ship from vials to pens. In terms of new patients that are being exposed to insulin therapy, more likely than not, its pens. But I don't think we can also ignore the fact that during the COVID epidemic, it impacted seniors disproportionately. Seniors have 3x the prevalence rate on diabetes as the general population and because of the advanced stage, also more likely to use insulin and that impacted syringe demand as well. So for those factors, I do think we have seen and will continue to see syringe decline. But we are heartened by the fact that both insulin intense, right, which is the key driver of the demand for our products remains stable to growing. And certainly, our pen needle business has continued to grow over time as well.

Opportunities ahead. I think the most eye-catching thing for me from the Q3 print was on the GLP-1 pen needle opportunity in Germany. Maybe refresh us on what that offering is, how you went about getting in, in place and which countries are next to target?

Yes. So I'm going to take this opportunity, Kallum, to talk, answer your questions would maybe expand a little bit on how I think GLP-1s could potentially be a sustainable tailwind for us over a number of years, right, even 5 to 10 years. But to answer your question specifically, it's a small pack. It's 14 counts. Why 14 count pen needle? Because typically with a 3-month prescription, you would need 12 pen needles, but obviously, you want to have extras. Lilly is launching Mounjaro in a KwikPen in Germany. KwikPen is the same pen that they've used before for insulin. It's compatible with our pen needles. And so our team saw an opportunity there that, obviously, if patient is going to go pick up a 3-month prescription of GLP-1s from their pharmacy, you don't want to give them a 100-count box of pen needles, right? So getting the right 3-month supply of pen needles at the point of dispensation with the treatment supply of GLP-1 made instinctive sense. Now what that allows us to do is obviously optimized pricing for GLP-1 delivery using a pen needle. And so certainly, we've taken advantage of that opportunity available to us. And as GLP-1 delivery via pens increases around the world, certainly, we are watching that closely and we'll introduce the right small count pack for that country over time as well. Now to speak about GLP-1s a little bit more broadly, right. GLP-1s initially when they were launched, they still are available in the form of auto injectors. Novo sells Ozempic in the form of pen. It comes co-packers with pen needles, right? And we'll see over time whether they continue to co-pack with pen needles in countries where they are allowed to, but in a couple of places like China and Japan, you can't co-package pen needles with pen. Lilly has spoken openly about launching GLP-1 equipment. And that was the opportunity in Germany. There will be opportunities. They -- I believe they have KwikPen approval for Mounjaro delivery in Europe, in other countries in Europe as well, and we're watching that closely. As the delivery forms changes or the mix changes between auto-injectors depends. Thirdly, we can capitalize on that because our pen needles are compatible. But we fully expect that over time, biosimilars will enter the fray as well. And we are in discussions with multiple potential biosimilar entrants about co-packaging our pen needles with their drug as well. The pen needle that we have currently, we believe, is well qualified to be part of that, including we have some data for cold storage, which is important for co-packaging and so we are involved in those discussions as well. And so over time, we think that the use of our pen needles for GLP-1 delivery can be a tailwind. It's one that we have the capacity in place to fulfill. So we don't need incremental capital. And given the highly automated nature of our plants, any revenue contribution from incremental pen needle volume for GLP-1 delivery has a pretty significant drop through our P&L. And so we remain excited about this opportunity broadly, and we think it certainly has the potential to be a multiyear tailwind for us.

And when does that become more evident in the P&L?

So I think this is evolving. I think it's going to be driven by the availability of pens for GLP-1s. But certainly, look, we'll monitor our performance in Germany over time year, over the next year. And then I think we'll be in a better position to sort of use at least that data point to have a more refined estimate of when you'll actually see the impact of that in that P&L.

And we received some questions, I think, last week or the week before, around Lilly and Zepbound vials, which maybe that's something you could potentially benefit from?

It is, look, any delivery form of GLP-1 that uses our existing products, whether it be pen needles or syringes, obviously, is a net benefit for us, right? On syringes, obviously, I want to caution that our syringes are marked for insulin delivery and not marked for the actual markings in the barrel, not for GLP-1 deliveries. So they are not indicated for GLP-1 delivery. And also, I think it remains to be seen where the vials actually become a sustainable form, if you will, of GLP-1 delivery over time or whether it is something that as GLP-1 manufacturers are trying to get beyond the shortages that exist is sort of, if you will, a temporary fix or not, right? It remains to be seen. But more broadly, anything that expands the use of our currently main products is going to be a net benefit for us.

