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West Pharmaceutical Services, Inc. (NYSE:WST)

Q3 2008 Earnings Call

November 4, 2008 9:00 am ET

Executives

Theresa Kelleher - IR, FD

Don Morel - Chairman and CEO

Bill Federici - VP and CFO

Analysts

Arnie Ursaner - CJS Securities

Larry Marsh - Barclays Capital

Ross Taylor - C.L. King

James Sidoti - Sidoti & Company

Operator

Good morning and welcome to the West third quarter earnings conference call. At this time, all participants are in a listen-only mode. (Operator Instructions). Today's conference is being recorded. If you have any objections, you may disconnect at this time.

Now, I will turn the conference over to Ms. Theresa Kelleher from FD. Ma'am, you may begin.

Theresa Kelleher

Thank you. Good morning, and welcome to West third quarter 2008 results conference call. As you know, we issued our results this morning. The release has been posted on the company's website located at, www.westpharma.com. If you have not received a copy of this announcement, please call FD at 212-850-5600, and a copy will be sent to you.

Before we begin, I would like to remind you that certain statements that may be made by management of the company may contain forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These forward-looking statements set forth anticipated results, based on management's plans and assumptions. Such statements give our current expectations or forecast of future events. They do not relate strictly to historical or current facts. In particular, these include statements concerning future actions, future performance or results of current and anticipated product, sales efforts, expenses, the outcome of contingencies such as legal proceedings and financial results.

We have tried wherever possible to identify such statements by using words such as estimate, expect, intend, believe, plan, anticipate, and other words and terms of similar meaning in connection with any discussion of future operating or financial performance or condition. We cannot guarantee that any forward-looking statement will be realized. If known or unknown risks or uncertainties materialize, or if underlying assumptions are inaccurate, actual results could differ materially from past results, and those expressed or implied in any forward-looking statements. For a non-exclusive list of those factors, which could cause actual result to differ from expectations, please refer to the factors listed in today's press release.

Investors are also advised, however, to consult any further disclosures the company makes on related subjects in the company's 10-K, 10-Q and 8-K reports. The company undertakes no obligation to publicly update forward-looking statements whether as a result of new information, future events or otherwise. In addition, management may make reference to adjusted operating profits and adjusted diluted EPS that are considered non-GAAP financial measures. These measures have no standardized meaning prescribed by US GAAP and therefore, may not be comparable to and should not be viewed as a substitute for US GAAP operating income and diluted EPS.

Reconciliations of the non-GAAP financial measures to the most comparable financial results prepared in conformity to GAAP are provided in the materials accompanying this morning's earnings release. This call is being recorded on behalf of West and is copyrighted material. It cannot be rerecorded or rebroadcast without the company's express permission. Your participation on this call implies your consent to our taping. Once management has concluded their remarks, we will open the floor for questions.

At this time, I would like to turn the call over to Dr. Don Morel, Chairman and CEO.

Don Morel

Thanks very much, Theresa, and good morning, everyone. Welcome to West's third quarter conference call. Thank you for taking time to join us this morning. As Theresa mentioned, joining me for the call are Bill Federici, West's Chief Financial Officer, and Mike Anderson, our Treasurer and primary Investor Relations contact.

I will begin today's call with a brief summary of our consolidated results and then provide a quick update on our ongoing expansion programs and major new product development projects, then close with an overview of our expectations for the fourth quarter and outlook for 2009. I will then turn the call over to Bill, who will take you through our quarterly results in greater detail.

We reported consolidated revenues of $256.2 million for the quarter, up 5.6% over the third quarter of 2007. Third quarter diluted EPS from continuing operations came in at $0.40 per share versus the $0.36 that we reported last year.

We are satisfied with these results in light of the unprecedented turmoil in the global financial markets, which reached its peak in mid-September and considering that the third quarter is traditionally the hardest for us to forecast, because of European summer plant shutdown and changes in inventory plans by our customers during the last half of the year. Predicting customer order patterns in the third quarter is further complicated by the fact that several of our large customers end their fiscal years on September 30.

As we mentioned in our press release, comparisons with 2007 are difficult due to non-recurring sales of erythropoietin stimulating agent, or ESA, packaging components and Exubera inhaler devices, the impact of a settlement with Nektar Therapeutics, restructuring charges, and several discrete tax items in both periods.

Excluding the effect of these items, adjusted operating profit fell slightly to $19.7 million in the quarter, resulting in adjusted earnings per diluted share of $0.37 versus $0.42 in the third quarter of 2007.

Excluding the $14.1 million in non-recurring sales from the third quarter of 2007 and the related $0.10 profit impact, sales on a constant exchange rate basis grew approximately 8% and adjusted earnings per share increased from $0.32 to $0.37 per share.

Our gross margin was 25.7% compared to 26.5% in 2007, with the decline attributable to product mix, inefficiencies resulting from the plant shutdowns in Europe and a significant lag in our ability to recover raw material cost increases under the terms of our supply agreements.

I would also point out that our margins, this quarter is impacted by the incremental expense of our ongoing expansion programs, particularly within our European facilities.

With all that said, through the first nine months of the year, adjusted earnings from continuing operations are $1.83 per diluted share.

Turning to our segment results, organic growth in key Pharmaceutical Systems product lines, coupled with the positive effects of foreign currency transaction, effectively offset sales declines in packaging for ESA drugs and the discontinued manufacturing of a diagnostic component. Normalized sales for the period grew approximately 9% with solid demand across most of our product lines.

Within the Tech Group segment, although, revenues fell just over 4% as a the result of the discontinuation of the marketing of Exubera, Tech continued its improvement through the strong demand for disposable delivery systems, medical devices, and carton fitment coupled with much improved operating efficiency at our Puerto Rico and Grand Rapids facilities following the restructuring implemented at the end of last year.

