西式醫藥服務 (WST) 2008 Q2 法說會逐字稿

Welcome to the West's second 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. [I'll turn] the meeting over to Ms. Theresa Kelleher from FD. Ma'am, you may begin.

Thank you. Good morning, everyone, and welcome to the West second quarter 2008 results conference call. As you know we issued our results this morning. The release has been posted on the Company's web site located at www.WestPharma.com. If you've 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 and 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 forecasts 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 anticipated products, sales efforts, expenses, the outcome of contingencies such as legal proceedings and financial results. We have tried wherever possible to identify 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 conditions.

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 statement. For a nonexclusive list of those factors which could cause actual results to differ from our 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 a related subject 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.

This call is being recorded on behalf of West Pharmaceutical Services and is copyrighted material. It cannot be re-recorded 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 to call over to Dr. Don Morel, Chairman and CEO.

Thank you, Theresa, and good morning, everyone. Welcome to West's second quarter conference call. Thank you for joining us today. As Theresa mentioned I am joined this morning by our Chief Financial Officer, Bill Federici, and by Mike Anderson, our Treasurer and Primary Investor Relations contact.

As we have done in prior calls, I will begin with a brief summary of our consolidated results, provide an update to several key programs and then review our guidance for the year. I will then turn the call over to Bill who will take you through our quarterly results in greater detail.

We are very satisfied with our overall performance during the quarter. Consolidated revenues grew 5.9% to $279.3 million. On a non-GAAP basis excluding nonrecurring items for comparison purposes, adjusted operating profit grew 7.2% to $37.4 million and earnings per diluted share grew to $0.73 versus $0.68 in the second quarter of 2007.

Gross margin improved to 29.9%, a positive change of [0.08]% versus Q2 2007 despite the decline in sales of some high margin items. Through the first six months of the year, adjusted earnings from continuing operations were $1.45 per diluted share putting us in good position to achieve our performance targets for the year.

Organic growth in key Pharmaceutical Systems product lines, coupled with the positive effects of foreign currency translations, more than offset sales declines caused by the market exit of the Exubera insulin inhaler; more restrictive reimbursement criteria for Erythropoiesis Stimulating Agents or ESA drugs, the discontinuation of manufacturing of a diagnostic component, and other small shifts in our product mix.

Collectively, these issues created a shortfall of about $20 million in our Q2 revenue when compared with last year's second quarter. In addition, despite lower revenues, the performance of the Tech Group segment improved substantially due to strong demand for certain key products and an intense focus on controlling costs.

Clearly the big story for the first six months has been the substantial rise in the price of crude oil and the subsequent impact on energy costs and petroleum-derived raw materials. We have worked aggressively to mitigate these cost increases on our profitability through a combination of SG&A spending controls, further efficiency and cost savings initiatives in our operations, price increases and raw material surcharges, where appropriate.

While these initiatives will cover a significant percentage of the native impact of higher energies in the last [American] material costs, the contractural lag with several large accounts and potential further price increases from vendors during the remainder of 2008 will have a moderate effect on our operating profit for the full year, primarily in North America. Our full year guidance includes our best estimate of the full year impact of these cost increases.

We also continue to benefit significantly from our exposure to foreign currency, particularly the euro, as more than half of our sales originate outside the North American market.

Turning to some important ongoing projects, we have maintained our investment plan in both our innovation programs and our IT platform upgrade to SAP in North America. We have completed Phase I of the SAP project on schedule and within budget. Phase II, which is well underway, focuses on a complete upgrade of our North America Shop Tour Systems and integration of those systems with SAP at the manufacturing plant level.

We expect the first plants to shift over to SAP in the fourth quarter.

On the innovation program front, I'm please report that we launched the Daikyo Crystal Zenith silicone prefillable syringe during the second quarter. Sample requests from potential customers remain strong especially within the Biotech segment where the technical performance of CZ has well-defined advantages over other packaging options.

We have also entered into several customer-funded R&D agreement for custom solutions and proprietary applications of CZ outside of traditional vials and syringes.

In terms of our expansion projects, construction of the new plastic facility in [Kechou], China, is in full swing. The Foundation has been completed and work on the building structure is now well underway. We anticipate completion of the facility in early 2009 with manufacturing validation in the third quarter and commercial production shortly thereafter.

In our Essweiler, Germany facility the building for additional molding and Westar processing has been completed. Installation and validation of the manufacturing equipment is now underway and molding should begin in late Q4. The water system for Westar processing should be validated in early 2009, with commercial production starting shortly thereafter.