Great. And then the patch pump, open-loop system received approval last Friday. How would you describe the company's motivation behind the patch pump program right now?

Yes. So first of all, thrilled to receive that clearance. Our team has been hard at work since then. And it was one of the three priorities that we had laid out pre-spin, right, stabilizers, core of business, separate and stand up and then the investments we're putting behind [indiscernible]. So absolutely pleased to receive that pay off with the 510(k) clearance on the open loop. But I also want to remind everybody that it was part of a broader strategy, which was, listen, what we are after is a closed-loop pump. But rather than doing all the pump hardware and software development and then doing a clinical trial and then getting the whole thing approved at one time, this was a way to derisk by getting the hardware software development get done as an open loop, getting the clearance because now what we have is we have a pump that's got 510(k). We signed up with Tidepool that has 510k clearance for type 1. And obviously, we would integrate with the CGM, which are obviously commercial, right? So sort of that derisks the closed loop now down to human factor studies and a clinical trial. I think what I want to say about the patch pump is we are very sensitive to the fact that our net leverage stands at approximately 3.7x at the end of the last quarter. And over the last couple of calls, we started talking about our desire to have more material paydowns of debt beyond the mandatory required for a term loan B. And so the way we think about pump investments, broadly, whether it be commercial or R&D, is we want to do them in a measured way because paying down the debt and managing net leverage is a key priority. And I think the way we'll approach this, we won't give numbers for '25 and beyond yet, but the way we will approach this is really to start thinking about what's the right level of pump investment that we should make, keeping in mind all of the priorities, and then making some trade-offs between where that money gets spent, right? Does it get spent on -- for example, enhancements we can make on open loop. We have 6-month shelf life now, right, because we wanted to get the pump done and obviously, getting more data just requires more time. We could go get -- we are getting more data to extend that shelf life. The pump that got approved with an open loop comes with a lockdown wireless controller, but we know patients want BYOD approach. Certainly, that's another area we could pursue. Extended where is the third area we could pursue, especially taking advantage of our 300-unit capacity for a reservoir. And then obviously, there's the clinical trial for a closed loop. And so we'll monitor pump spend carefully, be very choosy about where we spend. I think one thing I would like to sort of make sure everybody understands is that we don't, at this point, intend to do a full commercial launch of our open loop because we recognize now as we recognized 2 years ago, that in this marketplace, which you really need is a closed-loop pump.

How limited of a commercial launch, will it be for the open loop?

How unlimited?

How limited?

How limited? Quite limited.

Okay.

Listen, we'll talk more specifically when we talk in December, right? But again, let me just expand on that because I'm not trying -- given the product enhancements we want to make. We do think there's an opportunity to put the pump in the heads of a very, very small number of patients, so we can actually get real-time feedback in terms of how the pump performs even as we are making these choices between where we want our pump investment to go. So what you -- what we are not inclined to do at present is right now in the early stages, add a number of heads to go start selling this pump into PCPs or endocrinologists at this point. That's not something that we are contemplating at this point. We are more focused on, like I said, what's going to be the right investment level. And within that investment level, where should we spend our money between product enhancements, closed loop and commercial.

And time lines on the closed loop. Anything you can give us roughly just to put us in the right ZIP code?

Yes. Look, we've said closed loop in the past. I mean let's think about what needs to be done, right? I mean I think there is integration work that needs to be done within the pump sensor and the algorithm. The human factor studies that need to be done. And then obviously, there's a clinical trial, right? The clinical trial is going to involve a number of patients, right? Hundreds, typically 13 weeks plus some follow-up type. So you could imagine a clinical trial between start to finish easily taking a year or more. And then you add in all the integration work and some human factors where you could be looking at a couple of years time frame, roughly, right? And so I think that's the right way to think about it. Now listen, we just got open loop, right? We got to lay out our plans more specifically over closed loop. So I hope you don't mind that I reserve the right to sort of revise the time line as we do some more work. But what I do want to say is it's not 5 years away now that we have open loop approval.

