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

All right. Good afternoon, everybody. Welcome to the final session of Nashville 2022. We're going to end with a good one. I'm Jacob Johnson, the life science tools and former services analyst here at Steven. Really pleased to be joined with the team from West this afternoon. We have the man of many hats, Quintin Lai, VP of Corporate Development, Strategy and Investor Relations; and then Chad Winters, VP and Controller. So fireside chat format. I'll run the Q&A but try to open it up to the audience here. And with that out of the way, Quintin, I'll turn it over to you for any opening remarks, and then we'll launch into Q&A.

Well, thank you. And on behalf of West, Chad and I would like to thank you, Jacob, and your associates for hosting us here at this conference at really well-run conference, and we've had a very good day of meetings. So thank you again. So for those of you who may be not as familiar with West, I'll just give you a quick rundown. We are a global leader in primary packaging and delivery of injectable drugs. -- we manufacture stoppers, plungers, seals. We do wearable devices. We do contract manufacturing where we're making injection molding components used in diagnostic devices, injection devices. We have 25 sites around the world, and we have been on this journey for the last 100 years, powered mainly by the growth of the injectable drugs industry and in particular, over the last few years by the biologic injectable drug industry.

So. All right. Perfect. So I appreciate the high-level comments, which means inevitably, I'm going to turn to some of the near-term dynamics, but I promise we'll come back to longer-term opportunities. So just maybe with that as a jumping off point, third quarter results a bit lighter than we and I think you likely expected. Maybe with that as a starting point, just talk about the headwinds and what drove the shortfall in the quarter.

Sure. So as we were entering into Q3, as expected, COVID-19 sales started to decline year-on-year. And then with that expected decline, we knew that we had capacity that we would then be able to dedicate to processing products that have had really long lead times because due to the pandemic, we have been prioritizing components used for COVID-19 vaccines, which meant that lead times from some of our other products lengthened. And in some cases, orders that customers place for 2022 delivery were being pushed out to 2023. So as that capacity freed up, we were able to bring in some of that -- those orders. Now when we do so, they're not as productive. I mean it's our base business, which means multiple SKUs for multiple customers compared to COVID-19 products were fewer SKUs and higher runs. So there's just a productivity mismatch. What we expected though was that we expected to be adding capacity, especially in a couple of our North American high-value product manufacturing sites. And as the quarter progressed, we hit some project delays, which meant that we were unable to get that -- that incremental capacity online. So even though our non-COVID base business grew in the quarter, it didn't grow as much as we had anticipated.

Yes. So I think you called out equipment downtime was maybe a $30 million revenue headwind in 3Q. As we think about your guidance for the year and what it implies for 4Q, is there any way to frame up how much of a headwind there is in 4Q from it?

Yes. So by not being able to bring on that additional capacity, Jacob, we estimate there was about a $30 million shortfall in Q3. So when we reframed guidance for the year, what we assumed is that the issues that we had in Q3 would be resolved by early 2023. So that means that Q4 will have a full quarter. So you can take that $30 million, which impacted us in September and kind of bring it across the full Q4.

Okay. Got it. And then just in terms of your guidance assumes it comes online in early 2023, but I would assume you're working harder to get it done sometime before then. Any thoughts around that?

So the teams are working through those issues. The equipment -- especially the equipment that we're talking about, it is in place -- it is being installed. We're going through the processes. We've informed customers who have to go through their own validation process. So again, we feel good about the time line that we set, and we look forward to updating you as we continue to make progress.

Got it. So this seems to be a supply issue, not a demand issue. But I think investors are broadly concerned around the near-term demand environment. So maybe no shortage of things people are worried about, but why wouldn't stocking biotech funding kind of impact demand for your high-value products?

Yes. I mean, I think, first, if I start with the biotech funding, right? That happens at such an early stage in the process from a drug development perspective. And we're really more influenced by commercialized products. But from a stocking perspective, this is something that we discuss with our customers frequently. We're monitoring buying patterns or monitoring orders. So we're not seeing any anomalies right now associated with that, but it is something that we're constantly keeping an eye on.

