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West Pharmaceutical Services, Inc. (WST)

Q4 2008 Earnings Call Transcript

February 19, 2009 9:00 am ET

Executives

Theresa Kelleher – IR, Financial Dynamics

Don Morel – Chairman and CEO

Bill Federici – VP and CFO

Analysts

Arnie Ursaner – CJS Securities

Raphael [ph] – UBS

Adam Fizzard [ph] – Barclays Capital

Rick Dalton [ph] – Colombo Management [ph]

Christian Mikel [ph] – Orlando [ph]

Operator

Welcome to the West fourth 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.

And now, I will turn the meeting over to Ms. Theresa Kelleher from FD. Ma'am, you may begin.

Theresa Kelleher

Thank you. Good morning everyone, and welcome to West’s fourth 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 immediately.

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 products, 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 results to differ from expectations, please refer to the factors listed in today's press release.

Investors are 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, they 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 you, Theresa, and good morning everyone. Welcome to West 2008 year-end conference call. We appreciate you 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.

To begin, I will briefly summarize our fourth quarter and full-year 2008 results, followed by an update on our major development projects and our capacity expansion programs and finish off with a summary of our outlook for 2009. Bill will then discuss our financial performance in greater detail before we open the call for questions.

I should point out that as we mentioned in our press release, comparisons with 2007 are difficult due to non-recurring sales of erythropoietin stimulating agent packaging components, Exubera inhaler devices, the impact of the settlement with Nectar Therapeutics, restructuring charges and several discreet tax items in both periods.

Further complicating the picture for the full year are the dramatic swings in Euro-dollar exchange rates and the swing in oil prices through the year. We will call out the impact of these factors during our commentary, where appropriate.

I am pleased to report that we finished 2008 with a strong fourth quarter. Consolidated revenues were $244.9 million, an increase of 4% over the fourth quarter of 2007, excluding lost sales and currency effects. Fourth quarter adjusted diluted earnings per share from continuing operations were $0.56 per share versus the $0.51 in 2007. Our Q4 earnings were negatively affected by $0.05 due to unfavorable exchange.

Consolidated gross margin improved by 0.9 percentage points during the quarter to 28.4%. And for the full-year revenues grew to $1.05 billion and fully diluted adjusted earnings per share were $2.38 both consistent with our guidance at the outset of the year. Adjusting our sales and earnings for the year to account for the impact of lost sales and the impact of currency translation provides a better basis for comparison, and would yield sales growth of 6.8% and earnings per share growth of 18.3% versus 2007.

Given that we started the year with a roughly $60 million sales gap and an operating profit shortfall of approximately $25 million and faced with a less than favorable economic climate in the second half of ‘08, 2008 overall was a very good year for the company from an operating standpoint.

Overall, our financial condition remains very strong. Our net debt to total capital ratio is 38%, our operating cash flows provide ample resources to fund our expansion in R&D programs, and the structure of our debt requires no new financing until April of 2011, when our revolving credit facility will need to be refinanced.

Turning to our segment results, adjusted sales in the Pharmaceutical Systems division group grew approximately 5% driven by strong demand for serum and Lyophilization closures and Westar treated closures. Currency translation effects reduced sales and gross profit by $13 million and $4 million respectively during the quarter. We also recorded our first order for ESA packaging components, and anticipate sales for these items increasing gradually throughout 2009, although they will not return to prelevels [ph].

In another positive note, sales in Asia were particularly strong, with sales in India and China growing 31% and 26% for the year respectively, albeit off of a relatively small base.

Within the Tech Group segment, revenues were $66.2 million for the quarter, a decrease of roughly 5% as a result of lost Exubera sales, which totaled $5.3 million in the fourth quarter of 2007. This is the last period that will be comparable to the prior period with Exubera sales.

Adjusting for the lost sales, revenues at Tech grew approximately 2%. Tech did continue its margin improvements due to strong demand for medical devices and filter components, coupled with much improved operating efficiency at Texas [ph], Puerto Rico, and Grand Rapids operation.

Gross margins improved 0.6 percentage points overall versus the prior year to 12.3%. The restructuring initiated at the end of 2007 is now largely complete having being accomplished under budget and yielding cost savings ahead of plan. Bill will provide greater detail on our segment results in a few moments.

Overall, in light of the numerous challenges we faced throughout the year, I would say that our results reflect the underlying strength and resiliency of our business and our success in offsetting higher costs through an effective combination of improved operating efficiencies, spending controls and cost offsets.

Turning quickly to our ongoing capacity expansion projects, our operating groups made substantial progress against our goals, while holding total capital spending to $131 million versus a budget of $145 million at the outset of the year. Our China plastics facility began in the first quarter of 2008 will be completed in the first quarter of this year, and following systems validation and testing will begin commercial production in the third quarter. Production has begun in our newly installed systems in both Germany and Kovin Serbia facilities. Singapore will be completed in early third quarter, and our project team in India has identified a site for a future rubber manufacturing facility.

Also through a redesign of our plant layout in Clearwater, Florida, the project team managed to increase capacity and throughput to the point where a planned $3.5 million capital expansion investment can now be deferred. Also, the North American SAP conversion is on schedule and budget with the next planned switchover scheduled for mid-2009.

In terms of our three new major product development programs, NovoGuard [ph], ConfiDose, our proprietary auto injector; and Daikyo's Crystal Zenith resin, we also made excellent progress during the year.