I had the opportunity to tour the facility in early July and it really is quite impressive.

We have completed the installation of the compounding facility at our Kinston, North Carolina plant, which will go into commercial operation during the third quarter. And we have begun the expansion of our Clearwater, Florida facility, which produces aluminum [overseal].

From an organization standpoint, Matt Mullarky joined the Company as Chief Operating Officer last week. Having previously worked in rubber manufacturing, supply chain and logistics, and health care, Matt brings a broad base of experience in managing complex global operations to his position. Steve Ellers will continue as President of the Company and, in keeping with our succession planning, gradually transitioned his operating responsibilities to Matt through the remainder of 2008.

Steve will then continue to support our global expansion efforts especially in China and India, in addition to working more closely with our partner Daikyo. He will also dedicate more time to identifying and analyzing new product, technology, and acquisition opportunity.

Looking ahead in the short term, many of the challenges previously discussed will remain with us the end of the year. Specifically on the ESA front, although [Amgen's] Q2 sales were a little stronger than forecast, we do not foresee any measurable improvement in ESA-related business this year for the following reasons.

First as you know on July 30, the FDA mandated more restrictive labeling of [Arinest] and Procrit for certain cancer patients, which is expected to further limit volume. Second, our internal forecast indicate the customers that manufacture these drugs still have inventories of our products to work through. And, finally, recent regulatory changes in both the US and the EU may made to additional limits on reimbursement.

We also expect to incur higher energy and raw material costs versus the first six months of the year. Thus our execution of [lean] programs and pricing actions to mitigate these increases will be critical in order to achieve our full year targets. And although our backlog remains very healthy, we continue to carefully monitor our customers' order patterns. We have no doubt that they will aggressively manage their own inventories through the end of the year.

Taking these considerations into account we continue to forecast our full year adjusted earnings will fall in the range of $2.40 to $2.50 per share, despite the challenging economic climate. However, on an adjusted basis excluding the impact of lost sales from 2007 and the impact of currency translation, this would represent sales growth in excess of 7% for the full year, and earnings growth of 15%, right in line with our expectations.

Looking at the longer-term, the fundamentals driving our growth remain intact. And we believe we are well-positioned to take full advantage of the primary drivers in our key market segments, both in terms of our global capacity and innovative new product launches.

With that, I would like to turn it over to Bill for his comments on the financials. Bill?

Thank you, Don, and good morning, everyone. As indicated in this morning's press release, West reported second quarter 2008 income from continuing operations of $28.7 million or $0.82 per diluted share, including a net after-tax gain of $3.3 million for the combined effect of two items. A $4.2 million after-tax gain relating to additional payment received from the contract settlement we reached with our customer Nektar with regard to the discontinuation of Pfizer's Exubera; and a $900,000 after-tax restructuring charge, incurred in connection with the Tech Group restructuring program we announced last December.

We expect to incur in the third and fourth quarters at additional $1.5 million to $2.5 million in charges to conclude our restructuring activities, and an additional $3.5 million of Exubera facility charges while we reconfigure the facility to begin to produce other device products. As such, our ultimate gain on the Nektar contract settlement is expected to be approximately $4 million.

Excluding the $0.09 positive effect of these two items on our current period earnings, second quarter 2008 earnings from continuing operations were $0.73 per diluted share compared to last year's second quarter operating earnings of $0.68 per diluted share which included $0.06 of discrete tax benefits. Reported earnings in last year's second quarter were $0.74 per diluted share.

It is important to note that last year's $0.68 second quarter included $20.2 million or $0.15 per diluted share of sales of the Exubera device and EMEA drug components and disposable medical device components -- products for which we have almost no associated 2008 revenues. The Company's consolidated sales in the quarter were $279.3 million, a 5.9% increase over second quarter 2007 sales. Excluding exchange effects, the consolidated sales decline by 0.09% versus the prior year quarter.

At $212.6 million, Pharma Systems segment second quarter sales were 12.3% above 2007 second quarter sales with [8.4] percentage points of the increase due to currency. The relatively modest growth was expected to to the $10 million impact of a decline in sales associated with the ESA drug situation that Don described and with the discontinued production of certain disposable medical device components in Europe.

That decline reduced year-over-year segment sales growth by [5.8] percentage points. Excluding the effect of both the loss sales and currency translation gains, second quarter 2008 Pharma system sales grew 9.7% which is more in line with our longer-term growth expectations.