Yes. I mean does the share number skews you have, I mean that it's probably less likely that you're seeing stocking? And maybe if you are seeing anywhere beyond the COVID side, if anywhere?

We certainly -- yes, I should have clarified that. Yes, you're absolutely right. On the COVID side, there continues to be volatility and there likely is some destocking going on there. I mean the volume certainly could contribute to that.

Okay. And then just to get it out of the way, $90 million of COVID revenue in 2023, how much benefit does that assume from lower dose profiles? And maybe any updated thoughts on lower dose for vials?

So over the period, we've already been supplying components of different sizes for different vial configurations. So really, the -- as we were formulating that as our preliminary guidance for 2023, it's based on what our order book looks like now as well as conversations that we're having with our customers. And so that's what's driving it. And I think less about the -- how much is going into multi-dose versus single dose and more how many doses just in general are being ordered.

Yes. Got it. That makes sense. So you did get some frameworks around kind of the 2023 revenue outlook, but there's one piece you didn't give too much disclosure on, which is the outlook for margins next year. And that's the #1 question investors have and Quinn smiling at me casinos this one is coming. So if we use 4Q as a jumping off point, it would seem to imply gross margins in the low to mid-30s. Can you just talk about how much of a drag there is from the lack of equipment? And do you have certain lines where you're essentially bearing 100% of the costs but not generating any revenue.

So let's kind of look at the fourth quarter. And let's look at the -- what we're seeing right now is that we anticipate COVID sales to decline approximately $80 million year-on-year -- we're going to -- based on our October guidance, we see FX headwinds -- we don't anticipate any change in the inflationary trends that we've seen throughout the entire year. On the other side, where we have been getting some pricing. And so in the first half of the year, it was around 3.4%, 3.5% in Q3, it was about 4.4%. And so probably a similar amount in Q4. And then what we've assumed is that no incremental volume coming in from new capacity. And so what it means is that we're missing is that ability to bring on that incremental HVP sales and which would also help given the fact that with our overhead absorption. So all the -- you've got 3 headwinds FX, COVID, inflation, no change in the pricing and no incremental. And that's kind of what drives both the gross and operating margin that is implied with our guidance.

Okay. And then the other thing you alluded to earlier was this productivity gain around core because you're making a lot of the same component over and over again. Is there any way to -- you had really impressive margin expansion the last couple of years. Some of that certainly was from base business growth, which was strong. But there's also the COVID piece of it, and that had did have some productivity gains. Is there any way to frame up how much of the margin expansion in the last couple of years was from productivity gains?

Yes. Good question. So the core business, the base business over the last few years has grown in excess of our financial contract. And if you look at the components of driving that, they were HVP sales. It was NovaPure and FluroTec in our biologics business. It was Westar. And in some cases, NovaPure in our generics and pharma business. And so given the makeup of that drivers of the base business over the last 3 years, we believe, and we estimate that we would have exceeded that financial construct of 100 bps of operating margin expansion per year. Now that said, COVID sales were also layered on top, and they have an even higher percentage of HVP sales compared to our base proprietary products business, which makes them even more profitable and brings even more incremental sales growth. So the answer is that the expansion that you've seen over the last couple of years, it was both. And so we just break it out like that.

Yes. Okay. Well, I'll try one last one and that promise we'll move off this topic. But $90 million of COVID next year. That's not dissimilar to 2020. I have to feel I know the answer to this, but any reason why that's not it may be a fair comparison of how people should be thinking about margin next year in proprietary products.