The NovoGuard 510 (k) was filed with the FDA at the end of the third quarter. This is West proprietary passive needle safety system. And following the completion of an ongoing trial, we hope to have approval for commercial marketing early in the second quarter of this year.

We completed and sampled customers with the first prototypes of ConfiDose, and we continue to see growing interest in the application of Daikyo's Crystal Zenith resin to packaging and storage systems for a range of challenging molecules. Throughout the year, it was a substantial increase in the number of customers performing stability studies with CZ in both vial and syringe formats.

We also received our largest order to date for samples to be used initially in a filling trial, followed by a clinical trial planned by a customer for the fourth quarter. Current therapeutic areas where new molecules are undergoing stability and compatibility trials include cancer, autoimmune diseases such as lupus and arthritis, macular degeneration and vaccine.

Overall, I'm very pleased with our progress on both our capacity expansion and development programs for the year.

Looking ahead to 2009, there is no doubt that all sectors of the economy are to varying degrees feeling the effects of the global downturn, and this includes healthcare. Many of the challenges that arose in the second half of 2008 will remain with us through the end of 2009, and when coupled with the economic outlook globally made 2009 a much more challenging climate to manage through in 2008.

That having been said, overall, we believe we will see organic growth in the Pharmaceutical Systems segment of 6% to 8% excluding the currency, with Tech sales down slightly due to contractual resin cost pass through impacting sales in that segment. It goes without saying that both individuals and companies are managing their spending very carefully. Our pharmaceutical and healthcare customers are seeing this in their businesses, and while we have no specific indicators for downstream consumption of our products, recent customer order inputs suggest that many of our customers are simply looking for ways to reduce working capital, and are being careful with placing orders thus providing some uncertainty to our normal visibility.

Although our backlog remained strong overall, the composition and timing of orders leads us to slightly reduce our overall growth expectations to between 3% and 5% before currency effects.

Secondly, we absorbed significantly higher costs in 2008, and as a result of the terms of our purchase agreements, some of those higher costs will continue into and through the first quarter of 2009. While we expect to get some relief as the year progresses, we remain wary of renewed volatility, specifically in the global oil market.

Currency translation provided us with a tailwind during the first three quarters of ‘08, but turned against us in the final quarter of the year, and we expect it to work against us through 2009, where we think it will cost us about $70 million in reported sales and approximately $0.26 in earnings per diluted share. Additionally, pension assets, consisting of investment securities, suffered a setback in value as the result of the decline in equity markets during 2008, which will also have a measurable impact on our results in 2009.

Given these circumstances, we clearly faced a broad range of challenges in developing our plans for 2009 and beyond. We are taking a longer view and sticking to our strategic plan. We are doing this because we believe our financial strength provides us the ability to continue to invest in our primary projects, which have long lead times and span economic cycles.

We also believe that the cost of any delays in terms of opportunities lost or deferred outweighs significantly the potential near-term cost savings. However, this having been said, we will continue to periodically review all of our development and capital plans for opportunities to effectively reduce, differ, or eliminate costs.

The outlook we are sharing with you this morning reflects those reductions in productions where they make sense. We also continue to look for acquisition opportunities at appropriate valuations to bolster our product and technology portfolio. Given our global manufacturing footprint, strength in biologics packaging and pipeline of delivery systems, I believe our value proposition remains sound and the strength of our current product portfolio coupled with the depth of our balance sheet will continue to serve us well in 2009 and beyond.

I would now like to turn the call over to Bill Federici. Bill.

Bill Federici

Thank you, Don, and good morning, everyone. As indicated in this morning's press release, West reported fourth quarter 2008 income from continuing operations of $17.6 million, or $0.52 per diluted share versus the $0.19 per diluted share we reported in the fourth quarter of 2007. Excluding the effect of certain items in both years, fourth quarter 2008 adjusted earnings per share from continuing operations were $0.56 per share, $0.05 better than the 2007 fourth-quarter adjusted earnings of $0.51 per diluted share.

The company's consolidated fourth quarter sales were $244.9 million, an increase of 1% over fourth quarter 2007 sales, excluding the negative effect of foreign currency translation and a 4% increase over Q4 2007, excluding FX and lost sales.

This was the first quarter in several years that exchange had an unfavorable impact on sales and earnings, but we expect the continued relative strength of the US dollar to adversely impact reported results of each quarter of 2009 compared to 2008.

Fourth quarter sales in the Pharm Systems segment were $181.6 million and grew by 3.7% over fourth quarter 2007 sales, excluding currency effects. The relatively modest growth was expected due to the decline in demand associated with discontinued production of the disposable medical device components in Europe. Excluding the effect of those lost sales in foreign exchange, Pharm Systems sales grew by 5% with most of the growth in North America and Asia.

The Tech Group segment generated sales of $66.2 million in the quarter, 5.3% below sales in the prior year quarter, excluding exchange, largely due to the loss of Exubera sales to our former customer Nectar. In the fourth quarter of 2007, sales of the Exubera device was $5.3 million. Excluding the Exubera sales and currency effects, Tech’s Q4 2008 sales were 2.3% above Q4 2007 sales due to solid increases in demand for several products, including IV and blood filter products manufactured in our Michigan and Puerto Rico facilities, and (inaudible) closures produced in (inaudible).