Sales of noncoated stoppers used in vial packaging for a variety of products, flip off sales and sales of the Company's Safety and Administration System Products more than offset the expected sales decline in Pharma Systems.

The Tech Group segment generated sales of $69.6 million in the quarter, 12.9% below sales in the prior year quarter excluding exchange, largely due to lost Exubera sales. In the second quarter of 2007, sales of the Exubera device were $10.2 million. Sales of packaging for a customer's OTC product also declined by $4.2 million from last year's second quarter.

Serving to partially offset these sales losses, were increases in several specific customer products. Including IV and blood filter products manufactured in our Michigan and Puerto Rico facilities, this spout pack closures for juice and dairy cartons; components used in an intranasal allergy product and insulin pens.

Looking at margins, consolidated gross profit margins for the quarter were 29.9%, 0.08 of a margin point better than the 29.1% margins we achieved in the second quarter of '07. This margin was achieved despite a nearly 1 point drop in consolidated gross margins attributable to the lost Nektar and EMEA drug packaging and disposable medical device sales.

Gross margins in the Pharma Systems segment were 34.4%, 1 percentage point lower than last year's second quarter with much of the decline due to lower margins in the North America unit. The margin decline primarily reflects less favorable mix of sales and increased raw material cost, direct manufacturing expenses and planned overhead costs in support of expanding manufacturing capacity.

In the Tech Group margins increased over the prior year quarter by 2.4 margin points to 14.9%. The margin improvement was due to increased manufacturing efficiencies now that several of our new product transitions have been completed, a decrease in planned overhead costs stemming from our manufacturing restructuring effort and increased activity within our tooling and engineering facilities.

The cumulative effect of the margin improvement more than offset the impact of the lost of Exubera device revenues, which resulted in $3.3 million of Q2 2007 gross profits.

Consolidated SG&A expenses increased by $2.7 million or 7% in the current quarter versus the prior year quarter. The net increase was due primarily to foreign currency translation and increased compensation cost due to annual salary adjustments and severance obligations. Partially offsetting these increases were declines in stock-based compensation expense, intangible asset amortization expense and pension expense.

As a percentage of sales, second quarter 2008 SG&A expenses were 14.6%, roughly on par with our second quarter 2007 levels. Net interest expense was $1.8 million higher than the 2007 second quarter expense mostly die to lower interest income as we had less cash on hand throughout the quarter than we did in last year's second quarter when we had just completed our convertible debt offering.

The effective tax rate for the quarter was 27.6%, which includes the taxes on our gain on the Nektar settlement. Our annual effective tax rate for 2008, excluding any discrete tax items is currently estimated at approximately 27%. Our balance sheet remains strong and our business continues to provide necessary liquidity. The Company's cash balance at June 30th was $102.3 million, down $6 million from year end, primarily due to the payment of tax obligations in Brazil and increased working capital requirements.

Cash flow from operations was $55.8 million in the quarter. Working capital totaled $264.9 million at June 30th, approximately equal with last quarter and -- but about $35 million higher than at year end.

Debt at June 30th was $398.2 million, and our net debt to total invested capital ratio at quarter end was 34.9%, 2 percentage points lower than at year-end. We incurred capital expenditures of $30.4 million in the second quarter with the majority of the capital focused on new product and expansion activities, mostly for our Pharma Systems North America, Europe and Asia capacity expansions and our IT initiatives.

Looking ahead, our order backlog at June 30th remains healthy at $250 million, $11.9 million lower than our year end backlog of $253 million, excluding exchange effects. We continue to expect full year sales of approximately $1.08 billion at actual exchange rates; and consolidated gross margins are now expected to approximate 29.1%, taking into account current raw material pricing.

We also continue to expect 2008 adjusted earnings per diluted share to be between $2.40 and $2.50. That estimate excludes restructuring cost, the gain on our contract settlement with Nektar and assumes an average exchange rate of $1.50 per euro for the second half of the year.

Included in our EPS estimate is the adverse impact versus 2007 results of $0.44 per diluted share, representing the lost sales for Nektar, the EMEA drug components, and disposable medical device components, partially offset by the full year expected favorable currency effect of the weak U.S. dollar of $0.18 per share.

We also estimate that the adverse impact of higher raw material and energy costs at about $3 million or $0.06 per diluted share, compared to where we started the year. That amount reflects the higher market price for underlying commodities such as oil and natural gas mitigated by the effects of our purchasing agreements, which act to delay the effects of spot market commodity price changes as well as our product pricing and lean activities.

