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

West Pharmaceutical Services. And with us from West today are -- I just completely forgot your name, Bernard. Bernard Birkett, CFO; and Quintin Lai, IR. God, I'm getting old.

I've been there.

Sorry, senior moment. Gentlemen, thanks for being here and putting up with my stuff. So I'll let you start by doing some opening comments, if you want to make some comments on the quarter or anything like that.

Well, I was going to thank you for the invite.

Well, please do. There you go. But please do.

Thanks for inviting us to the conference. It's good to be here with you in London. And Quintin is going to join me here on stage and will answer whatever questions you have.

Great. So you -- let's talk something about just the second quarter to begin with. I mean, you had 13% organic revenue growth in the quarter, 18% growth in Proprietary Products. Great underlying demand offset a [ 650 ] -- FX headwind and decline in COVID sales. Can you sort of walk us through the puts and takes in the quarters? Because I think you have the -- certainly, when the quarter was printed, the -- I think a lot of investors that certainly hit me up on chat thought the stock was going to be down, and it certainly skyrocketed after that. So can you sort of like talk about the puts and takes in the business?

Yes. From our perspective, even with what we see going on with COVID, and we were focusing on the underlying growth within our core business. And this is something that we've been talking about right through the whole COVID experience, that our core business has been really robust. And in the second quarter, again, we saw strong double-digit growth within Biologics. And even within Generics and Pharma, there was double-digit growth. And we've been able to respond to the increasing lead times that we have seen, which have been as a result of responding to the COVID pandemic. But it's -- now we're getting the opportunity to start to reduce those lead times and responding to the core demand that's in our business. Now during that time, we didn't stock anybody out. We just had to allocate where the supply was going. So what we are seeing is the lead times starting to come back. There's still a ways to go. But that, I think, gives -- has given us confidence. We knew it was there, we can see the order book. But I think for investors to see that, it was probably helpful, that what we were saying actually materialized here in the second quarter.

I mean -- and I think you mentioned on -- I think there's been one concern about inventory build in the channels and such, and are people stocking? Because you've had some issues in the past was sort of like [ customers ] building inventories and doing things. It's like -- but it sounds like there just hasn't been any inventory out there sort of serve some these customers.

Yes. Well, it's something that we have really been cognizant of over the last 2 to 3 years and working closely with customers to help manage their stock levels. And in some ways, it's been the opposite for us, given the demands in certain parts of our business, and again, responding to COVID. Meaning that we had to manage our supply pretty tightly to customers to make sure they had enough of what they needed and that they weren't actually building stocks. And so one of the things that we realized was maybe the opposite to that, where safety stocks may be somewhat reduced over that period of time. And over a period of time, it's not going to happen immediately, is those safety stocks will need to be replenished. But it's something that, from day 1, we worked really, really closely with our customers to make sure that wasn't happening. So we had triggers in our system to see if there were any abnormal size orders coming in. But again, it's not to say some people haven't been able to do that. But in the mean, we believe we're in pretty good shape there.

And when you -- let's get some of the COVID questions out of the way. But I mean, your -- you've lowered your guide on COVID coming through, and you've talked about another 30% to 50% year-over-year potential decline next year in the business. What are some of the caveats on that, right? I mean, like what's embedded in terms of things moving to smaller dose formats? It seems like that has been slower to happen than I think people thought.

It has been slower based on what our expectations would have been. So there isn't a -- there's some [ embedded ] based on conversations that we've been having with customers. Us, we haven't seen this huge shift into single-dose format at this point. It's something, again, we monitor, and it could change as we move forward. It's a pretty fluid situation. So we're trying to be as realistic as possible about what that COVID business could be like. But again, it's shifted on us a couple of times this year already, and it could do that again. So it's really dealing with the information we have at the time and giving our best estimates.

So -- but do you feel like that 50% is a rational floor for next year? Or is it -- there's still some risk in that?

It's a rational floor based on what we know today. So again, ask me in 3 months' time. I'm hoping [ we'll be ] the same.