Yes. So we haven't given guidance to 2023 -- but on your hypothetical, yes, I guess, if you could tell me, is your hypothetical also that costs are going to be like 2020, right? So how about this? Let's look at it this way. Next year, what we see is that we expect a drop in COVID sales. So going from approximately about $280 million of COVID. And we've already said they are more profitable than our base business. We didn't guide to FX because we only gave organic sales growth guidance. What we said is that we anticipate at least growth -- so that implies that at least low teens and proprietary, that assumes that we're bringing on new capacity online, especially all the issues that we had. But we didn't give you what the number could be. We're right now working through our issues. And when we give our guidance, we'll be able to have that for you. So there's potential upside to that. And then on the other side is the pricing. We never did -- you know what we've done for pricing so far here in 2022. And what we said on the call is that we're in the process of informing customers of our 2023 pricing. And again, that is a TBD as well.

Okay. Last margin question, and I promise the sign. Just in terms of -- there's been a shortage of inflationary pressures this year, I think freight costs, energy costs, labor costs come to mind. Can you just talk about how those have trended throughout this year? And any thoughts about that into next year?

Yes. I mean I think you hit the right ones, right, freight, labor, raw materials, energy costs. No doubt that's been a headwind all year. That's been factored into our Q4, what we said last month for the fourth quarter. But again, it's too close to tough to call right now for 2023, that's also factoring into those pricing discussions, obviously, with the customers are being very transparent in having these discussions...

Would it be fair to say energy, labor, probably still some pressures there. We cover a bunch of transportation companies here. It sounds like freight costs may be that's cooling off a little bit right now. Is that fair? Or are you guys still seeing pressures from that?

I think we're still seeing some pressures there.

Yes. Okay. All right. Okay. Let's kind of think longer term or more interesting things. Just within high-value products, let's make set COVID aside because that was also a lot of FloorTecnoVO here. Can you just talk about the mix shift you've seen within high-value products in the kind of the base business as it relates to FluroTec and toupee in recent years?

Sure. So when we look at mix shift, there are 2 major drivers there. One is pipeline drugs. So drugs that have been approved over the last few years, predominantly are biologic -- and since we've launched NovaPure, many of them have adopted NovaPure. And as those drugs have gained traction, expanded their indication entered into new geographies. The volumes are growing, and that has been powering our sales from the mix. So really, it's more the -- not necessarily a conversion of FluroTec NovaPure, it's just adoption of NovaPure over FluroTec, because FluroTec used to be the premium product a decade ago. Now it's NovaPure.  On the other side, it's legacy customers. And those legacy customers that were perhaps in the past, buying standard product from us and Washington sterilizing themselves for a variety of reasons, they've decided to move up and adopt our Westar process, which means that we will then wash and sterilize and there's a meaningful jump in ASP. So the volumes are still the same. It's just that now we're selling HBP process. And then there's another subcategory of customers that were already buying one level of HBP and perhaps moving to, let's say, a vision inspected project product, which would also give an ASP boost. And so both have been successful for us here, and we anticipate we'll continue to be so here over the next few years.

Okay. I think something I think most are familiar with the story I understand, but I think it's an important piece of it is high-value products, a meaningful portion of revenue. But in terms of units, low 20s still? Like how much runway is there for -- in that journey? Unit perspective.

As we look at it, you're right, Jacob. I mean in terms of penetration of HBP in terms of our overall, it's still modest. If you look over the last few years, it's been growing about 100 bps of volume improvement every year. And we think that we still have continued runway for that for the next few years. And again, it's going to be a combination of conversion of legacy. It's a modest number, but what we're seeing is that customers only move up in quality. They don't move down. And then second is pipeline. And the pipeline drugs that are coming out now, they're almost all starting at the HVP level. And so as they launch and have successful expansions, again, that also will then drive the number of HVP components.

Got it. And then just kind of focusing again on FluroTec NovaPure. As we think about executed growth next year, you have COVID rolling off, which I think has a lot of floor Technip. But where are you adding capacity? Well, it's FluroTec NovaPure. I think Eric mentioned maybe NovaPure plungers is a key area of growth next year. Can you just talk about kind of ex cover demand for -- within high-value products where you're seeing the most strength there?

