西式醫藥服務 (WST) 2003 Q2 法說會逐字稿

Good morning. My name is Cheryl, and I will be your conference facilitator. I'd like to welcome everyone to the West Pharmaceutical Services second quarter 2003 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer period. If you would like to ask a question during this time, simply press star and the number 1 on your telephone keypad. If you would like to withdraw your question, press star then the number 2. I'd now like to turn the call over to Lanie Fladell with FD Morgan-Walke. Miss Fladell you may begin your conference.

Thank you, operator, and good morning, everyone. Welcome to the West Pharmaceutical Services 2003 second quarter conference call. As you know, we issued our second quarter financial results earlier this morning. If you have not received a copy of this announcement, please call FD Morgen-Walke at 212-850-5600 and a copy will be faxed to you immediately. Before we begin I would like to remind you that certain statements made on this conference call that are not historical are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The words estimate, expect, intend, believe, and similar expressions are intended to identify forward-looking statements. These forward-looking statements involve known and unknown risks and uncertainties.

The company's actual result may differ materially from those expressed in any forward-looking statement and are dependent on a number of factors. A non exclusive list of these factors is included in the company's press release from this morning and SEC filings. In addition, for the purpose of aiding comparison of period results references made on this call and in this morning's release to financial results determined by excluding certain unusual or non recurring items from each period and by re-measuring results of the most recent period by eliminating the effect of changes in foreign exchange rates. Those re-measured period results are not in conformance with the United States Generally Accepted Accounting Principals, known as GAAP, and are non GAAP financial measures.

The non-GAAP financial measures are intended to explain or aid in the use of, not as a substitute for the related GAAP measures. This call is being recorded on behalf of West Pharmaceuticals Service and is copyrighted material. It cannot be re-recorded or re-broadcast without the company's expressed permission and your participation implies consent to our taping. Once management has completed their remarks, we will open the call up for questions. With us is Drs. Donald Morel, Chairman and Chief Executive Officer, Linda Altemus, Chief Financial Officer and Mike Anderson, Vice President and Treasurer. I'd like to turn the call over to Don Morel. Don, please go ahead.

Thank you, Lanie, and good morning, everyone. We appreciate your taking time to join us for today's conference call to review our second quarter financial performance and the outlook for our business over the remainder of the year. As Lanie indicated, joining me on the call are Linda Altemus, our Chief Financial Officer, and Mike Anderson, West's Treasurer and primary Investor Relations contact. As you will have seen from this morning's press release, our second quarter was an extremely strong quarter. On a GAAP basis we reported earnings per share of 48 cents, on net income of $6.9 million, compared with net income of $5.3 million for the same period in 2002. Total sales increased 19 percent, or 10% in constant exchange rates, driven by very strong growth in the pharmaceutical systems division.

Our earnings were impacted 17 cents due to uninsured expenses associated with Kinston. In addition, incremental production costs associated with the company's manufacturing recovery plan were partially offset by an estimated business interruption insurance recovery of $2.6 million. The strength of our operating performance is highlighted by excluding the affect of one-time items. On this basis, net income increased $9.4 million for 65 cents per share, versus $5.2 million or for 36 cents per share for the comparable period in 2002. The company's strong financial performance is extremely satisfying given the challenges presented in maintaining our customer service levels post the Kinston tragedy and the impact of declines in our pension assets. The management team continues to receive very positive feedback from around the world from all of our customers regarding our recovery efforts in light of Kinston. Let me turn now to the pharmaceutical systems division.

The pharmaceutical systems division demonstrated strong sales growth in the quarter with sales increasing 20 percent, or 11 percent in constant exchange rate. Sales rose in each of the divisions geographic operating regions but were particularly strong in Europe. Sales growth in each division continues to be driven by strong demand for value added coated closures for the biotechnology segment as well as strong demand for Westar treated products. In Europe the strong demand for pre-filled syringe systems continues. A very positive product mix continues to benefit the operating profit line as pharmaceutical segment sales in general have remained strong. For the remainder of the year we will continue to focus on executing the fundamentals of our business plan for the division which include recognizing the benefits of our global capacity expansion, ensuring timely supply to our customers, achieving world-class quality and superior technical customer service and account management.