Gross margins improved by 1.7 percentage points overall to 14.4%. Bill will provide greater detail on our segment results in a few moments. However, overall, I would say that our quarterly, and year-to-date results, reflect the underlying strength and resiliency of our core business, and our success in offsetting higher cost through an effective combination of efficiencies and carefully selected price increases and [cost savings drug].

With regard to ongoing expansion and development programs, I am pleased to report that all of our major programs remain on plan. Our ongoing capacity expansion projects in North America, Europe, Singapore, and China remain on schedule. We are nearing the completion of our assessment for potential building locations in India for a manufacturing site. We continue to make progress on all of our Daikyo CZ resin development programs.

During the quarter, we filed a 510-K with the FDA for [NovoGuard], our passive needle safety system, and Phase 2 of our SAP conversion in North America remains right on schedule, with three plants converted to-date. Overall, our financial condition remains stable. Our balance sheet remains strong, allowing us to fund both our development programs and our ongoing capacity expansions through our operating cash flows.

In addition, the structure of our debt requires no new financing until April 2011, when our revolving credit facility will need to be refinanced. We will continue to manage our finances conservatively in the months ahead, creating value for our shareholders through the execution of our long-term strategic plan.

Looking forward to the remainder of the quarter, our order book continues to strengthen. On a positive note, our Q4 orders are currently at greater than 95% of forecast for the quarter, and we have received several significant orders for coated product, including our first ESA packaging order in approximately 12 months.

Although the market price for crude has recently declined dramatically, we continue to pursue actions to mitigate the impact of these cost increases on our profitability through a combination of SG&A spending controls, further efficiency and cost savings initiatives in our operations, price increases, and raw material surcharges where appropriate.

While these initiatives will cover a significant percentage of the negative impact, the contractual lag with several large accounts and potential further price increases from vendors during the remainder of the year will have a moderating effect, primarily in North America, on our operating profit for the full year. Also, our exposure to foreign currency, and in particular the euro, will not have the same benefit as the first half of 2008 due to the substantial strengthening of the dollar in recent weeks, as a little more than half our sales originate outside the North American market.

Taking all of this into account, Q4 adjusted earnings are expected to fall in the range of $0.55 to $0.60 per fully diluted share on sales between $250 million and $255 million. This assumes a dollar-euro conversion of $1.40 per euro, and would yield full year adjusted earnings per diluted share of $2.38 to $2.43 at or slightly below the low end of our recent guidance of $2.40 to $2.50 per diluted share. However, should the euro remain at approximately $1.30 to the euro, the fourth quarter EPS impact would be approximately $0.03 per diluted share.

Many of the challenges previously discussed will remain with us through the end of the year, specifically, fluctuations in energy and raw material prices, currency fluctuations and continuing changes in our customer inventory policies. Our 2008 guidance includes our best estimate of the full year impact of these cost increases and forecasted customer demand to-date.

Normalizing our sales and earnings for the year, excluding the impact of lost sales from 2007, and the impact of currency translation, would yield sales growth of 6.4% and EPS growth of 16% versus prior year. Given that we started the year with a roughly $60 million sales gap and an operating profit shortfall of approximately $25 million versus 2007, and faced with a less than favorable economic climate, 2008 is shaping up to be a solid productive year from an operating standpoint.

Turning to 2009; based on current order bookings and forecasted customer demand, our current expectations reflect sales growth of 7% to 9% at constant exchange rates, with an improving gross margin. As we have in the past, we will provide greater detailed earnings guidance during our year-end call in February of 2009.

Looking at the longer-term, the fundamentals driving our growth remain intact. That is, global demographics support an increasingly aging population. This population presents a greater incidence of chronic disease, and these diseases more frequently are treated with drugs of biologic origin. A broad range of new biologics are entering late-stage clinical trials, including novel vaccines. As, these drugs are all at the current time delivered by injection or infusion.

The parenteral market continues to migrate towards combination products, where the primary drug container is integrated into the delivery platform. Advanced Western healthcare options continue to make inroads into developing countries like China and India. Taken collectively, these factors strongly support our continued growth in 2009.

Given our global manufacturing footprint, our strengthened biologics packaging, and our pipeline of novel delivery devices, I believe West is extremely well positioned to take full advantage of these opportunities in our key market segments. We believe our value proposition remains fundamentally sound and that the strength of our current product portfolio, coupled with the depth of our balance sheet, will result in continued growth in the years ahead.

With that, I will turn it over to Bill for his comments on our financials. Bill?

Bill Federici

Thank you, Don, and good morning, everyone. As indicated in this morning's press release, West reported third quarter 2008 income from continuing operations of $13.3 million, or $0.40 per diluted share.

Our operating earnings in this quarter included a net after-tax gain of $1.1 million, or $0.03 per diluted share for the combined net effect of two items: a $2.2 million discrete tax benefit related to a reduction in the required tax reserves and an additional $1.1 million of after-tax carrying cost that we have incurred while reconfiguring the former Exubera facility to begin to produce other device products.

Excluding the net positive effect of these two items on earnings, third quarter 2008 earnings from continuing operations were $0.37 per diluted share, compared to last year's third quarter adjusted earnings of $0.42 per diluted share.

It is also important to note that last year's $0.42 third quarter included $14.1 million of sales, the equivalent of $0.10 per diluted earnings share of earnings, from the Exubera device, ESA drug, and disposable medical device components, products for which we had almost no associated third quarter 2008 revenues.

The company's consolidated third quarter sales were $256.2 million, a 5.6% increase over third quarter 2007 sales. Excluding exchange effects, consolidated sales increased by 1.7% over prior year quarter.

At $190.5 million, third quarter sales in the Pharm Systems segment were 9.6% above 2007 third quarter sales, with 4.7 percentage points of the increase due to currency effect. Relatively modest growth was expected due to the $6.8 million decline in sales associated with the ESA drug situation and the discontinued production of the disposable medical device components in Europe.

