West Pharmaceutical Services, Inc. (WST) Earnings Call Transcript & Summary

All right. Welcome, everybody. I'm Dave Windley with Jefferies Health Equity Research. Glad to be here after my parole. It's great to see everybody and glad we could in person for our New York Healthcare Conference here in June of 2022. I'm very pleased to have with us for our next presentation or fireside chat session West Pharmaceutical Services. The company is a leading player in the containment of injectable drug products. And representing the company is the company's CFO, Bernard Birkett; and head of IR, Quin Lai. So thank you, gentlemen, for being here with us.

I'm going to fire off just dig right into questions. Bernard, your high value products and the transition to those has really been a theme for the company for a long time. But in the last maybe 2 or 3 years, the kind of traction of those or the inflection of those seems to have kind of taking on the life of its own almost. So maybe you could talk about the drivers of demand for high value, but particularly where you're seeing kind of the upsell into the highest of high-value your FluroTec and NovaPure products.

Okay. Good afternoon. And first of all, thank you, Dave, for the invite here today. It's been a very busy day for us, meeting with a lot of various investors, and it's been very productive. So thank you for that. Yes, on the high-value products, I think you got to go back probably to 2015, 2016, when we looked at the structure of our organization and really put 3 market units in place, biologics, generics and pharma, and that gave us a lot focus as to how to really understand what our customers needed. And really to target those specific areas and obviously biologics was one of the key areas for us because that's where we sell really a lot of our high value products. And that's an area where customers are demanding that type of product. What we've seen, we have been gaining traction over the last number of years and I think in 2018, 2019 we were starting to get there and we were. Particularly where we're seeing uptake in our NovaPure product offering in and around 2019. And since then, as we've gone through 2020 and 2021, both from a responding to COVID vaccines and supporting those drugs getting to market and also really with the strong growth within our core biologics market segment. And we've seen a really strong uptake where biologics business has gone from probably just north of 20% of our business to 42% of our business right now. A lot of that is really driven by uptake on new molecules, particularly when we're looking at the NovaPure product platform, which is now really the go-to choice for many of our customers and also the growth that we're seeing in our FluroTec range of products. And what we're also seeing is there are some customers who are transferring from standard products to products like Westar. So we are seeing some traction there as well. But again, it's mostly driven by biologics, where we have a very high participation rate in that segment.

That's excellent. So a couple of follow-ups there. So as you think about the selection of high-value product, in some cases, I thought that maybe the product itself, the drug substance that is going into that container might dictate the appropriate container for it to go in, be it siliconization or things like low silicon content or friction elements or things like that. But for customers to buy up to NovaPure and just kind of go straight to the highest value products suggests a different set of drivers, perhaps. Maybe you could talk about why the client is kind of pushing to the highest of the high value. What's that driver?

Well, when we look at it and we are helping our customers select what product to look for, particularly at the higher end. And when you look at the cost of many biologic drugs, they're really looking for the best product possible to take as much risk off the table and at the highest levels of quality to make sure that they have no issue when they go to market. So that takes them to NovaPure essentially straight out of the gate in many cases. And they can see the benefits of that product and the various attributes it brings and the risk it actually takes off for them. And that's the same -- in my mind, that's why they go for it. I don't know if Quintin, if you have anything to add to that?

Dave, you bring up a good point cloud compatibility is always paramount for drug companies as they're trying to select their primary package. And in the case of some of the drugs that are coming out now that are large molecule, they happen to be extremely sensitive to particulates or extractables and leachables, which then pushes the selection toward a coated product like FluroTec, and then when you then start to take a look at, as Bernard said, the cost of the product. And if you think about the cost of goods of just the API itself, having to throw away product in case there is a contamination issue, opening up the chance for recall. All of those things weigh into the decision of just saying, look, I want to go -- not only I want to take something that's biocompatible, but I also want to take the highest quality product at NovaPure because of our process of quality by design, where we're looking at every step of the manufacturing along the way, gives them that quality assurance and better yield.

Got it. Okay. Another point here before I leave this particular topic is the -- that has been interesting to me is the seemingly universal move COVID products, non-COVID products. I guess it's mostly in biologics as you highlight that, that has grown a lot. But that it really has been a broad move, not a narrow selective move, but a broad move to NovaPure. And so maybe you could touch on the COVID versus non-COVID elements of the growth a little bit?

Yes. On the COVID response we had, there was a large uptake around NovaPure and also around FluroTec. So we're using both technologies and some standard product. But it goes back to what we've already mentioned, it's when you're trying to get a drug to market quickly, you want to take as much risk off the table, have the highest quality product. So you can make sure you get to markets with the highest levels of security. And I think that's what NovaPure brings and guarantees for customers. And again, as you look at it as a percentage of COGS, as Quintin mentioned, it's a pretty small amount. It's typically less than 1% to 2% of COGS -- so for a small amount of expense, you're taking a lot of risk off the table. And that's what we've seen, particularly around the COVID response and the speed that was needed. And then when you look at the non-COVID business, again, it's matching it up with the drug. And again, the biologics drugs are calling for the highest levels of quality to reduce all of the risk factors that Quintin mentioned. So it's similar in both areas. But again, it's -- when you look at it, what do you get for using our highest product, you take so much risk off the table and you are getting the highest levels of quality for a small cost in relation to the drug.