I'm sure we will.

And I know you will. I just wanted to offer.

Yes, yes. Sure we will. But I guess how much -- of the non-COVID business you're seeing right now, how much of that was products that had been delayed, pushed aside, things like that? And now they're sort of coming back versus new business, right?

There's a combination. And I kind of think delayed, pushed aside, that's not a terminology I kind of use. I think we try to respond to people as best we could, making sure that we got the appropriate products to market, based on the demand we were seeing from our customers, the immediate demand that they had. But we are seeing that our lead times did go out considerably within certain product categories, and that was in relation to high-value products, and you're looking at some FluroTec and NovaPure within that. And now we still have to ease into that, bring the lead times back down and can get that supply out of customers. And that's a book of business that's already there. And then we're seeing -- there's this potential new business regard -- around NovaPure and FluroTec. So a lot of the plants that we had running 24/7, some of those are still running 24/7 and will be as we try and ease into these extended lead times. We have made some adjustments with some of our other plants to bring them down to more normalized levels of production. And that's -- it gives us a little bit more flexibility as we can grow into the future. So there's a number of moving parts in it.

Got it. And so when you look at the -- you look at your 7% to 9% organic revenue growth guide, you raised that from 6% to 8% early this year. So when you look at that number, how much of that is -- can you just walk us through what went through the acceleration? How much is new capacity coming online? And just -- and new business or just simply -- because I know, obviously, you're very tied to -- you can only make so many products. And so if you're cast-constrained...

Yes. And that's -- as we were layering in capacity for COVID, we said at the time that, that capacity that we were layering in was embedded in our 5-year plan. We were just accelerating that capacity. So we could see the demand coming for our core business within that high-value product segment, and particularly within Biologics, even before COVID came. So now we're layering in that capacity so we're able to respond over the next number of years to that increased demand. And some of that is on an existing business that's already there and growth in the market. And then some of it is on new business.

And what do you -- how do you model or how do you think about some of the potential blockbuster drugs or things that people have high expectations for? I mean, things like some of the obesity drugs are coming online, for example. And how do you sort of model that into your forecast? Or how do you sort of think about that? Do you sort of like -- well, there could be this big product category that's out there, and we've got to sort of build that? Or do you just say, we'll deal with it if it happens? How do you sort of forecast [ for what you see in the pipelines ]?

Yes. I don't think you can say you're going to deal with it when it happens because one thing that COVID has taught us that the time to respond is -- it can take 1 to 2 years to layer in the capacity. And so for any new drug that's coming to market, we want to -- we're working closely with our customers on that. We're understanding what the base case would be based on their projections, and then if there are any upsides within that. We're looking for triggers from our customers to say, okay, when are they layering in the capacity? And that helps inform me as to when I should layer in the capacity. So we're getting ahead rather than being behind and getting into these extended lead times, like the position that we're in now. So it's really you have to be in lockstep with your customers. And you need to layer in some of that capacity before the event actually takes place. You don't want to go out over your skis, so you're trying to strike a fine balance. I think the positive thing for us is that the equipment that will be -- are layering in to respond to some of these potential opportunities is our products are somewhat agnostic, so we can use the equipment in other areas. So it's not as if you buy the equipment and it sits there for one company. And so you have flexibility. There may be a carry cost for a short period of time if something doesn't materialize, but we know we'll always have use for it in time.

Got it. And so when you -- okay. There it is. So how -- and when you think about new products coming through, what is -- are more products being specced in? Better HVPs, right? So when you look at the newer drugs that are coming along the line, it's like it's a higher percentage that is going for the higher-value products, the higher-margin products. So once again, it goes back to your confidence in that 7% to 9%. And sort like how much of that is just like mix shift? How much of that's volume growth, right? And are -- then [ I'm ] going to segue to a margin question...