Excluding the effect of the lost sales and favorable currency translation, third quarter 2008 Pharm Systems sales grew 9.2% which is in line with our longer term growth expectations. Growth was driven by increased sales, mostly in Europe, of non-coated stoppers used in vial packaging for a variety of products and higher sales of the company's flip-off seals and safety administration system products.

The Tech Group segment generated sales of $68.3 million in the quarter, 6.2% below sales in the prior year quarter excluding exchange, largely due to the loss Exubera sales. In the third quarter of 2007, sales of the Exubera device were $7.3 million.

Excluding the Exubera sales and currency affects, Tech Q3 2008 sales were up 4.5% versus Q3 2007. Serving to partially offset the sales losses were solid increases in demand for several specific products, including IV and blood filter products manufactured in our Michigan and Puerto Rico facilities, insulin pens made in both our Tempe and Dublin facilities, our SpoutPak closures for juice and dairy cartons, and components used in an intranasal allergy product.

Looking at margins, consolidated gross profit margin for the quarter were 25.7%, eight-tenths of a margin point below the 26.5% margins we achieved in the third quarter of 2007. As we have previously addressed, our margins are historically lower in the third quarter due to the reduced production output resulting from our summer plant shutdowns.

This year's consolidated third quarter margin was roughly even with last year's, if you eliminate the seven-tenths of a margin point drop in consolidated margins attributable to lost Nektar, anemia drug packaging and disposable medical device sales.

Gross margins in the Pharm Systems segment were 29.5%, 2.3 margin points lower than in last year's third quarter, with declines in both the North America and Europe-Asia units. The decline is primarily due to the effect of increased raw material, labor, and utility costs, which were not fully recoverable through sales price increases, an unfavorable sales mix due largely to the lower ESA drug demand and higher plant overhead costs supporting our manufacturing capacity expansion program, and various other global manufacturing initiatives.

In the Tech Group, margins increased over the prior year quarter by 1.7 margin points to 14.4%. The margin improvement was due to lower direct labor costs coming from increased manufacturing efficiencies, now that several of our new product transitions are behind us, increased utilization, and better overhead absorption in several plants.

The cumulative effect of the margin improvement more than offset the impact from the lower Exubera device revenues, which produced $2.5 million of third quarter 2007 gross profits. Consolidated SG&A expenses increased by $3.8 million, or 10% in the current quarter versus the prior year quarter.

The increase was due primarily to higher stock compensation expense relating to an increase in the company's share price during the current quarter compared to a share price decrease in the prior-year third quarter, which had a $2.1 million, or $0.04 negative effect on earnings versus the prior year quarter, the effect of foreign currency translation, increased compensation cost due to headcount increases, mostly in information technology roles in Pharm Systems segment and for annual salary adjustments. Partially offsetting these increases was a decline in projected incentive compensation expense.

As a percentage of sales, third quarter 2008 SG&A expenses at 15.8%, excluding stock comp effects, were slightly less than Q3 2007 levels. Net interest expense was $1.9 million higher than the third quarter 2007 expense, due mostly to lower interest income as we had less cash on hand than we did last year, and lower market yields on invested cash.

The effective tax rate for the quarter was 5.6%, which includes the effect of the discrete tax benefits we mentioned earlier. Our annual effective tax rate for 2008, excluding any discrete tax items, is currently estimated at 26.1%. The R&D investment credit extender tax bill passed in October 2008 will further reduce our effective tax rate for 2008 in quarter four.

Our balance sheet remains strong and our business continues to provide needed liquidity. The company's cash balance at September 30 was $102.5 million, down $6 million from year-end 2007, primarily due to the payment of tax obligations in Brazil and debt repayment activity. Cash flow from operations was $42.1 million in the quarter, nearly $18 million higher than in the prior year quarter. We believe our operating cash flows are adequate to fund our operations, ongoing expansion, and development activities, and our dividend.

In addition, we have a $200 million revolving line of credit maturing in April 2011, which has committed availability of approximately $165 million. Working capital totaled $245 million at September 30, 2008, about $20 million below last quarter end, but $15 million higher than at year-end 2007. Accounts receivable collection efforts reduced outstanding receivables by nearly $19 million during the quarter.

Our days sales outstanding was reduced by 4.9 days during the quarter to 47.8 days. Debt at September 30 was $382.5 million, down by $15.7 million from last quarter; and our net debt-to-total invested capital ratio at quarter end was 34.2%, 2.7 percentage points lower than at year-end. We incurred capital expenditures of $35 million in the third quarter, with roughly half of the capital focused on new product and expansion activities, mostly in our Pharm Systems North America, Europe, and Asia capacity expansion, with the remainder split evenly between maintenance, normal maintenance, and IT initiatives.

Our cash is conservatively invested, with approximately 80% of those funds invested in US dollar, euro, and British pound money market and bank deposits. Additionally, we have reviewed both our trade credit and non-trade counterparty risks, including interest rate swaps and forward currency, forward exchange contracts, used to minimize currency risks, and are satisfied that no significant exposures exist.

Similar to other companies, the global economic crisis and the resulting decline in global stock markets have resulted in a decline in our pension asset values. We are closely monitoring the value of our pension assets to determine the level of additional funding necessary, which could approximate $20 million and the adverse impact on our next year's pension expense, if global equity markets do not recover from current levels.

Looking ahead, our order backlog at September 30 remains healthy at $230 million, about $10 million below then the backlog from the same point last year, excluding exchange effects. The reduction is due to the prior year backlog including amounts related to the anemia drug components. Also, our reduced plant lead times result in customers not needing to order as far in advance, nor do they need to hold as much West inventory. We expect to incur an additional $500,000 of Tech Group restructuring charges in the fourth quarter, with additional restructuring expenses of approximately $400,000 to $600,000 spilling over into 2009.