Looking at margins, consolidated gross profit margins for the quarter were 28.4%, nine-tenths of a margin point better than the 27.5% margins we achieved in the fourth quarter of 2007. Gross margin in the Pharm Systems segment were 33.8%, six-tenths of a margin point above last year's fourth-quarter margins with most of the improvement coming from the Americas units. The impact of lower sales, a $3.7 million adverse FX translation and higher raw material costs and higher utilities and labor costs were offset by pricing and operating efficiencies.

In the Tech Group segment, margins also increased over the prior year quarter by six-tenths of a margin point to 12.3%. 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, and increased utilization and better overhead absorption in several plants.

The cumulative effect of the margin improvements more than offset the impact of higher raw material prices, which were mostly passed through to customers, and the 1.9 margin point decline related to the loss of the Exubera device revenues, which were included in Q4 2007 margins. Consolidated SG&A expenses decreased by $2.7 million, or 7% in the current year quarter versus the prior year quarter.

The decrease was due primarily to lower stock compensation expense relating to the decline in the company's share price during the quarter compared to a smaller share price decrease in the prior-year’s fourth quarter, the effect of foreign currency translation, and lower outside services expenses. Partially offsetting these declines were increased compensation related cost mostly for incentive compensation, severance cost, and annual salary increases and higher IT related depreciation expense.

As a percentage of sales, fourth quarter 2008 SG&A expenses at 15% were slightly less than the fourth-quarter 2007 level of 15.5%. Net interest expense was $1.6 million higher than the fourth quarter 2007 expense, due mostly to lower interest income as we had less cash on hand throughout the quarter than we did in last year’s fourth quarter.

The effective tax rate for the quarter was 17.2%, which includes the effect of the discrete tax benefits we mentioned earlier. Our full-year effective tax rate for 2008, excluding any discrete tax items, was 24.8% versus 28.7% in 2007 with much of the improvement due to negotiated rate reductions in certain international jurisdictions, additional use of R&D tax credits, favorable transfer pricing changes, and the change in the geographic mix of earnings.

Our balance sheet remains strong and our business continues to provide necessary liquidity. The company's cash balance at December 31 was $87.2 million. Working capital total $207 million at December 31, 2008, $22 million below the prior year end. Debt at December 31 was $386 million, down $9 million from prior year end; and our net debt-to-total invested capital ratio at year end was 38%, 1.1 percentage point higher than at the prior year-end with the increase due to the reduction in equity associated with our pension asset decline.

Operating cash flow was $44 million for the quarter ended December 31, 2008, and we incurred capital expenditures of $43.6 million in the fourth quarter with approximately 50% of the capital focused on new product and expansion activities, mostly for a our Pharmaceutical Systems European plant expansions and the construction of our new China facility.

Full year CapEx was $131.8 million, including approximately $50 million of maintenance capital, $25 million of IT related CapEx, and $55 million of new product and expansion activities. Our 2009 budget for CapEx is $140 million, but we will continue to monitor customer demand and will reduce our CapEx spend where possible.

In summary, in light of the challenging economic climate, and the significant adverse impact of the lost sales, we had a strong fourth quarter which capped off another successful year.

Looking ahead, we also detailed in our earnings guidance for 2009 in this morning's release. As indicated, we expect that our 2009 revenue and operating profit levels will be significantly affected by the strengthening of the US dollar versus the euro and other international currencies. At current exchange rates, 2009 results would be adversely impacted by $0.26 per share. As we now see it, we expect that the sales on an actual exchange basis will decline by about 2% to 4% versus 2008 sales levels, although they will grow on a constant exchange basis by 3% to 5%.

In addition, adverse market conditions contributed to a 29% decline in the value of our US pension assets during 2008. With the effect of increasing estimated 2009 pension expense by approximately $10 million or $0.18 per share over our comparable 2008 expense. Coupling that effect with the exchange effect, we expect operating profits will be adversely impacted by $0.44 per share. With that said, we expect 2009 earnings to be between $2.05 and $2.25 per diluted share based on expected sales of approximately $1.01 billion to $1.03 billion.

Excluding the exchange and pension effect of $.44 per share, earnings in the projected range would yield an increase in EPS of 5% to 14% over 2008. We expect that Pharm Systems will have sales of $770 million to $785 million, roughly equal to 2008 levels at actual exchange rates due primarily to the adverse effect of exchange. On a constant exchange basis, Pharm Systems sales are expected to grow 6% to 8%.

Gross margins in the Pharm Systems are expected to increase to 35.5% for the year, approximately 2 margin points above our 2008 margins. To get there despite low volume growth, we are counting on achieving price increases in the 2% to 3% range on average, additional lean savings in our European-American units to offset higher material prices in the first half of 2009, wage increases and higher depreciation expense.

In the Tech Group, we are expecting to see modest declines in sales levels of approximately 1% to 3% excluding exchange effects. The sales levels significantly affected by the impact of lower raw material resin prices on sales.

Tech Group’s gross margins are expected to improve by about three-tenths of a margin point to 14% on sales of $250 million to $255 million with the gross margin improvement due also to lean and restructuring savings, product rationalization, and continued margin improvement at the Grand Rapids, Michigan facility.

Consolidated R&D expenses are expected to increase $5.3 million versus 2008 as we continue to spend in support of our innovative products, heavily weighted towards spending on CZ, which is experiencing significant sampling activities and is expected to achieve commercial sales in 2011.

Selling, general, and administrative expenses will increase in 2009 with most of the increase expected to come from the $10 million increase in pension cost and increase in stock compensation cost based on our expectation that the stock price will increase in 2009 versus the stocks declined in 2008, continued investment and associated depreciation in information system initiatives mostly in our Pharm Systems North America unit, and the impact of headcount increases mostly in Pharm Systems business units to support new growth plans and new programs.