The key to achieving our goals for the year is the timely completion of our project to rebuild our molding capacity in Kinston which I will comment on further in a moment. Overall I'm very pleased with the strong year to date performance of the division. Let me now turn to drug delivery. Revenues for the drug delivery division were down approximately $1 million versus the comparable period in 2002. This short-fall was due principally to continued softness in the clinical services component of the division. Client funded program revenues in the drug delivery group increased slightly versus last year and the overall operating loss for the division improved modestly versus 2002. During the quarter we initiated two new client feasibility programs and the group continues to pursue a broad range of technology and product license opportunities.

As the new client funded program revenues begin to materialize throughout the remainder of the year, I expect the performance of the division to improve. Let me now turn to Kinston. On July 2nd, West announced that it had reached an agreement with Lenoir County to purchase a partially built shell building on Rt 70 to rebuild our molding operation. The schedule is to complete the necessary mechanical and electrical systems in addition to necessary utility connections by the fourth quarter of 2003 and to begin the process of relocating transferred production assets into the building by year end. Our goal is to restart production of selected items before the end of the year and to be back in full-scale production by the end of second quarter 2004. On July 17th West also announced that it had reached a settlement with North Carolina OSHA regarding the accident. North Carolina OSHA issued a single citation under the general duty clause.

West firmly believes that it fully complied with the OSHA Act and that the citation was unwarranted. We also believe that we would prevail if we challenged this citation in court. However, when taken into consideration the time and expense of litigation and in the interest of our community and employees, reaching the agreement was the most appropriate course of action. I would like to re-emphasize that the dedication of our employees has been a crucial factor in our ability to effectively manage and support our customers in the months following January 29th. We are fortunate to have many of our Kinston colleagues accept temporary reassignments to St Petersburg and Corning, Nebraska where production volumes were increased to accommodate the lost Kinston capacity.

At the same time, regular employees of our Carny. St. Petersburg, and St Austell, UK, and Singapore facilities have worked long hours week to week to support the increased production demands at these plants. Within six weeks of the accident our global production planning and logistic teams have re-allocated our compounding and production needs to other West facilities in the United States and around the globe. We continue to operating at our pre-January 29th level. Through close coordination with our customers we have reworked our production and delivery schedules at all impacted plants and at the present time are experiencing no extraordinary late items or product produced at Kinston. Our remaining rubber plants are operating at extremely high levels to absorb the capacity loss.

We are thus interested to get the Kinston facility back on line as soon as possible to relieve the pressure on our other production facility. In summary, I believe the second quarter was a very solid one for the company. We continue to make substantial progress against our major goals for the year and our recovery from the Kinston tragedy is well underway with strong support from our employees and customers. And we continue to recognize the benefits of our capacity investments made in Europe over the last two years, coupled with the strengthening pipeline in drug delivery, the remainder of 2003 should be positive for West. I'd now like to introduce Linda Altemus who will review the details of our Q2 financial performance.

Thank you, Don and good morning, everyone. As indicated in this morning's press release, we reported second quarter net income of $6.9 million for 48 cents per share versus earnings of $5.3 million, or 37 cents per share, recorded in the second quarter of 2002. Reported results in this year's quarter include the effect of $3.7 million in pre-tax expenses, equivalent to 17 cents per share after tax, for a potentially uninsured expenses related to the company's Kinston plant accident in late January. Reported results in last year's second quarter included 1 cent per share of income from discontinued operations. To provide a better comparison of ongoing operating results we have excluded the uninsured accident related costs from this year's quarter and the effect of discontinued operations from the 2002 second quarter.

Excluding these items, second quarter 2003 earnings were 65 cents per share comparing favorably to the 2002 Quarter 2 earnings of 36 cents per share. Consolidated net sales to the second quarter totaled $126.4 million, a 19-percent increase over the second quarter last year sales, of which 9 percent was due to currency. The company's consolidated gross margins for the quarter was 32.7 percent, nearly 4 percentage points higher than the 28.8 percent growth margin achieved in the second quarter 2002, and was also the highest consolidated quarterly gross margin recorded at West since the fourth quarter of 1999. The pharmaceutical systems division experienced another very strong quarter despite the effects of the Kinston accident.

