West Pharmaceutical Services' CEO Discusses Q2 2013 Results - Earnings Call Transcript

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 |  About: West Pharmaceutical Services Inc. (WST)
by: SA Transcripts

West Pharmaceutical Services Inc. (NYSE:WST)

Q2 2013 Earnings Conference Call

August 1, 2013 9:00 a.m. ET

Executives

Donald E. Morel Jr., Ph.D. – Chairman and Chief Executive Officer

William J. Federici – Vice President and Chief Financial Officer

Michael A. Anderson – Treasurer and Vice President

John Woolford - Investor Relations-Westwicke Partners

Analysts

Arnold Ursaner – CJS Securities

Sean Dodge – Jefferies & Company

Ross Taylor – CL King and Associates

Operator

A very good day to you ladies and gentlemen. Welcome to the West Pharmaceutical Services Second Quarter 2013 conference call. At this time, all participants are in a listen-only mode. 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 in this call implies your consent to our taping. If you have any objection, you may disconnect at this time.

Now I’d like to turn today’s meeting over to Mr. John Woolford from Westwicke Partners. Sir, you may begin.

John Woolford

Thank you, operator. Good morning everyone and welcome to West’s second quarter 2013 results conference call. We issued our financial results this morning and the release has been posted in the Investors section on the company’s website located at www.westpharma.com. Please note that we are issuing a corrected release which should be available soon. We are correcting the upper end of the 2013 GAAP fully diluted EPS range to $3.28. If you have not received a copy of the announcement, please call Westwicke Partners at 443-213-0500 and a copy will be sent to you immediately. Posted on the company’s website is a slide presentation that management will refer to in their remarks today. The presentation is in PDF format. Should you require a link to a free download of software that will enable users to view the presentation, it is also available on the website.

I remind you that statements made by management on this call and in the presentation will contain forward-looking statements within the meaning of US Federal Securities law and that are based on management’s beliefs and assumptions, current expectations, estimates and forecasts. Many of the factors that will determine the company’s future results are beyond the ability of the company to control or predict. These statements are subject to known or unknown risks or uncertainties and therefore actual results could differ materially from past results and those expressed or implied in any forward-looking statement. For a non-exclusive list of factors which could cause actual results to differ from expectations, please refer to today’s press release, as well as any further disclosures the company makes on related subjects in the company’s 10-K, 10-Q, and 8-K reports.

In addition, during today’s call, management may make reference to non-GAAP financial measures including adjusting operating profit and adjusted diluted EPS. Reconciliations and limitations of the non-GAAP financial measures to the most comparable financial results prepared in conformity to GAAP are provided in materials accompanying this morning’s earnings release.

At this time, I’d like to turn the call over to Don Morel, West’s Chairman and CEO. Don?

Donald Morel

Thank you very much, John, and good morning everyone. Welcome to West’s second quarter Analyst call. I’m joined by Bill Federici, West’s Chief Financial Officer; and Mike Anderson, our Treasurer and Primary Investor Relations Contact.

As you know, West released our Q2 earnings earlier this morning and during this call, Bill and I will be discussing our recent performance and our outlook for the second half of the year. As in past calls, we will refer to a PowerPoint slide deck to support our remarks which can be accessed via our website under Investors. However, if you cannot access the file, the information in the slides is covered in both this morning’s release and our prepared remarks.

Slide number 3 lays out a few highlights from the quarter and today’s announcements. First, results were very positive for both businesses. We’re growing sales, expanding margins and higher earnings per share. Those results in the quarter are a factor in raising our EPS expectations for the full year. I’ll come back to those in a moment and Bill will go into greater detail during his commentary.

We realized an important milestone in the quarter, receiving a $20 million exclusivity fee from a customer for the use of SmartDose in a single therapeutic area. We will recognize that income over the 13 year life of the agreement. And so it is not a major factor in our current results. It is however a major marker in terms of the state of the technology and while the customer and drug remain confidential, we are very excited about the future prospects for this platform.