We also expect to incur additional conversion and carrying costs of about $1.7 million in Q4 while finalizing the reconfiguration of the former Exubera facility. We plan to resume production in that facility in January of 2009. That effort is being funded by proceeds we received and recognized in the first and second quarters as a gain from the contract settlement we reached with Nektar. As we reported last quarter, our ultimate gain on the Nektar contract settlement is expected to be approximately $4 million.

On the capital front, we continue to expect that full year capital expenditures will be approximately $145 million at actual rates for the first three quarters and at $1.40 per euro for Q4. As you know, much of our capital is being expended for needed capacity based on increasing demand for key products in multiple locations around the globe.

I would now like to turn the call back to Don Morel. Don?

Don Morel

Thanks very much, Bill. Before we turn to your questions, I would like to reiterate several key points from our commentary.

First, fourth quarter 2008 and 2009 demand continues to strengthen. Second, going forward, we expect gross margins to improve as mix becomes more favorable and we continue to recover raw material cost increases through contract price adjustments and increased pricing. Third, our operating efficiencies will improve as our expansion projects wind down during 2009 and new capacity comes online. Fourth, we are fully able to fund our ongoing capital expansion and new development programs through our operating cash flows. Fifth, we have ample liquidity for our needs, including the potential for acquisition. Finally, we intend to manage our finances conservatively through the near term economic challenges we all face.

This concludes our remarks for this morning. We would now be pleased to answer any questions that you might have. Operator?

Question-and-Answer Session

Operator

Our first question comes from Arnie Ursaner, CJS Securities.

Arnie Ursaner - CJS Securities

Hi, good morning, Don.

Don Morel

Good morning, Arnie.

Bill Federici

Good morning, Arnie.

Arnie Ursaner - CJS Securities

Don or Bill, in the Q2 conference call, you had quantified you expected a $0.06 hit from oil in the quarter. And now, that it's behind us and oil has been all over the place, can you attempt to quantify what the actual impact was in the quarter?

Bill Federici

Arnie, on the gross dollar basis, it was about $2 million, $2.5 million. About the issue and just let me clarify this, the $0.06 that you were talking about. We expected that over the final two quarters of 2008 and that was a net number, net of the surcharges that we were expecting to get from our customers in that same time period.

So on a gross basis, we were expecting about $5 million and $2 million of price increases. So we are right on target in the $2.5 million that we incurred in the third quarter and expect about the same number, rough numbers, in the fourth quarter.

Arnie Ursaner - CJS Securities

Okay. Again, can you perhaps expand a little bit on the gross margin hit? You were up against the pretty easy comp last year, where you had inefficiencies as well. I mean again, simplistically, relative to my numbers, you had a $4 million revenue shortfall, but a $6 million gross profit hit. Can you expand a little bit more on some of the factors that hit? And why you're confident some of them may reverse?

Bill Federici

Sure. As you know, Arnie, there are a number of items that impact our margins in any particular quarter. If you look at the third quarter gross margin in 2008 versus 2007, and let's focus on Pharm Systems now, because we told you what the consolidated story was in the prepared remarks.

You had 31.8% gross margin in Q3 2007. We got price increases that gave us a positive 1.6% impact. We had raw material at $2.5 million translated into a 1.6% decline in margins due to raw material and energy.

Labor and overhead, during the same period in Q3 '08 versus Q3 '07 was another 1.6% negative. The lost sales impact that we have been quantifying for you was approximately 0.5% decrease in margin quarter-over-quarter. And FX was slightly negative when you look at it on a percentage of sales basis. So, those are the deltas that move you in that 2.3% down from Q3 '07 to Q3 '08.

Arnie Ursaner - CJS Securities

That's helpful. On Tech Group, can you quantify the impact of Michigan?

Bill Federici

Sure. Michigan was actually, if you remember in the prior year third quarter, it was slightly, prior year being 2007, was slightly negative. It was rough numbers order of magnitude about $600,000. In this year's quarter, we are basically flat. So, it was plus roughly $600,000 of OP increase.

Arnie Ursaner - CJS Securities

Okay. Bill, you went a little fast. Did you give us your operating cash flow number?

Bill Federici

Yes, we did. It is $42.1 million, Arnie, for the quarter.

Arnie Ursaner - CJS Securities

Two more very quick questions. You had a fire in your St. Austell rubber components plant in the UK. Did that have any measurable impact in the quarter?

Don Morel

No. We fully recovered from it. We lost a couple of days of production to get some electronics back up. But that was quickly repaired and there was no impact in the quarter.

Bill Federici

We did file a claim with the insurance company to pick up some money, a small amount about $700,000, Arnie. But obviously, we haven't seen that money yet. But we do actually expect we'll get a little bit back from that.

Arnie Ursaner - CJS Securities

Okay. My final question is for Don. I won't call it guidance, but your at least preliminary comments regarding 2009. The revenue growth makes a lot of sense and I can understand that. But just your broad comment of gross margin improvement seems to not capture a lot of moving parts that should lead to a dramatic improvement in gross margin.

You should eliminate the losses in the Midwest facility, in Tech Group. You've taken restructuring charges. You've built that and had tremendous inefficiencies on your capacity add. You ought to be picking back ESA sales. Why just the comment globally that margin should improve? But why shouldn't they be materially or several hundred basis points higher, particularly if you can recover your raw material costs?

Don Morel

Yeah, I think for the very reason you opened with, Arnie; there are a lot of moving pieces. Right now, we're going through the budget exercise with the Board. We're trying to put as best a number around some of those that we can. And as we always do, we'll give you further guidance on that, relatively detailed guidance in our February call. But I like the way that '09 is shaping up. It's going to be up to us to manage diligently, and we should have a very good year.

Arnie Ursaner - CJS Securities

Okay. Look forward to seeing you in the Midwest tomorrow. Thanks again.

Don Morel

Thanks, Arnie.

Bill Federici

Thanks, Arnie.

Operator

Our next question comes from Larry Marsh, Barclays Capital.

Larry Marsh - Barclays Capital

Thanks and good morning.

Don Morel

Good morning, Larry.