Adjusting for the lost sales and currency impact would result in an increase in estimated year-over-year sales of 7% and EPS growth of 15%. Both are in line with our longer-term growth expectations.

We continue to expect that full year capital expenditures will be approximately $145 million in current exchange rates. We also expect that much of our capital will be expended for needed capacity for key products at multiple locations around the globe.

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

Thanks very much, Bill. This concludes our prepared remarks for this morning and we'd now be pleased to answer any questions that you might have. Operator?

Thank you. (Operator Instructions). Arnie Ursaner.

This is Arnie Ursaner, CJS Securities. Good morning. Couple of questions if I can. Could you quantify the losses you incurred in Q2 at Grand Rapids, please?

Yes. Grand Rapids was actually break even for the quarter and second quarter of '08. And if you remember in the second quarter of '07 we lost approximately $600,000 at Grand Rapids.

So that's one of the key factors in the margin improvement in the Tech Group?

Yes it is.

Okay. You mentioned in your prepared remarks that you plan to reconfigure the facility that you had for Exubera for other devices. Are these likely to be for the Tech Group or are they likely to be for the pharmaceutical side?

A combination of both. There will no doubt be some molding work done for third parties in the custom molding business, but as CZ and some of the other new products come online we expect that molding capacity to go towards those items.

Because in Tech Group you've had some excess capacity, been more of the 50% or so operating rates. So I would have been surprised if you were expanding capacity for that.

No, it's more converting that facility into a clean [room] molding operation.

In your Pharmaceutical segment you mentioned $2.6 million increase in tool, development and lab services revenue. Typically those are much lower margins revenue. Can you comment on the impacts you think you have had in the quarter?

Actually the impact was slightly positive versus the last year second quarter. And if you remember, last year's -- throughout the year, in fact, we had some underabsorption of the overheads coming out of that engineering group. So we've done a better job of filling up the pipeline plus with our restructuring activities we took out some of the costs in that group.

You mentioned in your prepared remarks that you saw a $0.06 hit for the year from higher raw materials embedded in the guidance. Can you comment what the impact was in Q2? In other words is it $0.06 for the balance of the year?

Yes. It is $0.06 for the balance of the year. Through the first six months we were able to offset most of the increases that we saw through lean pricing initiatives, mix, etc.

Final question for Don. In your comments you mentioned cost and inventory management policies can impact our near-term results and the term you used is require our attention. Does that mean you are actually getting some price relief from your customers, given your raw material costs?

We are but the comment was more aimed at the traditional things we see in the second half of the year. As you know, we've got a couple of key customers whose fiscal year ends September 30; and then as we work through the plant shutdowns in Europe and the end of the year, obviously we keep a close eye on what our customers are doing. And it is a little bit more difficult to predict than the first half of the year.

I will jump back in queue and look forward to seeing you guys next week at our conference.

[James Sidoti].

It's Jim Sidoti, Sidoti & Company. Quick question on the commodity pricing. Is that something that you think is worse in the back half of the year just because the inventory in the front half was bought prior to the rise in -- prior to the increase in oil prices?

Partially, Jim. If you remember the way our contracts with our suppliers work, we have a series of -- the two major contracts. They have a series of price breaks built in where you don't see an increase in the price of the material coming to you until the costs of the underlying commodities go above certain band.

And what that does is it acts to help slow down the increases and we saw that throughout the first half of the year. We do expect to see them accelerate. We've had some fairly bolus increases in the underlying raw materials that are indexed to oil and natural gas.

So -- but we are also starting to see some of that come down now. It's anybody's guess. I'm not a betting man in terms of where we expect those commodity prices to go in the future. But what we have been able to do is, included in that $3 million or $0.06 is our best guess as to where we believe those prices are going. We do have right now built in the current pricing into those estimates.

Okay. So that was my next question. So you are assuming oil for the back half of the year stays in this [120 to 130] range?

No, what we do is actually we have the oil coming down slightly in the back half of the year, but it's -- again it's a graduated thing.

Then the price increases that you're pushing on your customers, did they all kick in in the quarter or are those things that start to kick in in the back half of the year?

No, they will kick in largely in the back half of the year.

So that should help offset the increase cost?

Yes.

And remember that $3 million is a net number. Okay that's [debt] net of what we believe we will be able to get through these price increases.

Understood. Okay. Thank you very much.

Adam (inaudible).