In addition to our results, we also announced today that we will affect the two-for-one stock split in September. This is the second split in the last 10 years and is symbolic of our confidence in West’s future. In connection with the split, we also announced today that West’s Board approved an increase in our quarterly dividend by $0.01, effective in the fourth quarter. This increase marks the 21st consecutive yearly dividend increase for West and is also indicative of our confidence and the long term prospects for the business.

Turning to some additional financial highlights on Slide number 4, consolidated sales increased to $344.5 million or by 5.7%, excluding currency effects as a result of ongoing strong demand across both operating segments. Our consolidated gross margin for the quarter improved by 1.8 margin points to 32.2%, and operating profit improved by $3 million to $42.5 million when compared with the prior year period. For the quarter, adjusted earnings per share were $0.86, versus $0.79 during the second quarter of 2012.

Additional segment details are provided on Slide number 5. Sales in the Packaging Systems segment grew by 6.3% and Delivery Systems grew by 4.3%, again excluding the effects of currency. Pharmaceutical Packaging Sales benefited from increased sales of standard, pre-fillable syringe components and higher selling prices. Sales of high value products increased 3.3% versus the second quarter of 2012, which is a smaller improvement than we’ve seen in recent quarters, primarily due to product growth of remarkable 28% in the prior year period. We fully expect high value product sales growth to be in the range of 10% to 12% for the second half of the year.

Delivery Systems sales grew as a result of strong demand for proprietary products, including CZ vials and cartridges and proprietary devices for reconstitution and safety. Contract manufacturing revenues were slightly lower as a result of regulatory delays for two new customer projects. Overall, sales of proprietary West systems accounted for 26% of total delivery system revenues, up slightly versus the first quarter of 2013, which compares very well to the 20% proprietary mix in the prior year quarter.

Operating results did not include any substantial part of the SmartDose exclusivity fee, whereas we recognized $3.8 million from development fees in the prior year quarter. In those terms, the comparison is unfavorable, although this year’s progress is more noteworthy in terms of the product’s commercial potential.

Our current backlog of firm committed orders at June 30 is 14% than the second quarter of 2012 on a currency neutral basis, but decreased slightly compared with the first quarter of this year. As discussed in our May call, this sequential pattern is in line with historical norms, as customers typically order larger quantities of product early in the year. From midyear through the third quarter, orders in sales slow as they focus on managing their inventories around production shutdown periods for summer and yearend holidays and as they address their yearend working capital and cash flow targets.

From a pure operation standpoint, we have made good progress in reducing lead times for certain key products in Europe, which also shortens order lead times while seeing orders grow in North America and Asia. All in, we expect our backlog to come down further during the third quarter before orders begin flowing in for 2014 in the middle of the fourth quarter. We don’t expect these order patterns to adversely impact comparable sales in the second half of the year, but I’ll speak to our guidance in a few minutes.

Slide number 6 provides a brief summary of our major expansion in new product development programs. We started limited commercial production at our China elastomer facility and continue to produce test samples for line trials and validation for other potential customers. Construction of the India plant remains on schedule and the expectation is that we will begin metal seal production in early 2014, followed by rubber production in 2015. Both China and India will provide much-needed capacity for the region, and will allow increased production of high-value products in our Singapore facility to support forecasted growth in the Asia-Pacific market.

Sales of our Proprietary Delivery Systems products are developing well and reached 26% of total PDS sales during the quarter, again driven primarily by increased sales on reconstitution systems and Eris safety devices. CZ revenues, comprised of comprised of vials, cartridges and the 1ml long syringe, were $4.8 million during the quarter, substantially higher than the modest start to 2012. We expect double-digit increases in sales of our proprietary systems during 2013, on top of the 16% increase produced in 2012. CZ revenues for the full year should fall in the range of $13 million to $15 million and we expect sample demand to cotinine to fluctuate as it depends entirely on customer requirements and timing for clinical trials and process development.

Development work on the proprietary SmartDose infusion system is progressing on schedule. During the quarter, West also completed the first in-human study using healthcare providers to place the device on subject and the results were extremely positive, with excellent feedback regarding minimal discomfort levels at the injection site.