As a percentage of sales, we expect full year 2009 SG&A expenses to be approximately 1 percentage point higher than 2008, excluding the impact of pension and SAP related increased cost. Our 2009 earnings guidance does not include any 2009 expenses related to the 2007 Tech Group restructuring, the effects of any significant additional increases in raw material and energy costs or the effects of currency valuation changes, particularly the euro, which is reflected in our 2009 estimate at $1.28 per euro. Every $0.10 strengthening of the US dollar versus our international currencies decreases EPS by approximately $0.12.

As you know, we do not provide guidance for any interim periods, however, unlike prior years, our first half of 2009 will be significantly impacted by the factors we have discussed, a $23 million decrease in backlog, which is comprised of $13 million of currency translation and approximately $10 million of customer order timing and inventory management, FX translation is expected to impact – to adversely impact 2009 by approximately $0.26, $0.10 impacting the first quarter of 2009 compared to our 2008 levels due to the relative strengthening of the dollar in translation of our international operations.

Our North America operations will take an operating charge of approximately $1.5 million in Q1 2009 to reflect the re-organization and relocation of our labs business. For the full year 2009, our operating profit margin, excluding increased pension and currency translation is expected to increase by approximately one margin point versus 2008.

I would now like to turn the call back over 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, as Bill indicated, changes in customer order patterns and the impact of currency translation and the timing of raw material price changes will likely result in stronger performance in the second half of the year.

Second, our backlog remains very strong with orders on hand just below 2008 levels at this time.

Third, going forward we expect gross margin levels to improve as mix improves, pricing [ph] to the full year and we recognized the benefits of lower oil prices and the cost of few raw materials.

Fourth, our operating efficiency will improve as our expansion projects wind down and new capacity comes on line. And finally, our operating cash flows and balance sheet provide us with the ability to manage conservatively the near-term economic challenges as we continue to fund our primary long-term R&D and expansion programs.

This concludes our remarks for this morning, and we will now be placed to answer any questions that you might have. Operator.

Question-and-Answer Session

Operator

Thank you sir. (Operator instructions) Our first question comes from Mr. Arnie Ursaner. Sir your line is open.

Arnie Ursaner – CJS Securities

Hi good morning.

Don Morel

Good morning Arnie.

Bill Federici

Good morning Arnie.

Arnie Ursaner – CJS Securities

I guess the first thing I want to follow – start with is, in November your revenue guidance for the year had been 5 to 7 or preliminary guidance for the ‘09 had been 5 to 7 and now you are bringing it down to 3 to 5 and that is ex-currency. I just want to be very, very clear because in the past you have walked away from certain programs or had cancellations. Embedded in this you did not have any specific program or cancellation that affected the revenue growth?

Don Morel

No.

Arnie Ursaner – CJS Securities

Okay. And again just to be very, very clear none of your guidance includes any of the contribution from your key development programs. None of that will create revenue in any material way in ’09?

Don Morel

Not in ’09, that's correct.

Arnie Ursaner – CJS Securities

Okay. Question – real quick question for Bill if I can.

Bill Federici

Yes sir.

Arnie Ursaner – CJS Securities

You mentioned you had $140 million budgeted capital spending, and Don you had mentioned in your prepared remarks you have identified a site in India. Do you have an India facility embedded in your CapEx guidance?

Bill Federici

We have in our – this year's 2009 guidance we have the cost of acquiring land, which is approximately, our guesstimate is approximately $3 million.

Arnie Ursaner – CJS Securities

But not the cost of the plant.

Bill Federici

Not the cost of the plant which would not – probably would not commence until either late in ‘09 or ’10.

Arnie Ursaner – CJS Securities

Okay, and do you have a D&A number expectation for 2009 please?

Bill Federici

Yes, it was just, you know, the D&A was $60 million in 2008 and the D&A expectation is about $8 million higher than that for 2009.

Arnie Ursaner – CJS Securities

And how much of that will run through the SG&A line?

Bill Federici

About $4 million of the increase will run through SG&A.

Arnie Ursaner – CJS Securities

Okay. So, you mentioned on your SG&A that it would be up about 1% but I think the 1% excluded –

Don Morel

Yes, it includes pension and currency Arnie.

Arnie Ursaner – CJS Securities

And since you will be incurring those, how much will the SG&A be up in total including those items.

Don Morel

About – percentage wise or – I will give you percentage. It is 17.9% as a percentage of sales.

Arnie Ursaner – CJS Securities

Okay. My final question relates to the margin trends in Tech Group. You obviously went through a restructuring and relative to my model at least in Q4 that was one of the more disappointing line-items, and yet your guidance for the upcoming year even with the restructuring is lower than your guidance or views two years ago. Can you comment a little bit more about what is happening in Tech group? I know, you had hoped to replace lower margin business with better business. Is that a challenge in the current environment and one of the factors behind your – what I would view is cautious margin guidance in Tech group.

Bill Federici

The answer to the first question is absolutely. We overall are still seeking to replace the lower margin business. It is happening slowly. A lot of it is related to the timing of the programs that are coming out of our development efforts because NovoGuard, ConfiDose, and the CZ 1mL insert needle syringe will all be produced at Tech, and as we have discussed previously they won't hit until 2011. You know, we continue to look for things to put in there that make good sense but, you know, the opportunities have been a little bit more difficult than we had imagined in this environment. The margin issue, I think, comes back to some of the pressures on converting the Grand Rapids facility overall to the high-volume filter production, and we are little bit behind there. Our hope is that as we get more efficient running those lines going through the year, those margins will improve.