With sales of $125.2 million, a 20 percent increase over second quarter 2002 sales, of which 9 percent was due to currency. Domestic sales grew an impressive 12 percent over second quarter 2002. And sales in our international market once again grew significantly with sales 30 percent higher than the prior year's sales, 19 percent of which was due to currency. Operating profit in pharmaceutical systems was $25.2 million, representing an increase of $7 million over second quarter 2002 operating profits of $18.2 million. Profit improvements were driven largely by increased volume, manufacturing efficiency improvements at several of our European plants, and $1.6 million of the increase was due to favorable exchange rates. Profit margins in the Americas region were aided greatly by the recognition of $2.6 million of the anticipated business interruption cost recovery related to the Kinston accident.

In the drug delivery systems division, revenues of $1.2 were $1 million lower than comparable 2002 revenues due to continuing low demand in the clinical services business. Operating losses of $3.7 million in drug delivery were approximately equal with those realized in 2002's second quarter. Consolidated selling, general, and administrative expenses increased by $5.3 million versus last year's same quarter. The increase is largely due to a $2.6 million dollar increase in pension cost, the effect of foreign exchange, and increases in compensation and outside services spending in the pharmaceutical systems segment.

Net interest expense for the quarter of $1.7 million compares favorably to last year's net interest expense of $2.5 million, due primarily to lower average interest rates and the effect of interest income from customer advances. We also received a boost from our affiliate operations in the second quarter with equity earnings of 700,000, substantially higher than last year, largely due to increased sales and cost reductions at both our Japanese and Mexican affiliates. In reference to Kinston, we continue to expect that our property and business interruption losses will largely be recovered through insurance. As a result, the book value of the fixed assets destroyed and the incremental costs incurred in the recovery efforts deemed recoverable through insurance have been deferred and recognized as an insurance receivable on our balance sheet.

These recoverable costs totalled $19 million at June 30th, and we have received a $15 million advance from our principal insurer to support our insurable costs, reducing the net receivable at June 30th to $4 million. Costs we may not recover through insurance include the $3.7 million, or $8.8 million on a year to date basis that continue to reside in our reported earnings. Anticipated costs of this nature include insurance policy deductibles, legal and investigatory costs, environmental cleanup costs, communication costs and other miscellaneous items. Uninsured costs could be higher depending on the outcome of ongoing legal and investigational proceedings. In the quarter we also recorded in our operating results $2.6 million of estimated business interruption insurance recovery to reflect a portion of the cost of manufacturing and efficiencies that resulted from the Kinston incident. The costs being offset by this reduction had been reported since the accident in our operating results.

While we believe our business interruption insurance recoveries will be greater than this, we have recorded them only to the level of our insurer's current estimate of the losses. Discussions aimed at arriving at a common loss determination methodology are continuing with our insurers. The business interruption receiveable of $2.6 million, together with the $4 million net receiveable for recoverable costs brings our total insurance receiveable to $6.6 million at June 30th. Second quarter 2003 cash flow from operations was $11.1 million. The company's cash balance at June 30th was $44.3 million, and working capital totaled $90.2. Debt stood at $179.6 million at June 30th, and the debt to total invested capital ratio at quarter end was 44.8 percent, continuing its favorable consist decline largely due to the favorable effect of exchange rates. Capital expenditures during the quarter were $10.8 million with nearly half of the expenditures focused on new product and expansion activities. I will now turn the program back to Don Morel. Don.

Thank you, Linda. At the close of our April 22nd conference call I reviewed the status of the five broad objectives set by management in the aftermath of Kinston. These were returning our production capacity in North America to pre-January 29th levels as soon as possible. Thanks to the efforts of many people this objective has been achieved. Working closely with customers to insure the continued supply of product to them and their eventual customers so that no shortages occur. The feedback from customers on the implementation of our recovery plan has been very positive and clearly service remains a major focus for our account management teams.