Let's -- while we're on this, let's flip to the capacity side of this topic. So you've announced several fairly substantial CapEx investments, pulling forward some CapEx investment in adding capacity in high-value, you've emphasized the point that this is essentially on the critical path of your long-term plan just kind of advances the timing of that. Do you have enough capacity in place in FluroTec and NovaPure to serve the demand that you see coming into your sales funnel?

Well, yes, so we've been layering in extra capacity since 2020. And as you say, it is particularly around FluroTec and NovaPure and that's where a lot of our growth investments have been going. And we'll continue to go as we progress through 2022, 2023 and into early 2024. COVID actually accelerated the demand that we have seen and we had been building the capacity and much of the capacity that we accelerated was built into our 5-year plan originally. But with this sudden acceleration where we saw the uptake around COVID products and then really strong growth -- core growth within our biologics units. It has put -- or challenged us into meeting the demands of our customers. What we have seen is that our lead times have extended around some of these products, and we've had to be selective and prioritize where we have been supplying to customers making sure that we're meeting their near-term demands and making sure that we're not stocking anybody out. So we have managed to do that. It has been challenging for us and that we see those challenges continuing for at least through 2022 and so we layer in this extra capacity.

Got it. Before we leave the COVID topic, there were some shifting sands in the first quarter when we talked at that time, you talked about maybe some orders that got canceled, some that were just deferred later into the year. Can you give us a sense of the firmness of your COVID book at this point? How much confidence do you have in that? And to what extent do you have visibility in this kind of long-waited shift in format?

Yes. So it's -- in our initial guidance back in February, we had initially expected COVID revenues to grow approximately in the mid-teens, in line with our core business. And then when we did our guidance after -- on our Q1 call, we had to reassess that. And now we're seeing our COVID revenues probably grow in the single-digit range. But to offset that, we've seen a pickup in our core business, again, particularly within biologics, we are actually able to reaffirm our guidance, essentially raise it as we were absorbing more FX headwinds. So again, it's like -- it is a moving target. It's something that we're watching very, very closely. We have still strong demand in orders in our books for COVID products, but it's something that we are watching with and really trying to understand their forecast as we progress through 2022 and into 2023. And also understanding from a delivery point of view are we still going to be supplying in vials of 10 to 14 doses? Or will there be a switch to buy 1 to 3 doses per vial and at some stage, possibly looking at prefilled syringes. So there's a number of dynamics that are playing into this, and we're running a number of different scenarios, but it is like a moving target.

That's very helpful. On that last part, it does sound like that's still -- as you said, a moving target is still somewhat uncertain in terms of the shift in format. I guess those of us in the, Quintin knows this, in the equity markets, we have attention spans of 5 minutes. So we think the world revolves in 30 seconds or something. But what's the hold up there? I guess, essentially.

I don't know if there's a whole hold up. I think the vaccine providers have to decide the appropriate time as to when they want to make that shift. And I'm assuming that they are working on that, we're having conversations with them as to how would we support them if that was to take place and will take place, will we have the capacity in place to be able to support that shift? And that's really our focus is being ready for that event when and if it takes place.

Okay. Let's shift to margin. The -- probably benefiting from both the COVID push in '20 and '21, but also the underlying non-COVID biologics lift that you've already highlighted, margin expanded 600 basis points in '21. Then in the first quarter, backed up a bit year-over-year. Could you just talk about some of the moving parts that are influencing margin and the margin progression?

Yes. So the -- in Q1, there were 2 callouts really that impacted the margin expansion. And one was there was a take or pay revenues that we had in Q1 2021. And that was about circa $15 million. So to [ compensate ] that against that was always going to be pretty difficult, net add about 160-basis point impact on our operating margin. And then also, we had some issues in the early part of the quarter with COVID-related impacts on some of our U.S. sites, particularly our high-value product sites that resolved itself as we move through the quarter, but it did impact our ability to produce in the early part of the quarter. And so again, that had a onetime impact on margins. So if you adjusted for the 160 basis point impact of the take-or-pay or margin would have actually expanded Q1 '22 over Q1 '21. So we would -- on our long-term horizon, we're still talking about 100 basis points expansion year-over-year on operating margin. And as we progress through 2022, we would expect to see margins step up quarter-over-quarter.