Arnie Ursaner – CJS Securities

Okay. One more – I do have one more question if I may – I know you don't have a direct competitor that we can really highlight, but (inaudible), which does compete with you in Europe just had really strong results. So the one question is, are you losing share to them?

Don Morel

No. We don't really compete head-to-head with them. There are customers on the prefill side. The only area where there might be competition is in their Golden [ph] subsidiary area, where we both do molding.

Bill Federici

For plastics.

Arnie Ursaner – CJS Securities

Okay, thank you.

Don Morel

You're welcome Arnie.

Operator

Our next question comes from Raphael [ph] from UBS. Sir your line is open.

Raphael – UBS

Hi, good morning. Can you hear me?

Don Morel

Good morning Raphael.

Raphael – UBS

Just a couple of questions for you. I know in the past in the discussions that you put out there that you do your annual renegotiations of contracts at the beginning of the year. Just wanted to get an update of where we stand and where you stand with those negotiations?

Don Morel

Actually, our pricing rolls in at the beginning of the year for those customers that are not covered by contract and that is about 95% complete. As we sit here today, we've been pretty successful in getting pricing overall. The other contract, the longer term contracts, that range between 3 and 5 years come up periodically during the year depending on when they expire obviously, but all of the major contracts to my knowledge have been finalized.

Bill Federici

Okay. And the price increases on those contracts are contractually dictated by the –

Raphael – UBS

Okay. Are you generally achieving a slightly higher pricing than you have in the past I think you've done about 1% to 2%?

Don Morel

Yes. As I mentioned in my commentary Raphael that we are expecting 2 – between 2% and 3% this year as opposed to 1% to 2% that we have seen historically.

Raphael – UBS

Okay, great. And I guess just a little bit more color on the 2009 guidance. I guess, you know, you mentioned the sort of organic growth that you're expecting from (inaudible). In general, what are your volume and pricing assumptions that are embedded in that 2009 guidance?

Don Morel

Yes, again it's the 2% to 3% on the pricing. Volume is going to be very low, you know, you can say somewhere between depending on which segment of the business you are looking at 0% to 1%, and the rest is mix and lean and some of the other things that we talked about.

Raphael – UBS

Okay. And are you incorporating any potential approvals of new biologics into this guidance?

Bill Federici

No. It is not significant.

Don Morel

There are, maybe some that will be out there during the year, but none that are going to move the meter significantly.

Raphael – UBS

Okay.

Bill Federici

You know, the only other thing I point out is that the volume situation relates directly to overall volume expectations in Western Europe and North America in terms of pharma growth.

Raphael – UBS

Okay. In terms of the ordering patterns that you're seeing, I know, you had mentioned that you are expecting a pick up in the second half of 2009, but can you provide us a little bit more detail on the different customer segments. I mean, are you seeing – are you expecting a bit more growth from your biologics customers or pharma?

Don Morel

I think the general economic conditions are just going to make things flow through the year a bit differently than we've seen in the past. We got a range of customers that would traditionally place the blanket order at the beginning of the year and reach a level load [ph]. I think they are being a bit more cautious and they are placing orders for six months with the second order coming in six months later on. We're also seeing some instances where customers are keeping to their traditional order pattern, but might be ordering something slightly less than what they had ordered previously, you know, overall when you look at the distribution of our backlog, it tends to push the back-end of the curve out just a little bit. So, this will be one of the more challenging years in terms of managing timing as we work through the year. We're not losing any business, but we are seeing a certain conservatism in the order patterns from our customers that we haven't seen in the last couple of years.

Bill Federici

And as we suggested, we think that the mix is also going to get a little better. You know, we talked about the ESAs having basically zero in 2008 sales. When we look at 2007, we were in the 18 million range roughly. We will get some of that back in 2009, and again that has a nice margin lift to it. So, we are guiding to a gross margin of approximately 2 percentage points increase versus the prior year for farm systems.

Raphael – UBS

And what exactly was your backlog, I mean –

Don Morel

It was 250, these are rough numbers. $250 million at the end of last year. At the end of this year you're talking about roughly $230 million. There is about a $23 million delta.

Raphael – UBS

And I guess, are you expecting that backlog just to remain flat or come back in with your operation efficiencies?

Bill Federici

It is – the backlog is even with last year as we sit here today, my guess is that depending on the nature of how orders develop it is probably going to creep down slightly as our ability to hit lead times improve, and as our lead times shrink. Last year, when we were early in the year even at the end of ’07, it had increased because demand in our European facilities in particular was so heavy. Customers were ordering a bit to create a safety range because the lead times were 14 to 16 weeks and in some cases longer. Now, in the metal side of the business that is back down to where we like it to be. It is in that kind of 6 to 8 range, and on the rubber side it is in the 10 to 12 and that is where we are comfortable and we operate best.

Raphael – UBS

Okay. And I guess just quickly can you remind us of the new products that we should be looking out for?