Continuing to improve the operating performance of the pharmaceutical systems division, making sure that our investments and added capacity come on line as planned and that we capture the overall value inherent in the production and services we provided. Again, we are very pleased by the growth experienced by the pharmaceutical systems division during the quarter. Completing our drug delivery business development initiative is underway and focusing on the timely progression of our lead nasal product development and clinical trial program. And finally, from a corporate standpoint, timely managing our cash and capital expenditures to improve our free cash flow and to further strengthen our balance sheet. I believe we've made substantial progress in all of these objectives. The management team continues to focus on these objectives in our efforts today to produce a very strong operating performance through the first half of the year. With the Kinston rebuild underway our efforts in the pharmaceutical systems division will remain focussed on our customer service levels and quality. In the drug delivery division we remain focused on advancing our lead clinical programs and finalizing key licensing negotiations underway with a range of clients in addition to strengthening the program base in the clinical services unit.

Thank you very much for your time. I'd now like to open the call for any questions that you might have.

At this time I would like to remind everyone if you would like to ask a question please press star then the number 1 on your telephone keypad. We'll pause for just a moment to compile the Q & A roster. Your first question comes from Larry Marsh with Lehman Brothers.

Hey, good morning. It's Steven Postal. A few questions. First, last quarter you guys said you expected about ten million in one-time costs. Do you still expect that? Second, the fines from North Carolina, was that in the second quarter? Was that in the second quarter financial statement?

Sorry, Steven, could we take those one at a time? Could you repeat them?

Sure. What should we expect for full year '03 one-time costs? You previously have guided to $10 million.

We're not changing our estimates. We still think $10 million is as accurate a number as we can give now.

And then the fines from North Carolina, were they recorded in the second quarter?

Yes, they were.

In terms of capacity, is Germany fully on line now?

Yes, it is.

And I saw a big increase in pharmaceuticals operating margins. What was the primary driver for that?

Really, I think it's efficiency through the plant especially in Europe, with the additional capacity that's come on line, the load demands on both Le Nouvion and Eschweiler have been somewhat relieved, and we're operating much more efficiently

But it's primarily coming from Europe?

Yes.

Going to drug delivery, do you have any update on the progress of the nasal technology, which is what you talked about, and the interaction with the FDA?

Not at this time. The current status is that we are in the process of a number of submissions as they relate to client-funded programs, and the major programs that are underway, basically the trial data is being analyzed in preparation for the second half of the year, and a submission sometime before the end of the year. But that's really up to our clients right now, that's not up to us.

And it sounds like there's not so much difference in what you previously said about it.

No.

Okay. And then, I guess, finally, has there been any change in customer concentration? We all know that Becton is your largest customer, but with the Pfizer/Pharmacia merger completed, has concentration changed any bit?

No, not really. BD continues to be our largest customer. Most of our pharmaceutical customers fall into a relatively narrow range, and those revenues are spread fairly evenly among the big multinational players. So no real change in that mix.

One more question related to clinical services. It seems like a few quarters now that's been pretty weak in drug delivery. Can you talk about the kind of strategic value of that segment to drug delivery and to the company as a whole?

I mean, obviously, it's not something that really fits with our core mission. The softness in that segment has been difficult to manage. Many of the larger customers that have funded trials, phase I trials specifically, at the unit, look at that part of their expenditure as somewhat discretionary. So we are not the only ones that have been suffering through the downturn. I think everybody involved in that part of the segment has seen some softness, although we do see some encouraging signs for the third quarter.

Like what?

Bid activity has picked up rather substantially, so we're getting a lot more requests for proposals.

Okay, great. Thanks.

Once again I would like to remind everyone, in order to ask a question please press star, then the number 1 on your telephone keypad. Your next question comes from Bentley Offutt with Offutt Securities.

Can you hear me

We can hear you fine, Bentley.