Turning to our outlook for the remainder of 2013, as outlined on slide number seven and in this morning’s release, we believe sales growth for the year will fall between 6% and 0% at constant exchange rates, yielding revenues in the range of $1.35 billion to $1.39 billion at currently forecasted exchange rates. The primary driver for packaging systems will be our high value product lines, whereas in delivery systems, the ongoing shift to proprietary products and steadying demand for contract manufacturing will be key.

We are forecasting improvement in our full year consolidated gross margins, which when coupled with our expectations for SG&A and R&D spending, should produce full-year adjusted earnings in the range of $3.10 to $3.25 at currently assumed rates. We believe the company is well positioned to generate revenue growth, in line with our long term objectives and remain firmly committed to our strategy of focusing on expansion of our value added product lines and packaging systems while continuing to invest in technologies and products in the PDS segment to address currently unmet market needs. In keeping with our historic practice, we plan to provide preliminary revenue guidance for 2014 and our revised long term outlook on our Q3 call in November and earnings guidance in our yearend call in February of next year.

I would now like to turn the call over to Bill Federici for a more detailed discussion of our financial results. Bill?

William Federici

Thank you, Don, and good morning everyone. We issued our second quarter results this morning, reporting net income of $30.2 million or $0.86 per diluted share versus the $0.45 per diluted share we reported in the second quarter of 2012. Second quarter 2012 earnings were $0.79 per diluted share after excluding the effects of special items, notably the Q2 2012 charge for refinancing our convertible debt. The effects of special items in this year’s second quarter were insignificant. The non-GAAP measures are detailed on slides 15 through 17.

Turning to sales, Slide 8 shows the components of our consolidated sales increase. Consolidated second quarter sales were $344.5 million, an increase of 5.7% over second quarter 2012 sales, excluding exchange. Packaging systems sales increased by $15 million, or 6.3% over the same quarter 2012 sales, excluding exchange. Volume increases, especially in Europe accounted for 4.2 percentage points of the increase. Sales increases contributed the remaining 2.1 percentage points. Sales in our high-value products increased 3.3$ versus the prior year quarter, excluding exchange. Standard packaging components grew 7.4%, excluding exchange.

While high-value products grew a modest 3.3% in the current quarter, you may recall that our Q2 2012 high-value product sales had increased 28% over its prior year comparator. Since Q4 of 2011, high-value product sales have enjoyed double digit increases versus their prior year costs. While the Q2 comparison was particularly challenging, we expect that high value product sales will show double digit growth for the second half of 2013 and for the full year.

Delivery Systems sales increased by approximately 4.3% over the prior year quarter, excluding exchange. Sales improvement for CZ and administration systems were partially offset by lower contract manufacturing sales. Sales of our proprietary products were $24 million or 26% of the segment’s revenues in the quarter, an increase of nearly 6 percentage points over the prior year quarter. CZ sales in development activity were approximately $4.8 million in Q2, about $3 million higher than the prior year quarter. CZ cartridge sampling sales accounted for the majority of the increase.

As provided on Slide 9, our consolidated gross profit margin for Q2 2013 was 32.2%, versus the 30.4% margin we achieved in the second quarter of ’12. Packaging Systems second quarter gross margin of 36.9% is 1.8 margin points higher than the 35.1% achieved in the second quarter of 2012. General inflationary increases in labor and overhead costs continue to put pressure on margins. But the impact was more than overcome by higher selling prices, continued lean savings and efficiencies in our plants and smaller than expected increased in raw material costs. Delivery Systems second quarter gross margin increased 1.6 margin points, versus the prior year quarter to 19.5%. Production efficiencies, higher selling prices and a favorable mix of products sold were partially offset by increased labor and material costs.

In June 2013 we received a $20 million exclusivity payment for SmartDose, covering a specific therapeutic area. The $20 million is included in cash at June 30th 2013 and will be recognized as income over the 13 year life of the contract. As a result, other income compares unfavorably to the $3.8 million of development related income recorded in the 2012 second quarter.