Don Morel

The biggest one this year is going to be NovoGuard, the uptake of NovoGuard. You know, as we speak the final clinical trial is ongoing. Hopefully, that will be wrapped up within a couple of days. Data will be submitted and will be good to go early in the second quarter. The main product, I think to keep an eye on is the customer uptake at CZ, in terms of clinical and filling trials and doing stability. Their 2008 was a tremendous year. You know, when I look at the backlog of customers that are testing not only vials but syringes in CZ with new molecules as well as existing formulations. That story is terrific. It is way above our expectations. Unfortunately, the commercial part of that won’t hit until 2011.

Raphael – UBS

Right, and just last one from me, in the past you have given your five-year financial goals, which include that organic sales growth of about 7% and 9% and operating profits of 10% to 12%. I guess, are you still sticking to those long-term goals or you currently reevaluating some of these metrics?

Don Morel

No. I see no reason to change those. I mean, we said we'll have some years where we are lower than that, and some years where we're higher than that. And this plant, when we developed it at the end of last year, you know, clearly we knew there was going to be some economic turmoil near-term, but we have factored those as we begin to phase in the newer products in 2011 through 2013. So, you may see some softer mid-to-high single digit growth in the first part of the plan, but our expectation now looking at our forecast is that it will average out to those numbers by the time we get to the end of the five-year.

Raphael – UBS

Okay, great. I will jump back in the queue. Thank you.

Don Morel

Thank you.

Operator

Our next question comes from Mr. Adam Fizzard [ph] from Barclays Capital. Sir, your line is open.

Adam Fizzard – Barclays Capital

Good morning guys.

Don Morel

Good morning Adam.

Bill Federici

Good morning Adam

Adam Fizzard – Barclays Capital

I am just trying to get a little more color on, I guess, the growth by region and I think you gave it last quarter. Kind of what was the domestic and international growth for the quarter?

Bill Federici

Hold on a sec, let me – I don't have that record in front of me, I'll grab it. If you have another question while I'm grabbing that we would be happy to take it.

Adam Fizzard – Barclays Capital

I mean, I guess for Don. Just, has there been any big difference in the feedback that you are getting from customers in the US versus Europe or has it been fairly similar?

Don Morel

No, I think we're actually seeing a bit more optimism on the European side. Our European backlog is actually ahead of where it was at this point in the last year. Within the US, we're seeing a great deal of more conservatism in how the orders are placed.

Bill Federici

Adam, I have those numbers for you if you'd like.

Adam Fizzard – Barclays Capital

Sure.

Bill Federici

On farm systems, our fourth-quarter domestic sales were up 4.7%, international sales were up 5.1%. On a consolidated basis, our domestic sales were actually down 1.1%, and international was up 3% for the quarter.

Adam Fizzard – Barclays Capital

And that Bill, I think that compares to domestic was down 5% last quarter.

Bill Federici

I don't remember the last quarter number Adam. I apologize.

Adam Fizzard – Barclays Capital

Okay, I will look back.

Bill Federici

But those numbers I gave you are excluding the exchange effect, so you're getting an apples-to-apples number.

Adam Fizzard – Barclays Capital

Okay, so it is constant currency.

Bill Federici

Yes, it is.

Adam Fizzard – Barclays Capital

Okay great. And then just a bit little more color on the pension assumptions.

Bill Federici

Sure.

Adam Fizzard – Barclays Capital

You were saying an incremental of $10.3 million.

Bill Federici

That's correct.

Adam Fizzard – Barclays Capital

Is that, I guess locked in or is that maybe good change if the markets continued to –

Bill Federici

The way the actuarial valuation works, which drives the pension expense for 2009. It is done as of December 31, 2008. So, we absolutely know, you know, that $10.3 million will roll through our P&L in 2009. What we don't know and what is the variable going forward is what the actual results of the investments will be in 2009 versus the assumptions we’ve made in our actuarial evaluation, which were 8% long-term return on assets. So, again the way it's kind of crazy accounting, but the way it works is you take whatever that – at the beginning of the year you strike your pension expense and that you take one-twelfth over each month over the year and as your amounts of return on your assets goes up or down that gets accumulated into an unrecognized bucket within the actuarial valuation and then when you strike your expense for the next year again. So, at 12/31/09 we will take into account whatever the actual performance was for 2009.

Adam Fizzard – Barclays Capital

So, I guess you're saying that we would see it could be another increase in 2010. That's what you are kind of seeing?

Bill Federici

It could.

Adam Fizzard – Barclays Capital

Okay.

Bill Federici

And you will see, just see if everybody – just to make sure we're clear on this. The 10.3 is composed of 2 pieces. The first piece is what I was just describing, which is roughly half of that number, about $5 million, which is the loss that we incurred in 2008 that is going to be amortized into the calculation. It gets amortized over roughly 10 years. So that is about $5 million a year on our $50 million loss. The other piece is the actual assets are less. So you're earning less interest on those assets, which helps to offset your service cost during the year, and that is roughly $5 million. So, the two pieces of the puzzle though are total up to $10 million, but if, for instance, the assets do recover during the 2009 year, you won't continue to see that $5 million increase in your P&L going forward, but the $5 million that relates to the amortized – the loss that is being amortized, you will see that over a ten-year period, each year of $5 million a year.

Adam Fizzard – Barclays Capital

Great, thanks for the clarification, the detail.

Bill Federici

No problem.

Adam Fizzard – Barclays Capital

And then just, I think, you mentioned in the release a $1 million charge taken on an investment. Could you remind me what that is?