So yes, so in the short term, which is the -- what impacts in the third quarter, that was more just HVP processing. But we also have expansion projects that are going on now at all of our HBP sites both adding equipment in existing facilities as well as building expansions or brownfield expansions, if you will. And some of those brownfield expansions are going to be for dedicated NovaPure capacity. And what we're seeing is that there is growing demand, especially on the plunger side, which would suggest an increase in demand in the prefilled syringe... Market.

We'll get to maybe some of the demand drivers behind that. But maybe first, we'll take a little bit of a detour. And just talk about the journey on the high-value products. You talked about FluroTec being the previous kind of high-value product and then NovaPure came along. You've got this interesting partnership with Corning. Can you just talk about the strategy behind that relationship, what the value proposition will be for customers and then time line and financial perspective, what it could look like?

So if you look at the journey from FluroTec to NovaPure, what there is you see the importance of quality by design and how customers value that concept value the improved quality reliability that comes with packaging their precious drugs. And you can see how they've embraced that. And it's because not only do they get better reliability, they get better yield, but it also fits the regulatory environment because the regulatory environment is pushing for QBD type of principles as well. The similar thing we think is happening on drug device combination products. We see it firsthand when we develop our wearable technology, the requirements that the regulators put our customers and us through to show robust performance for putting a drug in a dedicated device. They're taking a look now at, okay, taking some of that drug device combination therapy? And how can that work as for components that are right now fragmented for a elastomer, the fill finish and brought together and call the system, but they're really not truly a system because it's separate drug master files for each component.  So the opportunity we have with Corning is that we're working with an established glass supplier, the tremendous technology and skill set and resources that they have. They have ability to supply both borosilicate glass as well as aluminosilicate glass which has superior properties in many ways to bore circuit glass. We will be -- we're investing with them. We're investing in manufacturing. They are going to be making product for us. And the goal will be a designed integrated system, glass elastomer that will live under a single drug master file. It will be the industry's first truly integrated system and will no longer be fragmented. And we think that it will bring value to the customer, both in terms of quality, reliability, potential yield as well as fit within the framework that the regulators are setting for things to work together as a system.

And as we think about that, is that something you could convert existing customers to? Or should we think about that as something kind of for new launches that's more of an opportunity?

I think that given the -- how our industry works, understanding that we do work in a high inertia business where change is not easy for people who've already adopted products. It will probably follow what we -- our NovaPure experience, which is that drugs that are in the pipeline and as they go through their different clinical phases, will then start to spec in. And then when they get approved, that's when we'll start to see the first adoption.

Okay. And then just remind me the time line for kind of when that gets commercialized, what that looks like...

We haven't said it's just -- we are in the process -- we announced this year. We're investing in facilities, pilot facilities. We're doing the development work. And so we'll keep you updated as we continue to make progress...

Okay. Got it. And then there's delivery devices, which I think are a little bit different than how we think about high-value products, but you could argue that they're super high-value products. Can you just talk about what SmartDose and SelfDose are for those who are less familiar.

Sure. So we'll start with SelfDose. SelfDose is our design for an auto-injector. It is a patient-powered auto-injector -- unlike the auto-injectors most of you are familiar with, is a spring loaded. This one is something that you can place on the body and with the palm of your hand, push and apply -- press the plunger to have it inject into the body. It's great for people -- for drugs that are being delivered, self-delivered by patients who might have dexterity issues -- and so we see it as a niche product that fits applications for that category. SmartDose is a wearable device that you can -- that can range from 3.5 milliliters, up to 10 milliliters. The concept is that you can take a drug that would -- you can't formulate down easily to a prefilled syringe or an auto-injector, and instead fill it into that device, it be user-filled -- the patient will place it on their body, push a button and then over a period of time, whether it be minutes, whether it be hours depending on what the drug customer designs, it can deliver that dose into the body. And the real advantage here is being able to take drugs that are currently infused in a clinic or in a hospital, take that IV bag drug, reformulate it down to, let's say, 10 ccs and then be able to have it have the customer be able to apply it at home. So it is a trend that I think is just only accelerated since the pandemic, with now an understanding that patients really do prefer the ability to be able to self-administer as opposed to having to have to drive in and go see a clinic every 3 weeks.