The mix shift is something that's key in our revenue growth strategy and also in expanding our operating margin within that long-term construct framework that we've put out there. And what we are seeing is, particularly within the Biologics segment, the majority of customers, a large majority of customers will go for HVP products when they're launching new drugs to market. And it's a shift that we've been seeing. And again, it's the regulatory environment that I believe customers are now operating in, that, that's what's demanded.

And what about the biosimilars that are coming on? I mean, obviously, a lot of those older biologic drugs may not be using HVPs. Do the companies that are interested in making biosimilars moving that direction and willing to sort of take some of that risk out? Or are they still trying to do that? And also, how does it work for the biosimilar companies, in the sense that, I mean, it takes -- do they have to go through the same sort of stability trials that your -- I mean, because historically with West, I mean, when I asked when your first picked up coverage, it was like, what's underappreciated about the company was it always takes longer than you expect because pharma was glacial and that these things take a long time, you had to do a lot of stability testing. So how does that whole work? Do they need to go back and retest and revalidate products? And so does that give you sort of like greater visibility in terms of what these customers are thinking?

So you hit on some really points that I'll follow up on here. The drug, the molecule dictates the package. So that's why, for us, biosimilars, it's a mAb, and it's going to be a biologic. So we've always classified biosimilars as biologics and not generics. That's [ important ] and you've already picked that up. And absolutely, the -- all the stability testing, all the biocompatibility testing, that has to be verified by the biosimilar company. They have a blueprint because, at a minimum, they should use the quality that the innovator use. The innovator, though, may have launched the product 2 decades ago. And the regulations and the knowledge about all the frailties of that mAb could -- are known now, and it could suggest that they can't use the grandfather product, a component, that they need to go to an even higher-quality component. So that as we look at biosimilars, at a minimum, it will use what the innovator uses. But higher likelihood, they may use our highest-value product. And so when you take a look at biosimilars, you take a look at BLIs that are coming out -- BLAs that are coming out and all of that. That's why, as we're sitting here looking, especially for NovaPure demand, we continue to try to build ahead of the curve.

And so then if you are in a situation where there is this opportunity for the biosimilar maker to reevaluate, does that mean there is a chance of -- is there a higher chance of switching to like a competitor at that point in time? Are they reevaluating this? Or just because, historically, you were in the master file, you're going to be the ones that are sort of like this? You're to go-to first choice.

Well, I think that in any time a new drug comes to market, they have an opportunity to bring in a component. And so I think all the decisions that a biosimilar has is what an innovator would have that's new coming to the market. They're going to look at quality. They're going to look at scientific support. They're going to look at availability. They're going to think about how many different geographies they're going to try to put this into, not just the U.S., but in Europe, maybe even in Asia. They're going to take a look at track record. And they're going to put all that in. And so as our job at West is really to continue to improve on all of those metrics. And we keep a close eye on our participation rate, which is really high.

So speaking of competition, I mean, you have roughly a 70% share of this market, right, based upon what -- the numbers that we've heard over the years. So one would think, given the switching costs and how long you have to evaluate this, that you could take a lot of price. So how do you sort of -- I mean, we've got inflation going on, you've got oil costs, we've got energy costs, we've got wage inflation. So how are you thinking about managing that price dynamic? I mean, you've got this big lever you could pull, but I mean, you don't want to aggregate the customers. So how are you sort of thinking about all those things?

Yes. On price, in the past, we would have probably taken 1% to 2%. This year, we're taking 3% to 3.5%. And price is something that we have been studying at West to say where can we capture more value? And are there opportunities for increasing that price take? In some areas of our business, those opportunities exist; and in others, not so much. So it's not right across the Board. But I think in the times that we're in right now and with the inflationary cost pressures that we are seeing, and we've seen a certain amount through '22. When we look forward into '23 and look at energy costs and the likes, it's like who knows where that's going to go? So we have to be more flexible on price and bringing that to the customer where possible. And our sense is that, if we have a basis for doing that, then it's an easier sell to say, "Here, this is why I'm doing it. These are the factors." So we can explain it rather than just taking price for the sake of taking price, there's a rationale behind it. So that is something that we're looking at as a lever within our business. And -- but first and foremost, we're really cognizant of maintaining the long-term partnerships with our customers. And many of these partnerships have been built out over decades. So as you were saying, we don't want to antagonize them, but we have to be realistic in the world that we're living in today. And the pressures that everybody is under, every business is facing these same pressures.