As reflected on Slide 10, Q2 2013 consolidated SG&A expense increased by $5.3 million compared to the prior year quarter due to increases in performance based compensation expense associated with our improved operating results, inflationary increases in salaries and related costs, increased outside service costs related to our supply chain initiatives and labor costs, increased sales commissions and higher depreciation on our IT assets.

Slide 11 shows our key cash flow metrics. Operating cash flow was $98 million for the first half of 2013, $32 million more than the comparable prior year period, due primarily to our strong operating results and receipt of the $20 million SmartDose exclusivity payment. Capital additions of $84 million were made in the first half of 2013, including the $35 million of accrued new headquarters cost paid in 2013. Roughly half of the remainder of the capital was spent on new products and expansion efforts. We expect to spend between $125 million and $140 million in capital in 2013, excluding the accrued building costs.

Slide 12 provides some summary balance sheet information. Our balance sheet continues to be strong and we’re confident that our business will provide necessary future liquidity. Our cash balance at June 30th was $191 million, $29 million higher than our December 2012 balance. The vast majority of our cash is invested overseas and is generally not available to be repatriated to the U.S without incurring tax consequences. Debt at June 30th was $395 million, $16 million less than at the yearend, primarily due to the February maturity of our $25 million Euro note, partially offset by increasing borrowing on our revolving debt facility. Our net debt to total invested capital ratio at quarter end was 20.7%, about 5 percentage points lower than the prior yearend ratio.

Working capital totaled $395 million at June 30th, $99 million higher than at the prior year end. Approximately one third of the increase is due to the refinancing of short term debt to long term, one third related to the growth in the business, and the remainder due to the increase in cash.

Our consolidated backlog of committed orders continues to be strong at $356 million as of June, 14% better than the June 2012 number, but about $9 million lower than the prior year end balance, excluding exchange. We believe the lower backlog is due to a combination of seasonality and customers responding to anticipated shorter lead times in our plants. We continue to believe we’ll see strong sales and operating results for the remainder of 2013 due to continued high value product sales and sales of proprietary delivery systems, both of which are expected to show full year double digit growth in 2013 versus 2012.

Don has highlighted our revised full year 2013 guidance as summarized on slide 13. I’d like to call your attention to Slide 14 which shows the significant factors that can be evidenced, have been evidenced in our Q2 results and which are expected to impact our margins through the rest of 2013.

I’d now like to turn the call back to over to Don Morel. Don?

Donald Morel

Thank you very much, Bill. This concludes our prepared remarks for this morning and we now look forward to answering your questions. Operator?

Question-and-Answer Session

Operator

Operator instructions) We have our first question from the line of Arnold Ursaner from CJS Securities. Please go ahead.

Arnold Ursaner – CJS Securities

I’m sure you’re highly constrained in what you can say about the exclusive agreement that you have, but let’s try to take a stab at a couple of things. You mentioned that’s in a single specific therapeutic area. Which area is that?

Donald Morel

That is confidential.

Arnold Ursaner – CJS Securities

And obviously SmartDose has multiple potential applications. Maybe you could go through the thought process of why the customer would want the exclusive, why you would benefit from giving them an exclusive and how it potentially could impact other uses of this product? Let’s start with that.

Donald Morel

Sure. For the customer of course one of the things that’s key in the marketplace is differentiation and I think you’ve heard a range of folks talk about the potential for large volume infusion systems above and beyond the standard 1ml in certain spaces for certain therapeutic categories. We think the system has applicability for medicines that need to have a larger volume delivered, preferably outside of the healthcare setting, either the hospital or small clinics where you ensure dosing accuracy, you ensure patient comfort and most importantly, ease of use for patients that may be compromised in terms of their hand strength and other issues. So we think it’s got a broad range of applications for us. Clearly the customer putting some skin into a very complicated development project with the new technology is a good sign.