I think these are quite impressive all around. I had a couple of questions relating to the breakdown in your operating profit, I guess it's in the latter part of the report. You talk about -- it was interesting, in your corporate costs actually had moved up somewhat from the first quarter from about -- corporate cost of 4.5 million up to 5.1 million. I was wondering, is this an upward trend or some additional costs thrown in that we should be aware of?

There were two things in the quarter. One is an increase in the incentive compensation cost. Also, we had to catch up in our pension cost in the quarter, an impact of about 600,000.

The second thing, looking at pension income and pension expense, on a year-to-year basis, for the first six months last year it was a positive amount of 1.4 million, this year it's a negative amount of 3.2 million, with actually an increase during the second quarter. Is this -- what is your estimate for the year?

The estimate for the year is 6.4 million in expense.

And this is an ongoing expense because of the fact that you're underfunded?

We're not underfunded, it's just a function of the calculation.

And the variance has to do with the fact that the stock market is impacted?

Decline in the pension assets.

I see. Okay. And then the next question I have, I think it's already been answered, but your costs associated with the plant expansion, the uninsured costs, I guess your estimate for the entire year is 10 million?

Yes, it is.

Those are the uninsured expenses. They are not related specifically to the plant expansion, Bentley.

Going back to your overall business improvement in your gross margin, significant improvement, this is because of the shift in your product mix to more and more of the Westar product?

That's partially it, but it's also the fact that we've been able to get to more of a cost efficient production schedule thanks to the additional capacity in Europe. So it's really those two factors.

And I don't know, has West made any -- any guidance --

No, we're still wrestling with the overall impact of Kinston on the expense side. The guidance that we've given has focused on the full year growth in our revenue line, and that's really where we're sticking.

So are your earnings, on a non-GAAP basis, I think, what, $1.14?

Yes.

So the degree of cyclicality in the business, in the summer, I guess it weakens somewhat?

It will go down a little bit and then return in the fourth quarter. Typically what happens is that the latter part of the third quarter and the early part of the fourth, we experience our plant shut-downs in Europe, take care of our preventive maintenance and a lot of expansion activities, and our customers do as well. And of course once that happens, you've got some start-up associated once you do come back. That tends to take place over a period of about six to eight weeks from July through early September. But that's the cyclical nature of our business.

Congratulations for the good results.

Thank you.

Your next question comes from Don Taylor with Franklyn Advisory.

Good morning. Couple of things. Have the efficiencies you expect from Europe as a result of that expansion, are they fully in place in this quarter?

I don't think so. We're pretty close. But we have some additional presses that are coming on line in Le Nouvion, and we continue to look at the optimal production site for certain products. So we're probably pretty close, but we may have a little more room.

I guess we won't really see it in the third quarter because of what you were just talking about the plant shutdowns.

The shut-downs affect us, principally in Germany and in France, but also to some extent at st Austell in England.

Back to the pension issue, what were the changed assumptions from Q1 going into Q2 and then the rest of the year?

It was computational changes which we revised to better match our current compensation.

I mean, I would have thought that this would have been done at the beginning of the year, then, going into Q1. I guess what -- I mean, you made these kind of calculations going into the year to determine, so what changed?

No, there were no change in assumptions. There was a change in the compensation amount that was used for the calculation.

Oh, I'm sorry. I misunderstood. The 2.6 million insurance recovery included in the pharmaceutical systems division, did that all relate to Q2? It was booked in Q2

It was booked in Q 2, but there was an impact from Q1, which we estimate to be about 775,000 or 3 cents per share.

And then roughly a million eight, then.

Right.

Are there issues that -- I guess if you could expand upon the issues that you're dealing with, with the insurance company, to determine what is recoverable, the amount that's recoverable, both with respect to this number and the 4 million net balance that's outside of the operating results of pharmaceutical systems.