Got it. And how should we think about the margin progression for the rest of '22 and then going into '23? I mean, there's a lot of moving parts, which we sort of looked at this mix and COVID, inflation and FX is a big headwind. And so walk us through the margin dynamics.

Yes. There are many headwinds. And we -- the margin that we are -- for '22 is embedded in our guidance. And that would indicate that there will be an increase in margin. Nothing like what we saw in 2021 and 2020. I don't want to guide '23. So what I would say, in our long-term construct, in normal circumstances, we would still expect to see a 7% to 8% growth and 100 basis points margin improvement. But we are cognizant of everything that's going on with inflation right now and cost pressures on our business. But that leads back into how are we looking at price? And so that's something that we're reviewing right now. We're also looking at our cost base within our business to see, is that appropriate for 2023? And do we have to make adjustments within that? And then looking for greater efficiencies within our operating infrastructure. So we're approaching it in a number of different ways, and even down to looking at what projects are we running? What's core to run right now and what do we need to fund? And are there areas that we can say, "Hey, I don't need to do this right now. I can push it out." So it's something that we are working through. But again, as you say, it's like a moving target.

Right. And how should we think about the CDMO business on this one, your contract manufacturing business -- not CDMO -- your contract manufacturing business, right?

Yes. On contract manufacturing, we did expect to see a down year in '22. So we called that out. But over the long term, we would expect that business to be growing mid-single digits. Margin-wise, probably tracking in the kind of high teens and similar to where it is today. But what we are looking at there is really looking at strategic partnerships within contract manufacturing and to make sure that the -- that, that growth rate is sustainable. And so again, looking at how we're modeling that business. But we do expect it to return to growth. The one thing that we're cognizant of is that it outpaced the growth of the rest of our business in 2017, 2018 time frame. That's not something we will be predicting at this point in time. So probably at that mid-single-digit growth rate.

Right. And just to -- for those investors, when I do it, I mean, it slowed down because you had some consumer business that went elsewhere.

Yes. Well, it slowed down because there was some consumer business, and then there was 1 or 2 supply contracts that some customers reduced their demand just for a specific period of time. Because within that business, customers are usually dual sourced and sometimes have 3 suppliers for the same part. So it's where do they place the demand at specific times? So we knew that was coming, and that's obviously built in, baked into our numbers.

So West has not been particularly acquisitive in his history. And when you have done, it's been more in the drug -- you've done some stuff in drug delivery. How -- it's not really been a big focus, the whole drug delivery segment of it in the conversations for the last couple of years for obvious reasons. But how should we sort of think about those products? I mean, when I -- when I first picked up coverage in 2007, drug delivery and Crystal Zenith were like the 2 big buzzwords, and those have not been buzzed in recent times. And so how should we think about the drug delivery?

On drug delivery, what we have seen is an uptick in interest, particularly around SmartDose and wearable combination devices. And so -- and that's been building over the last probably 2 to 3 years. So we are starting to see encouraging signs that there is a pathway to growth for this business. What I'm conscious of is not going back to 2007 and projecting this huge growth. It's going to take time. These are disruptive technologies. You have to give a time for market adoption and then for companies to want to use it. But we are seeing positive signals coming from customers within that space. And then from an M&A perspective, if you look at it, drug delivery is an area that we could further explore. We haven't been that acquisitive. When Eric joined, I think the first thing that needed to be done was the market units needed to be set up and get the organic growth story firing on all cylinders and to be more sustainable and consistent. We believe we've done that, then we had COVID for the last 2 years. And then the other thing that we had noticed, even in businesses that we have been looking at, is that the multiples that were being asked for were just so high, it was very hard to say, okay, yes, this works from a financial perspective for us. And so we kind of held fire. But we have built out our corporate development function. We put more resources into that to start looking at spaces that we can explore. So it is more of a priority for us. But again, it's all about can you get it at the right value and what makes sense. So we are very deliberate on how we approach M&A.