Yes. So if I'm not mistaken, I didn't get these confused. I think Smart just received its fourth approval. Okay. I got a nod, that's that right... Just that last point you made, I think it makes a ton of sense, and we probably haven't talked a ton of SmartDose and itself does over the last couple of years because there's COVID to talk about. But that trend at health care movement home is pretty powerful. Like if we look out the next couple of years, do you think these become kind of a bigger piece of your business if the world is moving that way.

So it's one of those things where you're right. We don't talk about it very often on the calls, but the interest level continues to grow -- higher and higher. And it's not just from new drugs, but it's from existing drugs that are reformulating and moving from IV to subcu. And so we -- you're right. We've had 3 approvals this year, and we have a very good pipeline of candidates that are looking to move to SmartDose.

Got it. And then maybe it probably relates more to SelfDose than SmartDose, but I'm curious kind of your thoughts here, Quintin, which is it seems to be some pharma companies have developed their own pens, their on delivery devices. Is the target customer for SmartDose and SelfDose kind of mid-sized biopharma? Or is the offering more differentiated than that? Just kind of curious your thoughts there.

Yes. So good question. So for SmartDose, no, it is for -- some of the largest companies as well as some of the smallest company. So because the SmartDose wearable infuser is the only one out there, it's gotten a traction from a variety of customers. In the case of auto-injectors, yes, auto injectors is a little different. There comes -- sometimes companies have their own design -- and in that case, we'll work with them on the contract manufacturing side. Sometimes they don't have their design, and they're looking for something unique and there's where our self-dose product provides something that -- again, it's not for everyone, but it is a differentiated product that does fit a niche.

Okay. And then as it relates to kind of customer pens that they developed, you mentioned contract manufacturing, maybe it's an opportunity on that side of the business. Is there any -- for the people who manufacture those pens, is there any -- are you selling proprietary product components to them for that at all?

So if it's an auto-injector or a pen, most likely inside there, there's going to be a cartridge. And if there's a cartridge, it's going to be a plunger. And on the other end of the cartridge, if it's a reusable auto-injector, where you're putting needles in and out of it. There's just going to be a multilaminate seal on the end, and we would participate in both of those.

Okay. All right. So then as we think about end markets and key growth drivers, maybe a couple just to run through diabetes and weight loss drugs and neuro drugs seem to be where there's some interest from investors. Can you just talk about those end markets as potential opportunities for West.

We don't go to that ad. But what we said is that it is an exciting time to be a supplier in the injectable medicines market. And because of that and because of the enthusiasm of some of our customers that they're seeing, we have not slowed down our capital projects. So even though we're seeing or expect to see a drop in COVID-19 sales in 2023, we are moving forward with our capital expansion plans, and we've got capital expansion projects at all 5 of our sites going on right now.

Okay. And then maybe just last kind of end market question. biosimilars, those are coming next year and probably will continue to come after that. Can you just talk about maybe the level of high-value product a biosimilar may use versus the originator given the originator was developed years ago when Pre-NovaPure didn't exist.

So the name says it all. It is similar to the innovator drug, which means it's a macro molecule, which means it's going to have all the frailties that the innovator drug has to the drug packaging, whether it be extractable leachables, whether it be silicon oil, whether it be -- whatever that comes along with it. And so with it, at a minimum, they will use the HPP packaging, most likely that the innovator used. But what we're seeing in some cases is that they are looking to move up toward NovaPure. And in some cases, they're even looking for even better than what we have with NovaPure. And so it just kind of underscores that just because it's a biosimilar, they actually have higher concerns of improving quality.