Lehman Brothers. I guess this is following up on the last question. If you'd comment maybe on the managing of the price increases that you are expecting or --?

It depends on rubber and aluminum, but you can go probably in the low single digits to mid singles from -- for on average.

And we are trying not to be very specific, Adam, as you can imagine.

Understood. I guess next question, just I know last year, I think it was four or five larger contracts that you've renewed. I guess for the end of this year, what should we be thinking about with larger customers that you guys need to get resolved?

Out of those five, we only have one that's still outstanding and the only reason that hasn't been resolved is because of the spike that we have seen in the oil prices. So we are trying to work our way through the appropriate PPI as part of that agreement.

To the best of my knowledge, we don't have any contracts of the magnitude of the four that were renewed early this year, late last year coming up for renewal. There are some smaller ones that are in the kind of two- to three-year range, but nothing of the magnitude we faced over the last six to 12 months.

And those -- remind me, the ones last year I think they were like three- to seven-year agreements on average.

There were a couple that were in the three- to five-year range and there was one that was seven.

Okay. And then, lastly, maybe over the last three to six months has anything changed in the acquisition environment for you guys? Or any interest in expanding the platform?

A lot of interest in expanding the platform. There are some interesting opportunities out there for us if the discipline around the valuations and the multiples we are willing to pay.

We'll see how it goes. But there are some interesting opportunities out there.

All right. Thanks a lot.

(Operator Instructions) Ross Taylor.

Ross Taylor with CL King. Just a couple of questions.

Don, in your remarks I think you said that you are not anticipating much change in demand for your products that are used with the anemia drugs. Is this a change in your expectation from the start of the year?

I think it shifted out a little bit. We thought we would see some return in the late third and early fourth quarter, but again that was a projection ahead of the mandated label change by the FDA.

So our expectation now is that any sales will be moderate through the end of the year. And that we will start to see that pick up again in '09 although it will not return to the levels that we've seen prior to the warning.

Okay. And you also related to the resin CZ. Can you give any feedback you've heard from customers or just a little bit more color on kind of what you are seeing the uptake or response, like from your customers?

I think the color is all positive. As you know, there are some technical issues with current glass syringes that the market is looking to overcome. The response that we've seen from the clients that have tested CZ is very, very positive.

As you know, with our system, we eliminate the use of silicone oil. We don't see the aggregation problems that are [contramitent] with the use of silicone. Stability has been very, very good. There are filling trials underway and there are longer-term stability trials underway.

So from my vantage point the response has been extraordinarily encouraging. And that is on the traditional vial and syringe side. I think what is more interesting is that over the last six months is a material option. We have seen some non-traditional applications emerge for CZ which actually are covered by development agreements for us.

So the customer in effect for the proprietary work is footing all of the R&D costs. So I would say very positive to date.

Okay. That's helpful. Last question and I think you probably answered this already with some of your responses to the prior questions. But you assume oil prices basically stay flat from here. Given the lag built into some of your purchasing contracts, when would you be through all of the price increases you'd see from your vendors?

That's an interest -- a good question. I think, let me just clarify one thing. I think we are seeing it already, number one; and we are expecting some decreases built into that estimate that we have, the $3 million net number. We are not expecting it to stay at this $129 -- I guess, this morning or wherever -- $120 something this morning. Wherever it ended up.

You -- with the way the contracts work on the supply-side again, we will have natural breaks built in. There are approximately, I think there are a number of price increments that they could push on to us in the pricing. We will start to see those starting on August 1st; and they will come, depending on what happens going forward with the price of oil will determine how that goes.

In terms of when do we expect to see the full pricing effect, my guess would be that it wouldn't be at least until the end of this year before you would see the full effect.

That's helpful. Thank you very much.

And just remember that part of that will be offset because we will have a series of price increases going through at the end of the year with the contracts that are covered by PTI and CPI adjusters.

We haven't seen those prices roll in now because they're under contract. The price increases have been largely due to accounts that are on an order-to-order basis.

Okay. That's a good point. Thanks.

At this time I'm showing no further questions. I would like to turn the call over to Don Morel.

Thank you very much, Operator. And thanks to everyone for your time this morning. (inaudible) the first half of the year, our performance has been very good despite the economic climate and the sales shortfalls in key products versus '07. And while the remainder of 2008 will likely not see a dramatic change in the global economic conditions, we remain confident in our ability to deliver our projected full year results. Thank you again.

Thank you. This concludes today's conference. Thank you for participating. You may disconnect at this time.