So thinking about -- so I'm bouncing around, my apologies. But thinking about, again, on the high-value products segment. Where are we in penetration of that point? And what sort of is the upper limit of that adoption?

Quintin will take that.

So from a sales point of view, if you look at our proprietary business, well over 70% of the sales are high-value products. From a volume perspective, we're probably about 22%, maybe a little bit more than that percent, is high-value products. There are going to be a percentage of products that we make on the standard side that will always be standard. If it's not a primary package, if it's not directly in contact with the drug, seals, blood collection, stopper, those will probably always stay standard. But if you look at it from the things that do touch, and there's some legacy products that do touch, every year, we see a percentage of them. Not much, but a few, that do migrate into the Westar wash or Westar sterilized format. And so that modest volume that does change comes at a fairly meaningful price change, going from $0.01 or so to maybe $0.05 to $0.10 apiece, and that helps with our mix shift. And we think that runway of being able to do that still gives us plenty of opportunity over the next 5 years to continue to see that type of mix shift. When you look at it from the new drugs that are coming out, primarily -- the primary component is going to be HVP because primarily a lot of the new drugs are biologics. And so they're going to use FluroTec and most likely NovaPure to come in. There will be some standard product that comes with it, like an aluminum overseal. So long answer to your short question. The percentage of standard product will continue to go down, but it's not going to go down to 0. There will always be a lot of West business is going to be on the standard side.

Got it. Any questions from the audience? I'll keep going. So just from a stock perspective, I -- out of curiosity's sake, back in July, I ran an analysis on my coverage universe, and I looked at the 2 best-performing stocks over the last 20 years that I've covered in my coverage universe. So the #1 was Illumina, but it was $1.50 a share back in July of 2003, so I don't think that counts. The second-best performing stock in my coverage universe is West in that time. So about that time, I mean by a mile, right? So what is your -- but yet, when people look at West, it's like, oh, it's always too expensive. It's always too expensive. And like that. So I guess, what has sort of -- what's -- when investors talk to you, what's the underlying reason why, even at these multiples, they want to own the stock? What's the compelling reason that has made the stock this massive outperformer over this history?

Let's just go back to kind of who we are: Highly critical to injectable drugs in the primary containment and delivery. Highly focused. All right? As you talk and so correctly notice that we don't do a lot of other things in M&A, we focus on that, we add technologies to that. And we're fortunate in that we have -- we participate in a sector, injectable drugs, that has secular growth, and the driver of that secular growth is biologics, which happens to use our best products. So I mean, it's almost as if you could say, if I wanted to be in drugs and then tools, I would want to be with biologics. And then we're there. The other thing is, is that because we're highly critical to the -- it's hard to change. And so one of the things that people don't -- they look at West, and it kind of goes other ways. We're pretty stable in terms of our strategy and how we work. We can get chop from quarter-to-quarter, whether it be on the upside, like COVID-19. On the downside, it could be when customers decide that their working capital is too high and they want to take down their safety stock. And so then they will put -- that happened a few years ago. right? Those are short-term changes and they can cause short-term chop. But if you look at our growth pattern and the dynamics of our growth pattern, it is pretty good organic sales growth and margin expansion. And that's what, as Bernard hinted, the long-term construct.

And cash flow has also dramatically improved over that time. I mean, it was a time when there was no free cash flow because you were doing so much capacity expansion. And now those metrics have also gotten a lot better.