Bill Federici

Good morning, Larry.

Larry Marsh - Barclays Capital

How are you?

Don Morel

Good. How are you?

Larry Marsh - Barclays Capital

Just elaborate a little bit about your currency assumptions. Obviously, you are commenting about $1.40 to the euro I guess fourth quarter, I guess implicitly for 2009. Just where do you come up with those assumptions? And you elaborate a little bit on the delta for the fourth quarter. It also could be, I think you said the delta, if it is $1.30..

You also talked about, I guess, 63% of Pharma Systems sales recorded in currency other than the US dollar. What is that percentage for your Tech Group? And do you have a rough estimate of constant currency growth in the US versus outside the US so far this year? Thanks.

Bill Federici

Okay. We will try to take those one at a time, Larry. You were right; it is $1.40 is what we have predicted for the fourth quarter. At $1.30 per euro, that would have a $0.03 effect on Q4, a $0.03 negative effect on Q4's earnings. Yes, you would have, why we picked $1.40? We have listened to our external experts, they are all over the map, as you would imagine. We don't have a crystal ball, but that's the number that we believe is our best guess at this point in time. We will continue to monitor it and change it as we go forward.

Larry Marsh - Barclays Capital

Just to be clear, I mean it is now at, what, $1.26?

Bill Federici

It was $1.28 this morning. I don't know where it is right now.

Larry Marsh - Barclays Capital

$1.28. So I guess your experts or whatever, you're assuming I guess a big increase in the euro versus the dollar given some of the global challenges. I would assume you would just say let's take the current rate and just kind of run it from there.

Bill Federici

Yes. If you remember two months ago, the current rate was almost $1.60, $1.50-something. So we are operating in a very, very volatile currency environment, and Larry, we are doing the absolute best we can with that that. We picked $1.40. We gave you the kind of the impact from that to $1.30. Where it's going to end up is anybody's guess. But we do believe it is going to strengthen.

On your second question about the split between sales being inside, versus outside the US. For Tech, it is a much smaller percentage. It is only about 20% of their sales are outside of the US. So the impact of currency has been and continues to be much muted compared to Pharm Systems.

Larry Marsh - Barclays Capital

And then just the growth, rough growth rate, US versus outside-US year-to-date, constant currency?

Bill Federici

On a constant currency basis? I don't have that number off the top of my head, but I can find it. Hold on, give me one second.

Larry Marsh - Barclays Capital

Okay. I just wanted to, while you are looking for that, maybe just get you to elaborate a little bit on your pension cost assumptions and how that could change, given as you say the turmoil in the broad market. You threw out a $20 million number. Just help me understand what that is.

Bill Federici

Yes. And I will put some numbers around it and hopefully I won't bore you with the details. But we have approximately a $190 million pension liability. We had approximately $190 million worth of assets out there at the beginning of the year. During the year and just of late, in the last couple of months or so, that has declined by approximately $60 million, the asset base, based on the global stock market decline.

So, if you just take the standard 80% funding formula, if nothing were to change between now and year-end, we need to put another $20 million, rough numbers, cash into the pension plan to meet that 80% funding threshold.

As you can imagine, both of those items, the loss that we have incurred to-date and the impact that the less assets we will have on our ability to generate interest income off of those assets in the pension plan, have a negative impact on 2009 earnings. We don't know what that is, because quite frankly we don't know where the equity markets will go between now and year-end. We do not have to do anything at this point in time.

Again, the idea of giving you the $20 million, Larry, was just to give you a sense of the order of magnitude that you could expect if things were to not recover from where they are now.

Larry Marsh - Barclays Capital

Right. Just to mark-to-market. So if there is no big change from now until mid-'09, early to mid-'09, what would your incremental cost be to support that pension plan for '09, ballpark? Are we talking another couple million, another $5 million or just hard to say?

Bill Federici

I'll help you with the math. If you just used that $60 million, and again, we don't know if that is where it is going to end up. We think it will recover. But if you were to take the $60 million, our assumption is on the rate of return on our assets is 8% in that plan. So you can do the math there. And then the loss would be amortized into the income statement over the life of the employees, which is roughly 10 to 12 years.

So, you are talking, order of magnitude, somewhere in that. If things stay the same, somewhere in that $8 million to $10 million range.

Larry Marsh - Barclays Capital

Okay.

Bill Federici

And I have those numbers for you, Larry.

Larry Marsh - Barclays Capital

Great.

Bill Federici

Domestic. In the third quarter, domestic sales were down 5.2% on a constant currency basis and international sales were up 9% on a currency adjusted basis.

Larry Marsh - Barclays Capital

Okay. And then just one more question on just the components of the income statement. The tax rate, you are saying, it should be lower in the fourth quarter. Are you giving us a--?

Bill Federici

Well, I said, we had the extender bill passed, the R&D extender bill was passed. And before that we were at 26.1%. And again, these are rough numbers. It all depends on where the income is going to ultimately come from in the fourth quarter. But given our best guess on that, we think it'll be about a $0.03 decrease in tax expense. So, a $0.03 increase to EPS.

Larry Marsh - Barclays Capital

$0.03 impact in EPS based on a lower tax rate, so...

Bill Federici

Right in the fourth quarter.

Larry Marsh - Barclays Capital

Right. So you are talking about maybe a low 20s tax rate?

Bill Federici

No. Effective tax rate would be approximately 25.2, 25.3, somewhere in that range.

Larry Marsh - Barclays Capital

I see, versus your prior expectations be high 20s?

Bill Federici

Right, versus 26.1%.

Larry Marsh - Barclays Capital

I know you are not giving a detailed component guidance for '09, but just broadly speaking, would there be any reason to think that your, sort of, tax rate going forward '09, 2010 would be much different from that high 20s rate or again, is it too early to say?

Bill Federici

It's obviously too early to say. But what we're kind of thinking in our judgment is that we will be in that 25% to 26% range barring any major changes in tax law, which who knows what will happen after the election?