Got it. Maybe I'll pause there to see if anybody in the room has any questions. If not, I've got a couple more. Go ahead. For those listening, the question is, your Bard, can you take 2019 margin -- and if you're assuming COVID goes away, can you add 100 bps a year? And should that be what 2022 looks like? And maybe Quintin just talk about the ex-CovA growth over the last couple of years and maybe what the -- I'm not sure you're going to tell us what the number would be ex coded, but why it probably was maybe more than 100 bps over the last couple of years.

No. Thank you for the question. So the way to look at it is -- so perhaps we can use Q4 as an instructive way to look at it. Our implied guidance for the fourth quarter of this year is for EBIT margins to be a shade under 20%, right? Compare that to your, what, 16% that you had in 2019? And what do we see in Q4, we see large COVID headwinds, we see FX. We see inflation with some offset in price and no incremental capacity coming online that brings in incremental HVP sales. So what we anticipate is that we're going to be bringing on that incremental HBP capacity next year. And we think that, that EBIT margin that we implied in Q4 is not a number that we would move forward with. It should be better than that..

All right. We've talked a lot of proprietary products. Just contract manufacturing. Can you just talk about the factors that weighed on growth in 2022? And then you're, I think, pointing to that returning to growth in 2023, just how much visibility you have into that?

You given -- Quintin voice break. Thank you, Chad. Yes. So as you rightly said, right, we -- 2022, we saw a slight decline. We had visibility to that, right? So that was in our guidance at the beginning of the year. That wasn't a surprise. As we said on the call in October, return to growth, that's probably that low single-digit growth. But the same visibility that the transparency of our customers working with our customers that we had at the beginning of '22, we're heading into 2023 with that same visibility based on our production schedule with customers.

And Chad, is that a business that just inherently kind of can shift around year-to-year. And that proprietary products is more of the story and the key growth driver. But like is that a business given the nature of it being outsourced that there's only so much you can control what it's going to look like in a given year? Well, I mean...

I mean, if you look back in 2022, right, we had a customer that decided to move some of those volumes to a different supplier. So that's obviously out of our control. So that's certainly a dynamic that can happen.

Okay. Then maybe capital allocation. Glenn, let's start with something you mentioned one of the recent questions is you're still going forward with capacity expansions. Traditionally, maybe CapEx has been a little more modest, but given the growth you've seen in the last couple of years been kind of through an investment cycle. How should we think about this kind of duration of this CapEx investment, kind of stepped up CapEx investments you've made in the last couple of years... Or chat?

So the way we look at it is -- looking out on the long horizon and our financial construct of 7% to 9% top line and 100 bps of margin expansion per year. In that type of environment, we think 6% to 7% of sales for CapEx should be the appropriate amount of reinvestment to support that top line growth. Now everything comes with an asteric and when there is indications of upside demand for that, then we have to build ahead. We are in a business where capacity addition is something that takes 12 to 18 months to get in place. And so because of that, we have to build ahead of the curve in order to make sure that we can meet the customer expectations...

Got it. And then maybe last question for me. Just on capital allocation. I think since Eric came on board, very focused on organic efforts, and you guys have done a great phenomenal job there. But you have mentioned the potential for M&A over the last year or so. You've done some interesting partnerships like the Corning one, but just kind of any thoughts on M&A and what could be interesting to you?

Sure. Well, you're right, Jacob. I mean the #1 focus for the capital allocation has been organic sales growth and just been CapEx. We're always looking for opportunities to bring more value to the industry to patients. And really it just starts with that. M&A for us is all about the value creation -- we want to do it in such a way that we are bringing together something that's differentiated, something that because the industry is -- has a high inertia to change, it has to be something that is much better than whatever the incumbent is out there. And so the combination with us brings that synergies. And so with that, most of what we've been doing is mostly technology, licenses, sometimes equity investments. We -- when the opportunity comes, we'll definitely take it, but that's our strategy.

Got it. All right. Quintin, Chad, -- thank you... So much for being with us in Nashville today. We really appreciate it.

Thanks, Jacob.

Thank you.