Bill Federici

Yes. What we had was a – what we referred to as a super money market account. We had invested $25 million with one of our banks to give us a little better than the standard CD rates that we were earning and that fund which was, it is Colombia's strategic cash fund, I think it is the name of it, actually ran into some redemption problems and it did not invest in any super sophisticated assets, but it wasn't all just plain money market account, and so what we have been doing is, what is required by GAAP is that you take that amount and reclassify it as investments as opposed to cash, and you mark it to market each quarter, which is what we've been doing. So, we took an approximately $1 million charge during the year for the fact that this – the underlying investments have gone down in value. Now, the good news is we originally invested $25 million in this in the fourth quarter of 2007. We're down to $5 million left. We had redemptions in that fund of $19 million rough numbers, and there is only about $5 million left to be recouped, most of which, $4 million of which, we believe, we are going to get in 2009.

Adam Fizzard – Barclays Capital

Okay, so unlikely to see other write-downs, I guess associated with this.

Bill Federici

There is a possibility that there could be some small additional write-downs, but again you're talking on a base of $5 million now, not on a base of $25 million.

Adam Fizzard – Barclays Capital

Okay, and last question from me, just on, I guess, AR collections, looking at any signs of slowing or changes there.

Bill Federici

Actually, what we are seeing is our guys have done a great job. You noticed our working capital was down $20 million. Our actual current receivables have actually gone up. So we are – the percentage of our receivables that are current has actually increased over the year reflecting our – we've been beating on our people pretty heavily to get out there and collect receivables. Will we see it? It is very possible, but as of right now we are not seeing it, Adam.

Adam Fizzard – Barclays Capital

Great, thanks a lot for the details guys.

Bill Federici

You're welcome.

Don Morel

Thank you.

Operator

(Operator instructions) Our next question comes from Mr. Rick Dalton [ph] with Colombo Management [ph]. Sir, your line is open.

Rick Dalton – Colombo Management

Yes, I just would like to make an observation and then maybe get some feedback on, you know, philosophy I guess in general regarding expenses. We listen to an awful lot of calls, and obviously it's a tough economy. You guys have talked about all the headwinds you are experiencing, and yet upfront you talked about pay raises for this year. I think you said, you know, there were some bonuses paid and things. Why not, you know, in I guess the good times, you guys have done quite well. Why not in these tougher times, you know, sort of waive the increases like 95% of the other companies are doing. Why are you putting yourself on a different platform on the expense side than philosophically a lot of other companies are.

Don Morel

I think there is really two parts to that question. One is that the broad-spectrum of the folks in the company that produce the results in ’08, I think, deserve an increase. The workload that was put on them between simultaneously managing very heavy demand, while executing our expansion programs in existing facilities and even building the new facilities was an absolutely terrific effort. That having been said, I do think it is appropriate that the officers of the company defer an increase in their salary and we're going to do that. Looking forward for us, it is an issue of competing for talent and we're going to continue to recruit and build our base as best we can with the best people that we can find and for us being a billion-dollar company within the healthcare segment, it means bearing some pain on the salary side. So, those two factors are going to keep us there.

Bill Federici

And the one other comment, I think I would add to Don is that our incentive compensation is based very much tied to the growth and profitability of the company. You know, our long-term incentive plan has two metrics, 50% rated each, one is the compound annual growth rate on sales and the second one is the return on invested capital. So, to the extent that we don't perform, we won't get paid and that is the way it is.

Rick Dalton – Colombo Management

I mean, you know, in one sense clearly you guys shouldn’t be penalized for a pension expense, and you shouldn't necessarily be penalized by FX expense but having said that you had been a huge beneficiary of FX and you're getting the rewards for that. So I guess, you know, you can’t have it both ways in my mind anyway.

Don Morel

We don't do that. Our plan specifically calls for everything to be FX neutral. So, we do not benefit when FX works with us.

Bill Federici

In the past three years, we have reduced our payouts for the fact that there was positive FX.

Rick Dalton – Colombo Management

Okay, I'm glad to hear that, but you know, this is a tough job environment. I hear what you're saying as it relates to healthcare but I would ask you to re-look at that in these tough times, and see where else you can take some cost out during these more painful times. You know, clearly shareholders are taking it on the chin today and have been and, you know, I think we'd take it less on the chin if the cost side were being choked back a little bit in this environment.

Don Morel

We don't disagree. We tend to watch that line very, very closely and where we have opportunities we will cut cost when prudent.

Rick Dalton – Colombo Management

All right, thanks.

Don Morel

You are welcome.

Bill Federici

Thank you.

Operator

Our next question comes from Mr. Christian Mikel [ph] from Orlando [ph].

Christian Mikel – Orlando

Yes, thanks for taking the call. I have three questions. The first is on the backlog. You mentioned some moderation of that and as you entered the year, and so I guess the question is how much visibility does this really provide. Can customers cancel their orders at any time or these take-or-pay contracts, maybe just some –

Bill Federici

Combination of both. The actual change in the backlog has really to do with the composition of the delivery times. The overall dollar magnitude of the backlog is healthy as it has ever been. So, what we're seeing is a slight change in delivery expectations and quantities within those delivery expectations. You know, and again I think that is just the sign of the times.

Christian Mikel – Orlando

But that means that customers are simply ordering less.

Don Morel

But they may either be ordering less or they may actually be just, you know, our lead times have come down in our production facility. So, they don't need to order as much in terms of safety stock or order ahead of the curve as they had in the past when our lead times were up in the 16 to 18 weeks. So, you know, you're seeing – there are a number of variables that play there that, you know, as Don mentioned we are not losing any business. It is – these are really timing issues plus some conservatism on the fact that the economy is troubling most companies and, you know, maybe causing them to delay putting their orders in.