Larry Marsh - Barclays Capital

That's pretty consistent with what you had been thinking before?

Bill Federici

Yes. We were at 26.1, Larry. The extender bill drops it down into the mid-25s, and we see no reason why, other than some major change internationally in taxes or domestically in taxes, it shouldn't change much.

Larry Marsh - Barclays Capital

Okay. And then just really a big picture for Don. The good news I guess you talk about you haven't seen any real change in demand from your customer base as you start thinking out for '09. As you make your budgets for 2009, how much do you have to factor in the overall economy or is it, you realize that the specific demand flow from your customers is somewhat independent of the broader market? And then how are you thinking about those customers working down their own inventories as you think into 2009?

Don Morel

Yes, I mean, that was obviously one of the big challenges in this quarter was the number of customers that were working down inventory and it was very substantial versus what we saw in the third quarter of 2007.

When I look at the broader picture in '09 and beyond, the real positives for us are the fact that the broader pharmaceutical markets are going to continue to grow. I know a lot of people are predicting a contraction from that 5% to 6% range globally to kind of in the 2% to 3%. But you have to remember that the bulk of that is actually in orals.

And when you look at our franchise, which is predominantly injectable, many of those drugs are going into the chronic diseases, and all those factors work in our favor. If you take a look at growth in sales in our key product lines, which are oncology, rheumatoid arthritis and things that are treated with biologics, those are all continuing to be double-digit growers and we've seen no change in that going into '09 and beyond.

Same thing with diabetes, those are the things are going to drive the franchise. So, we feel very upbeat about that, particularly the fact that the pipeline is improving a little bit on the biologics side. You've got a number of monoclonals that will be launched next year. You've got some big applications pending now that will get approved probably in the middle part of '09 as well.

So, the broader picture long-term, all the things that we've historically talked about are still working very much in our favor. Yes, we're going to have quarter-to-quarter hiccups. We've always talked about that, whether it is the fact that customers are working down an inventory or we've got a launch build, or you have a regulatory issue with a customer whereby their contract manufacturer may stop ordering and be working on some regulatory issues.

So, the small bumps are going to be in the road. Long-term, broad picture, things are still very positive. We feel good about where we're at not only with the underlying portfolio, but with the things that are in our pipeline and are going to be coming to market in the '010, '011 timeframe.

Larry Marsh - Barclays Capital

One more. Do you have any other balance sheet figures? Do you have your own inventory figures? Was there much change to that at the end of September, Bill?

Bill Federici

There were some changes, as I said from the end of -- you mean from the end of September or you mean from the end of June?

Larry Marsh - Barclays Capital

Just your period end balance sheet, if there's any other changes.

Bill Federici

Our period end balance sheet? Our period end balance sheet is, we did have a decline in our accounts receivables coming from North America. We had an increase and these are all versus, if you look at it from the quarter end, prior quarter end, we had a $19 million decline in accounts receivables, as I mentioned due to some increased collection activities.

But when you look at it compared to the prior year end, which is the way we try to look at it from our perspective, they actually increased. The accounts receivable was up about $4 million. Inventories was up about $13 million. Payables, regular trade payables were down about $18 million. Those are the major components in working capital.

Larry Marsh - Barclays Capital

Okay. And then just finally back to Don, again you sound like you are very much on track with your capacity expansion plans both domestically and internationally, sort of if that is going to be a multi-year project or multi-year projects? Given where you are in the economy, given the turmoil in the markets, it sounds like you are still very much committed to that. Or do you think there would be any timing as you go out to the end of the '09 and 2010? Or the CapEx should still be sort of in that 130 to 140 a year, up until 2010?

Don Morel

Yes. I will split that answer into two parts, Larry. The ongoing expansions that are in Europe and Asia right now fundamentally will be complete by the end of '09. With China, because it's a new facility, that will be actually finished in the early part of '09, but the validation and the qualification won't result in commercial sales until the latter part of '09, as the customers go through the testing.

The big question for us, I think, is going to be a new rubber facility in China for which we have the land or a new rubber facility in India. It's very likely in a three- to five-year time frame that we are going to need both, especially with the growth that we are seeing in India on the parenteral side of the business, both in generic injectables and in vaccines. We are still working through the capital numbers for next year; but given the fact that we also have some very strong demands for capital in our new product launches, you are probably going to see capital remain close to the level that we are at this year.

Larry Marsh - Barclays Capital

Okay.

Don Morel

But for all the right reasons.

Larry Marsh - Barclays Capital

Right. Just one follow-up. I promise I will shut up after this. Raw materials costs, you have sort of fought through that; so you would argue that has been a little bit of a headwind. You've had to pass on prices. Now you have got raw materials arguably that are going to be flat to down, as you think about '09. Is that a good guide for you, net neutral? Or do you have to somehow adjust your pricing back to your customer?

Bill Federici

Larry, if you remember the way our supply contracts work, we have a delay with the way the contract works, between when the actual commodity prices decrease and when we see those decreases. So we are still going to fight a little bit of a headwind as it relates to those underlying raw material prices going into 2009.

We will get the ability to pass those on to the customer, but it is on even a more lagged basis because of the way our customer contracts work. We only get once a year that we can increase prices, either on the contract date; anniversary date if it's a contracted sale; or if it is a non-contracted sale, the prices are generally increased once a year on January 1.

So we think at the end of the day that you're right. As prices decrease, commodity prices decrease, that that headwind will become less of a headwind and may actually become a positive. But because of the way the supply and the customer contracts work, it will be a delayed effect.

Larry Marsh - Barclays Capital

Right, okay, very good. Thank you.

Bill Federici

You are welcome.

Don Morel

Thanks, Larry.

Operator

Your next question comes from Ross Taylor, C.L. King.