Yes, Don. There's -- obviously, it's a very complicated situation we're dealing with on the business interruption side. There's a number of issues about what costs are driven by what events. And as importantly, you know what would have happened had it not occurred, and that's kind of the hardest question to answer on the business interruption side, what you're comparing your actual results to. Really, to get to a final point on that, the agreement between us and the insurance company is that you need a number of months of operations to compare that. We're really only just getting there, which is why we chose to book a number at this point, but we still have a ways to go before we agree on that. I wouldn't characterize the situation with the insurers as antagonistic, it's actually been very cooperative. On the property side, likewise, you've got a lot of discrete issues to deal with in terms of pieces of equipment, tooling, and two separate operations, so that it will be a, certainly, a number of months, and probably well into the end of 2004, 2005 before we ultimately resolve some of those.

Okay. How are you determining what kind of insurance recovery to book at this point? Presumably you believe you have a case for something, more than what you've booked. I'd just like to get some sort of sense as to the degree of conservatism that's in the accounting savings at this point. We want to be as realistic as we can be, but given the complexities, we're trying to err where we err, on the low side of the estimates on recoverys. On the business interruption front, we certainly believe we've incurred the costs running through those operating results far exceed the BI recovery we've reflected, so there's probably room for improvement there going forward.

It's a very complex issue to manage, Don, because the relocation didn't simply happen to two plants in North America where you could look at your performance and come up with a number relatively quickly. The off-shift happened for to us go to Singapore as well at St Austell, so we've got exchange considerations as well as transfer consideration. It's a very, very complicated issue.

Okay. Well, good enough. Thanks.

Thank you.

Your next question comes from Vandana Bapna with Oxford Securities.

Good morning.

Good morning.

Congratulations on good progress.

Thank you.

I had a question on your formulation and drug delivery business. Considering the environment, your end market value in this business can be, the potential is very high, at the same time, several of your programs are, from what I understand, are on hold, either due to lack of funds or your licenses are not really progressing on those opportunities. I'm wondering whether the technology is not strong enough or why you're not able to raise the funds, or they are not able to raise the funds. Obviously there's a lot of competition, and that must reduce the demand. But your patents are expiring, your intellectual property, on several of these initial developments, so what is your plan on that? Because some of your resources are also getting used on this program, your personnel as well as financial resources. How do you plan to capitalize on this potential?

It's a very complicated series of questions in there but let me try and answer them in a couple of ways. First off, with regard to our patents, the base patents on our nasal technology do not expire until 2012 and 2013, and there are improvements on those that continue for about five years further, so there's still a long life on the patent. In our business model, as we've talked about before, we typically seek to develop the product to a certain stage, then out-license it to clients for them to take on the development risks. One of the downsides of this model, of course, is that once the product is out of your hands, we cannot control the time line, and that's really up to our licenses. It wouldn't be appropriate to comment on their situation as we often not privy to it. It's actually kept quite confidential by them. With regard to the technology, we have no doubts that the technology is viable, we have conducted a number of phase 1 and phase 2 trials, covering both conventionalities as well as proteins and peptides. The base nasal technology with the kitazan works quite well. And as you know better than we do right now we're in a situation with tough capital markets in terms of raising capital for certain things. And I'm sure that some of our licenses are experiencing the toughness of those markets. But the patents have a long life left to them. The number of feasibility programs that we're developing continue to be very encouraging. It demonstrates an awful lot of interest in the technology, and we firmly believe that the nasal root is going to be a viable one and a growing one for the foreseeable future.

Thank you. Good luck in this area. It's a huge, huge potential for you there.

Thank you very much.

At this time there are no further questions. Mr. Morel, are there any closing remarks?

Yes, just quickly, obviously completing our negotiations with Lenoir County and the acquisition of the new site on which to reestablish our molding operations in Kinston, and finalizing this element with N.C. OSHA represent major milestones for the company as we complete our recovery. I would again like to recognize the efforts of our more than 4,000 employees worldwide for their ability to focus on our customers' needs over these last six months. This focus is responsible for our strong year to date performance and the positive outlook we enjoy for the remainder of the year. As stated in this morning's press release we anticipate sales growth of 6 to 8 percent at constant exchange rates for the second half of the year or 7 to 9 percent in keeping with our prior guidance for the full 2003 operating year. Thank you very much again for your time today.

This concludes today's teleconference. You may now disconnect.