Okay. You also talked a little bit about given the environment we're in, inflation, supply chain disruptions, et cetera, that you're adding some surcharges into your pricing structure. And then the yield which I think historically has tended to be about 1% to 2% on price yield was more like 3.5% in the first quarter. Can you talk about kind of pricing strategy? How much are you pushing through that you would view as more temporary? How much is more of a permanent price taking? And is that higher price taking something that you expect to do long term?

Yes. So we -- as we went through the back end we were setting our prices for 2022, we did incorporate some inflationary cost increases that we forecast coming through, and that was part of that 3.5%, and we didn't break out exactly how much. But in addition to that, we have been reviewing our pricing strategy and the methodology where we were using as to how to capture value and capture more price and we had done work through 2021 on that. So even without the inflationary addition to pricing, we would have been increasing our pricing guess for 2022, and that's something that we will continue to look at as we move beyond 2022. So it's really understanding how best we should capture value within West. I think in the past, we looked at 1% to 2% as being sufficient, but there has been kind of a shift in our view in that. On the other inflationary costs regarding freight, certain increases on components and raw materials, they are passed on to customers through surcharges. They're not included in that pricing adjustment. But that's -- again, that's been ongoing. We've been doing some of that since 2020 as we see freight costs increase as we went through the COVID experience and on into 2021. On the other side, on managing those inflationary costs, we have hedges in place around oil. So we hedge about 60% of our exposure around oil-related products. And we have an 18-month rolling hedging policy in place. So we're actually seeing that as a benefit as we're going through 2021. And then from a lot of our utilities, there's fixed price contracts in place through this year. And again, that's something that we'll have to review as we move into 2023 and then how does that inform our pricing strategy as we move into next year.

So just a quick clarification on the utility point. Are those also rolling? Or are you saying all your utility contracts are coming up this year?

There will be -- some will roll into 2023 and then some will have to be renegotiated for 2023.

Okay. In terms of the -- I guess one of the historical postures around pricing has been kind of not to poke the bear so to speak, like don't take so much price that you dare the client to look elsewhere. Maybe talk about how that philosophy has changed.

Well, it's still -- that the philosophy is similar, but it's just believe that in certain areas of our business, we're able to expand on that pricing strategy. So there is more value we can capture based on what we're bringing to the market. So it's not as if we're suddenly going to go market and increase prices exorbitantly. It's a measured approach because the relationship we have with our customers, these are long-term partnerships, and that's what we want to maintain.

Got it. Okay. So then moving on to a more maybe more longer-term strategic development is, I think, the company's view that the end market will evolve toward more of an integrated delivery model, where you're not just providing the component, but you're providing more the system that -- where the need will be driven by very hard to deliver drugs and self-administration at home and things of that sort and the trend. So maybe talk about how you're building toward that, and Quintin looks like you're going to answer this one. How does Valor Glass fit into that?

Dave, this has been a trend that has been coming for a while now. Our customers and the regulators that regulate them are looking not only at the quality and the reliability of the components, but they're looking at it as how the components all are put together as a system. Today, for injectable drugs, it's piecemeal. They'll buy an elastomer, they'll buy a glass, They'll work with a different fill/finish company, and each one has their own different processes. And especially on the glass and elastomer side, you could be looking at multiple drug master files that you're having to juggle for not just the component but the processing that goes along with it. The opportunity that we have now to work with an established player like Corning who brings a wealth of knowledge and experience on glass to develop a truly integrated system where from manufacturing, how the elastomer in the glass work together, fully characterize single drug master file we believe will be a truly innovative system that does not exist today. since we've announced that deal, the customer feedback has been very positive. They have reinforced that this is what they've been looking for. This is what the regulators are looking for. And so over the next few years, we're going to be investing in capital in product development, and you can expect to see new offerings being launched that will go to where we'll be providing both from a PFS prefilled syringe and vial and cartridge formats.

Okay. Last question, Bernard, for you. On capital allocation, I look back through my model and over 5 years, your net -- you've gone from small net debt to about just shy of $4 a net or just shy of $5, I think, of net cash. Your positive cash flow in, you can fund your CapEx out of annual cash flow. What are your thoughts about how the company wants to use what is now a growing store of late in cash?

Yes. So in the past, we have focused on really CapEx deployment and for organic growth. And we have a modest share buyback, which is just to cover share creep and then we have our regular dividend payments. So what we are focusing on more in the future is looking at M&A and looking at areas where we can -- from a strategic point of view and where we should be adding more capability to support our customers which will be close to our core, our plan is not to go too far away from the things we do today, but there will be more focus in that area. But it's also bearing in mind that we have kind of strict guidelines around where we will invest and what level of exposure we will take on. And we're also very cognizant that we have a very powerful organic growth story, and it's also making sure that we don't get distracted from that. But M&A is becoming more of a priority for us at this point.

Excellent. I think that brings land the plane there. That brings us to the end of our session. Thank you to the West guys for your attendance and participation and to our audience for listening in and enjoy the rest of the conference. Thank you.