Arnold Ursaner – CJS Securities

One more question regarding that. To the extent they have this exclusivity agreement and you’ve been going through a testing phase, has this customer taken a certain number of testing units already? Or more broadly, when in your agreement do you expect to see commercialization or use of the product for commercial applications?

Donald Morel

The only color I can add is that we are working very, very closely with them. Clearly they have been testing devices as we’ve done along, but that’s about where we stand right now.

Arnold Ursaner – CJS Securities

Final question for me and I’ll give others plenty of chances, on the gross margin in pharma, it was particularly strong, better than we had modeled and I think better than you had expected and yet the sales of proprietary products grew slower than your more traditional products and yet you highlighted mix as being one of the factors driving higher gross margin. It seems a little inconsistent. Can you expand on that a little?

William Federici

Sure, Arnie. Actually we talk about mix being a smaller part of the equation today in the second quarter. What you see is it’s more about volume, especially in Europe that was driving the – plus we had very high efficiencies in terms of throughput in the plants and our lean programs. Our inflationary pressures were not as high as we had expected, especially with the raw materials. So when you take – we had many, many variables that worked through our gross profit. And mix happened to be very, very, not that important in this quarter. We think that’s an anomaly. We talked about the sales volume of high value products in PPS, the packaging, pharma packaging systems being low, only 3.3% in the second quarter. And as Don had said, and as I had also reiterated, we expect the second half to be double digit growth, and for the full year to be double digit growth. So somewhat of an anomaly related more to the prior year second quarter being as strong as it was than it is anything as it relates to the current year’s second quarter.

Donald Morel

The only color I’d add to that, Arnie, is we saw very strong sales of pre-filled syringe components out of our standard product line. So a positive there for sure.

William Federici

Mostly volume related, Arnie.

Operator

We have a next question from the line of Dave Windley from Jefferies. Please go ahead

Sean Dodge – Jefferies & Company

It’s Sean Dodge on for Dave. Bill, we’ve seen inventory building. It would be helpful on the packaging side in the past, curious to know what extent if any that played a role in the second quarter or are we largely beyond that now?

William Federici

No. It did not have as much of a role in the second quarter as you saw. However, whether that’s the end of it or not remains to be seen. We are again reiterating that we expect our high value products to continue to show double digit growth in the back half of the year and full year 2013. Each individual customer is different. Sean, I can tell you that they all have different stories. It really is a customer by customer basis. We did not see as much inventory building in the second quarter if you look at the backlog. Sequentially the backlog is actually down slightly versus December’s backlog, but still healthy over last year’s second quarter. Is it over? Really remains to be seen.

Our backlog now if you think about it, as we’ve mentioned in other calls, represents right around 85% to 90% of the next quarter’s sales. But there are still obviously a piece of the next quarter and obviously the fourth quarter that are not known at this point in time. so we’re going into the period here in July and August where customers in Europe shut down for their maintenance purposes and we do as well. It will really depend on how that startup happens and when as Don said, we start to see the orders start to flow back in, in the fourth quarter. But for now it did not have a big impact in the second quarter, but we do expect high value product growth to be double digit for the rest of the year and for the full year.

Sean Dodge – Jefferies & Company

And then on that, how much if you could maybe split the high value product growth between maybe new injectable approvals and just maybe improving volumes into your existing base. So maybe higher same store sales call it?

Donald Morel

I think the bulk of it is higher same store sales. Clearly existing products in the marketplace comprise the bulk of the increase.

William Federici

We had a -- if you remember back in the first half of 2012, we had a biologic that we were a part of that was launched. And that caused part of that 28% increase in the second quarter of 2012. You had tough comps to compare to as well.

Sean Dodge – Jefferies & Company

And then just lastly, Don, on the delivery side, you mentioned in the press release the manufacturing project delays. Could you elaborate on that a little bit please?

Donald Morel

Actually there are regulatory delays associated with two customers. They’ve been asked to provide some additional data on a product they’re seeking approval for. They are working on that. It’s not related to us and we are just waiting for the go ahead.

Sean Dodge – Jefferies & Company

Any visibility on how quickly those could be resolved?