Ross Taylor - C.L. King

Most of my questions have been answered, but may be two or three left. First of all, Don mentioned once or twice that he saw demand strengthening in the business. And I just wondered if you could elaborate on maybe some of the specific products or some of the specific areas. I know you did mention that you expected to get an ESA drug order in Q4; maybe that had already come in and maybe you could talk about how quickly you think your ESA business could ramp up back toward the peak number? So I'll start with that.

Don Morel

Yes, I think, taking the ESA question first, we have booked our first order. The customers there, believe it or not, are still working through some of the inventory issues that they've got. So we expect those sales to moderately return through '09. We don't expect them to get back to their historic highs, and neither do our customers. So we are discussing that with them now. We will have a better idea what demand is going to look like for the full year when we get to our February call.

Across the board, maybe generically on some of the other systems that are showing strength, encouragingly in our major markets; the traditional products, the serum stoppers, the lyo stoppers, seals for those systems, infusion closures, all of those are showing mid to kind of high single-digit growth, which is very, very good for us. So it's really across a broad spectrum of products.

The only areas where we are not seeing historic growth are in lining materials, which was down slightly. That is purely an inventory question. That will reverse itself next year. On the prefilled syringe side, where as a result of the ESAs, we've seen a moderate decrease there. But for the broader parts of the portfolio, demand is solid.

Ross Taylor - C.L. King

Okay. To touch on foreign currencies again, I roughly estimate that, assuming currencies stay constant where they are now, the negative effect you are going to see in 2009 is going to roughly equate to the benefit that you saw in 2008, on an EPS basis. I mean is that a fair assumption would you guess at this point?

Bill Federici

I think that may be a little high. Because I think we are averaging through the first three quarters, we are in the kind of high $1.40s in terms of what the actual rates are, convert to, if you're using the euro as the main predictor. And obviously, it's at [1.28ish] now and we do expect that to strengthen some over that kind of near term environment that you're talking about.

So if you're talking about what our FX impact was on the first three quarters, it was about $0.15 positive. So again, I don't think it's at high $1.40s for the first three quarters, and certainly in the fourth quarter we expect that to be much more muted and actually run the other way, be an actual drag on earnings of about $0.02 in the fourth quarter.

So, overall, it's anybody's guess where 2009 will come out, but I think to say what you said is maybe a little too much of a simplification.

Ross Taylor - C.L. King

Okay, all right. I'll work through the numbers a little more. And final question. I know you've mentioned before there is a good chance that you'd be able to start committing some capital to production lines for resin CZ during 2009. Can you elaborate at all on what the timing of that might be? How much money that would involve?

Don Morel

I wouldn't jump into the money question just yet because that will depend on capacity and the first order. I think that we will be committing capital in '09, probably the early part. On one of the key programs right now, which is what we call the insert needle, where the needle is glued into the syringe itself.

We've got a single robotic cell working to prove out the concept. We are now working on the scale-up to a [four] cavity cell for that system. Depending on the validation there and how the trials go, you can probably look for the real capital for the large volume cells to be committed somewhere in the latter part of the year. But, again, that is going to be wholly dependent on the outcome of stability trials that are currently ongoing with customers and the placement of that first order.

Ross Taylor - C.L. King

Okay, that's helpful. All right. Thanks very much.

Don Morel

Thanks, Ross.

Operator

Our next question comes from James Sidoti with Sidoti & Company.

James Sidoti - Sidoti & Company

Good morning. Can you hear me?

Bill Federici

Hi, Jim.

Don Morel

Hi, Jim. Sure, we can. We can hear you fine.

James Sidoti - Sidoti & Company

I'm just trying to get a little more color on the capital expansion program. It sounds like you're going to finish the Europe and Asia facility expansions during 2009. Does that mean production comes online during 2009?

Don Morel

It will actually be phased in. So if you step back, as I said in the Q2 call, the Bodmin facility, which was tooling in Europe is complete. That's up and operating and producing tool. The expansion that is being done in Essweiler, which was our major German facility, the buildings and mortar are complete.

First cells will go in at the end of this year, with the validation being done early next year and we'll be phasing in production off of that as we see demand evolving, so that you will get production out of Germany.

France has been delayed a little bit for the reasons that we talked about. That program will not begin producing until probably 2010 or later, with one exception. We have a B-2 coating line that's going in, that should be done by the end of the year.

Singapore is nearing completion. That will be producing in 2009. And China's bricks and mortar will be done. The equipment will be going in early part of the year. We will be going through the validation trials. We should see commercial sales out of that facility by the end of the '09.

But the important thing is, again, we needed to get the bricks and mortar done at most of these and we will phase in production, the actual presses, trim dies, et cetera, as we see demand evolve.

James Sidoti - Sidoti & Company

So it sounds like part of the answer to Arnie's question at the beginning of the call about margins is that you are still going to have some startup costs in 2009.

Don Morel

Yes.

Bill Federici

Yes, absolutely.

James Sidoti - Sidoti & Company

Okay. In India, is that a plant that will supply to just India or is that a plant that will supply to the rest of the world as well?

Don Morel

The initial plan would be to have it supply India. The growth in generics there, although off of a small base, our sales there are really increasing dramatically. And there is tremendous investment going in by the Indian Pharmaceutical industry, not only into generics and vaccines, which is their predominant product line now, but into original innovative R&D. So, it's pretty clear that that's evolving into a major pharma hub for the future.

James Sidoti - Sidoti & Company

And is that a new market for you? And when do you think you'd actually start producing?

Don Morel

It's not a new market for us, because we've actually sold into the multinationals and the locals from our Singapore facility for probably more than 15 to 20 years. So, our actual team is on the ground in India, a very, very good team. The plan would be to support not only the multinationals, but also the local pharmaceutical firms out of that facility.

We'll probably pick a site early part of next year, get the contractors lined up, depending on how things unfold, look at beginning construction hopefully end of the year, early 2010.

James Sidoti - Sidoti & Company

Okay. And then my last question is with the potential charge because of the pension plan, is that something you would decide on at the beginning of the year and then take quarterly or would that all be in one quarter?