Christian Mikel – Orlando

And so, then the second question is how much do you expect customer inventory destocking or slower sales, which is specifically related destocking will impact you in 2009, either sales growth reduction or dollars lost, and how do you measure the impact of this drawdown. I mean, what sort of visibility do you have about your customers’ inventory levels. How much do you assume will be drawn down and how long that adjustment process will take and in your guidance do you assume a replenishment of the inventory levels in the back half of 2009 or do you assume that they don't or, you know, maybe you can just talk a little bit about that.

Don Morel

With regard to the visibility question, usually our visibility on a quarter-to-quarter basis is pretty good and it tails off as we go through the year. So, as we enter a quarter historically we got between 85% and 90% of our orders on the books. I think, the uncertainty we are seeing now is that there is probably a 5% to 10% swing in that number as the composition of the backlog goes further out and in some cases now even part of that backlog is into 2010. We try and stay as close to our customers as we possibly can. It benefits us because smoother order patterns allow us to level load our factories. Sometimes, they are not the most forthcoming folks in the world, then we have to go on historical averages, which is the way that we would plan. You know, as we said here now I think for the first half of the year they are going to be conservative, they are going to draw down their inventory slightly and then we'll see it start to come back in the second half of the year.

Christian Mikel – Orlando

So, are you assuming that the inventory drawdown is done by the end of Q1 or do you assume that –

Don Morel

It is going to go up and down through the year.

Bill Federici

But the big chunk of it does hit in Q1, you are correct.

Christian Mikel – Orlando

But you are also implicitly assuming that those inventory levels – that drawdown of inventories would finish by year-end.

Don Morel

It will stabilize. It may not completely come back and again our visibility in the back half is a lot less clear than it is in the first-half. So, but that is our assumption.

Christian Mikel – Orlando

And are there any products in particular in which this kind of destocking issue has occurred or is this across-the-board.

Don Morel

I can’t think of a single category where it has been pronounced. It is certainly not like the ESA situation we saw, which was dramatic.

Christian Mikel – Orlando

And the last question is just free-cash flow expectation for 2009.

Bill Federici

The free cash that we are expecting for 2009 is in that roughly – let me back up. I'll start from the top. Operating cash flow is going to be roughly $150 plus million. We'll use approximately again our guess is $140 million for CapEx, although we are looking very closely at that to see whether there are items that we can defer or delay or cancel. We also pay a dividend as you know to our shareholders and that is roughly $20 million. So, when you’re defining whatever you are going to define as free cash flow. If you are looking at operating cash flow less our CapEx and our dividend, you know, there will be very minimal free cash flow in that regard but our operating cash flows are very healthy and allow us to afford the dividend and the CapEx.

Christian Mikel – Orlando

And why is the CapEx so high, I mean is there – how would you break down maintenance versus – because right now, the cash flow from the business isn’t covering the capital investment and the dividend.

Bill Federici

If you look at the maintenance cap, it is only about between $50 million and $60 million. It was $50 rough numbers for 2008. We spent roughly $25 million in 2008 on IT, mostly for SAP and related shop floor systems that we are changing out in our North American unit. And the rest of it, about $55 million is these new product expansions that we are going through mostly in Europe.

Christian Mikel – Orlando

Okay.

Don Morel

But the other answer to the capital question is that the new product capital and we can’t emphasize this enough typically takes from 2 to 4 years to start generating commercial sales. That is the price we pay for the longevity of the business once it goes through the FDA cycle. So, by the time we order and put an equipment; by the time we validate and test sample our customers they complete their analysis and begin to produce commercial orders. It is a relatively lengthy process.

Christian Mikel – Orlando

So, is this 55 in capacity expansion just this year or is that something that is to recur in 2010.

Bill Federici

It will recur in 2009, we think to a certain extent less in Europe, more in Asia and in United States. We believe that a number, and again we are not guiding to 2010, but a number in that same kind of range is appropriate for 2010 if we continue to see the demand growing the way we expect it to continue to grow. You know, to grow in the kind of long-term range that we described earlier in the high-single digit, you need to add capacity to be able to continue to get those sales, and as Don said there is, you know, 2 to 4-year delay between when we put the cap in and when we get it, but once that capital is up and running and fully charged, all of this expansion capital that we are putting in is in these advanced systems that we're talking about the, you know, advanced coding and Westar processing systems that carry margins that are very, very – very strong margins and we believe are good investments in the long term.

Christian Mikel – Orlando

But it sounds like there was going to be some level of capacity investments on an ongoing basis.

Bill Federici

Correct.

Christian Mikel – Orlando

All right. Okay, thanks very much.

Bill Federici

Thank you.

Don Morel

Thank you.

Operator

Thank you. This concludes today's question-and-answer session, and now I would like to turn the call over to Dr. Don Morel.

Don Morel

Thank you very much operator, and thanks to everyone for your time this morning. 2008 was another successful year for the company despite the economic climate and the loss of key sales at the outset of the year. For 2009, and beyond we remain focused on running the business efficiently, while continuing to invest for the future and building value over the long term. Thank you very much for your time this morning.

Operator

Thank you for participating in today's conference call. Please disconnect.

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Source: West Pharmaceutical Services, Inc. Q4 2008 Earnings Call Transcript
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