Donald Morel

Our hope is that they’ll be resolved before the end of the year, but I wouldn’t be surprised given the unpredictable nature of these things if it slipped into the first quarter of next year.

Operator

Operator instructions). Next question is from the line of Ross Taylor from CL King. Please go ahead

Ross Taylor – CL King and Associates

Just circling back to the exclusivity agreement again, do you think it’s likely that you may enter into exclusivity agreements with other partners in your different therapeutic areas or is there something unusual about this particular market?

Donald Morel

No. I think that’s the nature of the beast with systems like this. If you look at what happened in auto injectors, what you typically see is exclusivity for an indication to a customer and for other customers entering the therapeutic category you see different systems coming in. my expectation is fully that we’ll see more agreements of this type in a range of therapeutic areas.

Ross Taylor – CL King and Associates

If my memory is correct, I think on your last call you mentioned that you may or one of your partners may initiate a clinical trial with SmartDose later this year. Is that still the case? I just wondered if you could say whether it’s with this partner you just signed the exclusivity agreement with.

Donald Morel

Not going to comment on the partner, but our expectation is that it will be in a clinical trial within the next two to three quarters.

Ross Taylor – CL King and Associates

Final question just related to CZ. I don’t know if there’s any general comments you can make about whether any of the efforts or development timelines by some of your partners may have changed, if commercialization is still on track with your expectations.

Donald Morel

Everything we’ve seen is things are still on track relative to the general timelines we’ve talked about in the past. So no real changes there. Stability trial is ongoing. Line trial is ongoing. A lot of data being generated, but so far so good.

Operator

We have one more question from the line of Arnie Ursaner. Please go ahead.

Arnold Ursaner – CJS Securities

A couple of follow up questions. One, how should we think about the accounting treatment on this agreement, the exclusivity agreement that I think you’re going to receive?

William Federici

It’s pretty straightforward. We’ve got it on our balance sheet right now the $20 million sitting in cash and ratably over the next 13 years. So roughly $1.5 million per year will find its way into the income statement. So in the second quarter of 2013 we had just under $200,000 of income relative to this. It’s about $120,000 a month. So for the full year the eight months that will have recording income on it will be about $1 million.

Arnold Ursaner – CJS Securities

And going to the SG&A line for a second. You mentioned or highlighted increased outside service costs in connection with IT. Just remind us -- and supply chain efficiencies. Remind us how we should think about that on a go-forward basis.

William Federici

A lot of the IT – I’ll answer the first one first, the IT question. It’s really infrastructure changes. We’re going through a lot of private Cloud environment architecture and it’s expensive stuff and the lives are generally shorter than you think of machine and equipment. So those assets that you’re putting on the books and the P&L to increase deprecation over somewhere between three and five years, depending on what it is. So that’s what we’ll expect there. And we’ll continue to see that, Arnie. That will continue for the rest of this year and for the next several years. The total number that you’re talking about in terms of a base is somewhere between $10 million and $20 million. On the outside service costs for our supply chain initiatives, that is – we’re looking at our manufacturing footprint, our global manufacturing footprint and the demands on our manufacturing platform which are pretty great, especially in the Packaging Systems side. So we’re looking at trying to optimize that and we’re spending some money with some outside consultants to help us look through that.

Arnold Ursaner – CJS Securities

Going back to – you know you’re going to get asked again more about this exclusivity thing. So as part of the deal, are you committing certain manufacturing -- A, remind us how you plan to manufacture SmartDose? And B, are you committing manufacturing or a certain amount of output to this exclusive customer for their $20 million?

Donald Morel

The manufacturing strategy currently utilizes our assets in Israel. The plan is to bring manufacturing into the United States when volumes reach a certain point. We have not dedicated specific capacity to this agreement.

Operator

Thank you very much for your questions, ladies and gentlemen. I would now like to turn over to Don Morel for closing remarks. Please proceed.

Donald Morel

Thank you very much for your time this morning everyone. We look forward to speaking to you again on our third quarter conference call in early November.

Operator

Thank you. Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Have a good day.

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