Bill Federici

No, it's not all in one quarter, Jim. What happens is the actuary; we'll work with the actuary to determine the amounts. We'll wait to see what the actual asset values come in around at the end of the year. Based on those two factors, we will then determine an expense and a funding vehicle, how much cash we're going to put in and the resulting expense that will translate into. And that will be spread pro rata over each of the quarters.

James Sidoti - Sidoti & Company

And where will that be on the P&L?

Bill Federici

It will show up a lot of it in cost of sales. Well, actually it shows up both -- we have it broken out down below as a single line item in what we report to you as called pension expense. But it would affect people in the US, SG&A, et cetera.

James Sidoti - Sidoti & Company

It will be clear to us what the magnitude of that charge is?

Bill Federici

Yes, it will be absolutely clear. When we know what the number is, obviously in the year-end call, we will let you know what that is.

James Sidoti - Sidoti & Company

Okay, thank you.

Bill Federici

You are welcome, Jim.

Operator

Our last question comes from Arnie Ursaner with CJS Securities.

Don Morel

Hi, Arnie.

Bill Federici

Hi, Arnie.

Arnie Ursaner - CJS Securities

A couple of follow-ups to the questions you were asked. First on China and the facility you are building there. When will we start getting amortization? And when do you anticipate perhaps, you had talked about two facilities in China, had you not? And when might we see some movement towards the second one?

Bill Federici

The depreciation question, Arnie, obviously we don't pick that up until the facility is complete and operating. So that would happen sometime in 2009. It will start with that depreciation.

Arnie Ursaner - CJS Securities

And what will that expense run?

Bill Federici

I'm sorry?

Arnie Ursaner - CJS Securities

What will the expense be?

Bill Federici

I'm not sure what the exact number of that we are talking about for capital, but it was running about, last estimate I saw was in the mid-$25 million to $30 million range. The bricks and mortar obviously are amortized or depreciated over 30 years, and the machinery equipment is in that 10 to 15 range.

Arnie Ursaner - CJS Securities

Okay.

Don Morel

And the answer to the second part of your question, Arnie, is that we have already purchased the land for the rubber facility. It is contiguous to the land that we actually have for the plastics facility we are building. We are going to see how things evolve in the marketplace. It is going to be more related to the timing of approvals for our products out of the SFDA in terms of when we make a decision to actually break ground.

Arnie Ursaner - CJS Securities

Okay. Follow-up to Ross' question on the ESA drugs. Can you tell us what your actual ESA revenues were in '07? Give us your best feel for what you think '08 will look like. And based on current script trends, how you think '09 might shape out on what is arguably one of your highest margin products?

Bill Federici

All right. Let's take you through it. In the 2008 quarter, third quarter, just to have some ground you in the numbers. We had $3.6 million of effect, so that was $3.6 million more sales in Q3 2007 than in Q3 2008 for that. For the full year, Arnie, it will be $17 million, our best guess of sales that were in 2007 that we won't have in 2008.

Turning to 2009, again these are guesses based on where we believe and looking at our backlog now. We expect it to recover by about $5.5 million. So if you are looking at '08 to '09, the increase we expect over that full year will be approximately $5.5 million. Well, there is some in the first quarter, very little in the second and third, and most of it in the fourth quarter.

Arnie Ursaner - CJS Securities

And why would it not be picking up in Q2 and Q3?

Bill Federici

That is just the timing of the way they put their orders in, Arnie.

Arnie Ursaner - CJS Securities

My final question is, you obviously are maintaining a very conservative balance sheet, as well you should given the crazy environment. But your converts are trading at probably $0.85 on the dollar. Have you given or are you considering repurchasing converts in the open market to one of the key factors in your debt structure?

Bill Federici

Yes, we are looking at it, Arnie.. If you can buy those at a discount, there is an accretive factor to the P&L, no doubt about it. The problem is, as you said in the beginning, we are trying to be conservative as it relates to our balance sheet. And we are looking at the cash we'd have to give up to basically take those converts out, versus the other things that we can invest our cash in, and looking at the relative returns on all of those.

Arnie Ursaner - CJS Securities

Okay. And Don, in your prepared remarks you at least speak about acquisition opportunities without being unduly specific, can you tell us the kinds of things you are looking for and what you hope to gain by acquisition versus organic growth?

Don Morel

Yes, there is no real change in our strategy, Arnie. We continue to look for bolt-ons that have the same characteristics as our current business. If you took Medimop as a model, that's the kind of thing we are looking for. Sales in the $20 million to $50 million range, very strong IP, drug contact with the material surface, can be integrated into our current manufacturing operations and sellable by our sales force.

That is kind of a tall order. We tend to look more at private firms that are entrepreneurial than anything else. We have kicked the tires on a lot of things. You would hope that valuation expectations might moderate in this environment, but that hasn't been the case. But that is kind of the thing we are looking for.

Arnie Ursaner - CJS Securities

Okay. The facility that had been used for Exubera, you mentioned, I think that that is going to come online in early next year, which segment will it be used for?

Don Morel

It will be used on the Tech side in the device area. It will be primarily a molding facility that is feeding the assembly operations.

Arnie Ursaner - CJS Securities

Okay, thank you very much.

Don Morel

Thanks, Arnie.

Bill Federici

Thanks, Arnie.

Operator

I would now like to pass today's conference call back to Dr. Morel.

Don Morel

Thank you very much, Operator. And thanks to everyone for your time this morning. Through the first nine months of the year, our performance has been very good, despite the economic climate we face and the loss of sales for key products at the outset of the year. We remain focused on running our business efficiently and are confident in our ability to deliver our projected full year results. Thank you very much for your time this morning.

Operator

Thank you for joining today's conference call. Parties may disconnect at this time.

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Source: West Pharmaceutical Services, Inc. Q3 2008 Earnings Call Transcript
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