Yes, I think the metric -- yes, those metrics have. But thankfully, that cash well spent because we needed equipment at some point. So it's getting the timing right. But there's -- like the regulatory moat around our business as well gives us some level of protection. I think as well when Quintin said, once you're specced in, you're specced in to a drug. And as long as there's no hiccups, you're with that for the life of the drug. And I think that's been very important for West. It's a globalized network. The infrastructure is there to support growth in any geography now at this point. And part of it for us was developing consistency about being able to deliver. And I think that kind of gives people some confidence around the stock. And as Quintin said, there's always going to be puts and takes and challenges, but [ that's what I think... ]

Speaking of challenges are -- has the China situation resolved itself?

Yes. The China situation for us was -- that there was some impact in the second quarter, but it was really immaterial. Our plants are back up and running. They were down for about 2 or 3 weeks. We actually had employees who came back into the plants and stayed -- physically stayed there 24/7 to be able to run product. So once they came in, they couldn't leave. So for us, we've got a really good workforce there. It's an area of potentially a lot of growth for us, even in-country. So it's back up and running.

I'm sure my director of research would love us to come in and stay 24/7 as well like that. So you recently did this deal, partnership with Corning to do more systems as opposed to sort of like just components to it. How does that -- how could that impact the business over time? I mean, clearly, this is just now starting. And that's -- as we've all said, it's like this takes a long time to sort of like -- all of this. So how should we sort of think about that relationship? And could you contextualize it in the competitive landscape and what it means?

Sure. I think let's just take a look at the industry trends. A highly regulated market. And the regulators have been increasingly insisting that companies demonstrate that their delivery devices work together as a system. And today, the components are selected by the drug companies. But you've got an elastomer company, you've got a glass company, you've got fill-finish, you're pulling all these things together. And then they go, "See? It's a system." Well, the regulators then say, "Oh. Prove it." And so then the drug companies have to validate it as a system, which means that they're going to turn to the suppliers and go, "Help us validate that it's a system." So we've been doing this and other suppliers have been doing this [Audio Gap]. We only affect the elastomers and the aluminum seals, so we can't control any other variables that come out there. The opportunity that we had with Corning was that we have a partner now who will help us make, to our specifications, components that we will then make with our specifications, high-end elastomer. And we're going to characterize the 2 together as a truly integrated system. And you're right, it does take time, but we think it's worth the effort because it addresses the needs that the industry has. We think it's going to create a lot of value in terms of quality, in terms of reliability. And we think it could be the next rung in our HVP journey.

Got it. Any questions from the audience? So I guess sort of wrapping up. As we're here, well, I sort of already asked this question about what's a -- what was underappreciated, misunderstood about West. But I guess, if you -- how do investor -- and this is a question I get from people. it's like I think people are generally positive on the component suppliers, the CDMO industry, bioprocessing, that whole industry. But how do we really gain comfort that there's all this magical, mystical volume out there? Because we don't have the sort of insight of the company's order books. I mean, we just don't see that, right? I think there's always going to be a little bit of skepticism that there's all this capacity out there and it's not going to get utilized. So how do we gain comfort into your visibility?

Yes. And ours isn't -- our growth rate isn't pure volume. So it's made up of some volume, but then a big part of it is mix shift, and then you've got the third element of price. So that gives us confidence, based on what we see happening within the market, that we're able to commit to those longer-term growth objectives. So it's not just pure volume. And what we've seen is, over the last number of years that, that is actually the case. So when you take out COVID and even go back '18,'19, those growth rates are what we have been seeing and delivering on. The pushback that we get from investors is they think 7% to 9% is too low. They're saying, "Well, you're doing right now, you're doing like double-digit organic growth on your core business. Why can't you commit to that long term?" So I'm getting the opposite question that you're getting. But over the long term, that 7% to 9%, for us, is achievable, okay? If we do more, great. So they were asking us different questions.

Well, that's because you get more people who want to actually buy your stock versus where I probably get more people that want to short your stock. It's probably the simple answer to that. But once again -- but then again, as I sort of alluded to, the stock chart, would sort of indicate that, over the long haul, that's a very difficult thing to do. And with that, we're out of time. Thank you once again for being here. Thanks everybody for listening.

Thank you.

Thanks for putting up with us.