Very fair. And on the 300 unit reservoir, why don't you think that's worked in the market before?

Look, I can't comment on why it hasn't worked in the market for other places before. But maybe what I can comment on why, certainly, we think it's the right product, specifically on Type 2. The most obvious one is the 300-unit reservoir, right? I mean Type 2 is require on average about 100 units a day, a 3-day wear. It makes sense, right? I think it makes also sense from a payer perspective because the cost per day could potentially be lower. But there are other factors, I think, in the design of the product that we -- that sort of give us some incremental confidence but why this product side. So for example, we are far fewer basal rate settings than the predicate device here, which sort of argues for less complexity. We've tried to design the user interface in such a way that it's easier to use. It's a fully disposable pump unlike some other pumps that are -- that have reusable components. Therefore, it can flow easily through the pharmacy supply chain. And obviously, we have a lot of experience in selling products through the pharmacy. We have established relationships with all the key retailers. 95% of the covered lives in the country have some sort of payer relationship with us. So we have good payer network coverage as well. So I think for all those reasons and finally, obviously, while the product is indicated for both Type 1 and Type 2, given that we've designed it with some Type 2 considerations in mind, we would sort of be from a marketing standpoint, more targeting Type 2. And Type 2, as you know, is a prevalent disease, right? I mean most of these people are starting with exercise and ending up with insulin, but we'll start with insulin, they're standing -- starting with the basal injection. More likely than not using our products. So we have a unique opportunity to sort of reach these people with diabetes and inform them on the availability of our products. So I do think that we have some things that give us some incremental confidence around why this product could get adopted.

Is it fair to say at the planned Investor Day, I think, in December, maybe we're going to get more color on the costs associated with the patch pump and then maybe some more product differentiation color? Is that fair?

Yes. I think -- yes, I think that Analyst Day, broadly speaking, what we want to do is just lay out certainly what FY '25 looks like, but we're considering sort of laying out a 1 year to 2 year road map from a business standpoint and a financial standpoint.

So you've established significant manufacturing facilities that can produce these med supplies at quite a scale. Are there any additional opportunities aside from those that we've touched on that you're looking at to leverage those facilities that you have?

Yes. And that's a great point, Kallum, right? I mean if you strip down to what are the core strengths of the company. I mean we are world-class at high-volume medical devices, built using a quality system that today produces 7.5 billion devices that enter the human body. And there's not that many companies that can claim that kind of expertise, right? And it's not just the engineering expertise, but our whole ops team. If you look at 2.5 years or even more going through the COVID years, what they have demonstrated over time is the ability to keep product supply in pharmacy so that people didn't get interruption in their care. That is something that we want to leverage. In a couple of the plants we even have space available. If we wanted to get into producing other products. And the other stent we have is we can get products into the hands of consumers/patients in more than 100 countries in the world. So we will be now that separation is, call it done but getting close to done. We will be looking at opportunities of how to leverage the strength. And so broadly speaking, we have several choices here, right. Our cash features and separation will go down in '25 versus '24. We do want to manage our net leverage and start making so as debt repayments. We talked about potential investments in the pump. And we've talked about wanting to take advantage of GLP-1 tailwinds, which fits right into the core of our business and then also look at opportunities how we can widen the product portfolio here. So that we can really leverage our sales channel.

Are there any agreements in place with BD that prevents you from pushing into other areas within like the, I guess, med supplies drug delivery space?

So there are agreements that were part of our separation agreements that limit what we can do with the technology that came to us with spin. But I'm not aware of anything that would prohibit us from independently getting into new areas, right? So we get our cannula from them, right? We have a cannula supply agreement. We can't use those or anything besides the products we make today. But that doesn't mean we couldn't acquire something else and get into a different space.

Sure, sure. And Jake, on the separation activities, it seems we are essentially done now, with nearly all the way there, I think just some rebranding next year. So any color you could provide us on the next steps here and any potential financial impact, I think, from that?

Yes. So separation activities, I mean, as you can imagine, we had 11 major separation programs. And life to date over the last 2.5 years, we've probably spent around $400 million worth of our cash on separation activities, including -- we estimate to spend around $180 million this year, a mixture between mostly OpEx and some CapEx associated with the ERP systems. That's probably 2x what was originally included in the pre-spin model. And I think it's something that, candidly, really has masked the free cash flow generation capabilities of this company. The amount of cash that we've had to use to be able to separate as effectively as we have and avoid any type of ERP disruptions or distribution network disruptions and set up our own shared service functions and whatnot. In addition, pre-spin SOFR rates were close to 0. We probably had to absorb another $35 million per year in annual interest expense over and above what we -- what the pre-spin deal model would have indicated. And we started the spin at around, let's call it, $270 million in cash on hand. At the end of last quarter, we had about $280 million of cash on hand. And that's despite using a significant amount of cash, obviously, for separation, for interest, and then we also continue to pay around the $35 million dividend. So I think as we move forward here, we certainly expect to see the costs associated with those onetime separation activities to materially decrease. So on our last earnings call, I think we talked about it going from around $180 million in 2024, down to somewhere in that kind of $50 million-ish range next year. And the overwhelming majority of that is going to be spent associated with brand transition. And that brand transition activity is going to last into 2026. So we're going to see a material step down an improvement, if you will, in free cash flow generation next year as the separation costs go down. There's still going to be some lingering amount of separation activities associated with brand that's going to linger into 2026. But then beyond that, it really goes away. And I think it's really going to free up. Beginning next year, it's really going to free up or the options that we have as of what to do with that cash. And Dev mentioned several times, there's an intention here to make significant amounts of more material debt repayment beginning in 2025.

And on that debt repayment, you said leverage is about 3.7x. Is there any target maybe you're pushing for next year that you can maybe give us some color around right now?

Yes. So the 3.7x again, net leverage, right? So it takes into consideration the cash that we have on our balance sheet. That being said, we do want to actively delever and help reduce interest expense moving forward. Over the longer term, I think to the extent that we could target a capital structure with a net leverage ratio in or around the 3x mark, I think we would feel comfortable with that. So from time to time, that might continue to dip below 3x. If we found something attractive in terms of an acquisition that would take that up, as long as there's a path back down, over the next, let's call it, 12- to 18-month time period to bring that back down closer to a 3x net levered mark, I think we would feel comfortable with that.

Understood. And then on the longer-term margin outlook for Embecta, I think the street is kind of hovering around 30% EBITDA out to like 2027. What are the drivers in your opinion, that are crucial to margin expansion if you think there's room for some looking ahead?

Yes. So I think I'm going to refrain from giving specific commentary regarding 2025 through 2027. We'll certainly do that as Dev mentioned at the Analyst Day in December. But maybe, look, in relation to sort of pre-spin margins that we would have laid out, we talked in March of 2022, about a flattish top line, a gross margin profile that was sort of in the low 60s and EBITDA margin profile that was around 30%. I'm pleased to say that as we've gone through an enormous amount of separation activities, we've done a little bit better than that in terms of the financial performance. The top line CAGR is going to be somewhere in that kind of 1-ish percent range, so modestly better than flat. The EBITDA profile is going to end up being somewhere close to 125 to 150 basis points better than what we had laid out sort of pre-spin, and that's largely coming from the gross margin line. And that comes despite having to absorb, probably close to 400 to 500 basis points of inflation that was never previously contemplated in those pre-spend margins. And how have we been able to do that? We've really been able to do that through an excellent supply chain team continuing to take cost out of the system as well as our ability to drive price and favorable mix. More higher-margin pen needle and safety products and less of a focus, if you will, in terms of syringe volumes. Now this business has remained incredibly stable despite a lot of noise going on regarding GLP-1s and whatnot since then. And I think as we move forward, I think there's going to be additional opportunities to rightsize the cost structure associated with this organization. I mean, very, very deliberately, we have not done that to date. But there is going to be an opportunity as we move forward to rightsize and do some cost optimization to kind of our core business. I think that this business could benefit, as we've said, from GLP-1 tailwinds moving forward. And that's going to sort of then help counterbalance additional investments that we're going to choose to make on the pump and any potential pricing pressure that we may see moving forward over the next few years. But this business I think, has been incredibly stable despite going through a lot of separation work. And I think our thoughts are that over the next several years, this business is going to continue to be pretty stable.

Pretty helpful. I think that takes us the time. Dev, Jake. Thank you so much.

Thank you.

Thank you for having us.