西式醫藥服務 (WST) 2011 Q2 法說會逐字稿

Welcome to the West Pharmaceutical Services Second Quarter 2011 conference call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session. (Operator Instructions). This call is being recorded on behalf of West and is copyrighted material. It can not 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 objections, you may disconnect at this time.

And now I would like to turn today's meeting over to Mr. John Woolford from Westwicke Partners. Please proceed, sir.

Thank you, Operator. Good morning, everyone, and welcome to West's Second Quarter 2011 Results conference call. We issued our financial results this morning and the release has been posted in the Investor section on the Company's web site located at www.westpharma.com. If you have not received a copy of this announcement, please call Westwicke Partners at 443-213-0500 and a copy will be sent to you immediately.

Posted on the Company's web site is a slide presentation that management will refer to in their remarks today. The presentation is in PDF format. And should you require it, a link to a free download of that software that will enable users to view the presentation is also available on the web site.

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. Statements that are not historical facts, including statements that are preceded by, followed by, or that include words such as estimate, expect, intend, believe, plan, anticipate, and other words and terms of similar meaning are forward-looking statements. West's estimated or anticipated future results, product performance, or other non-historical facts are forward looking and reflect our current perspective on trends and information.

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. You should bear this in mind as you consider forward-looking statements.

For a nonexclusive list of the factors, which could cause the actual results to differ from expectations, please refer to today's press release. Investors are also advised to consult any further disclosures the Company makes on related subjects in the Company's 10-K, 10-Q, and 8-K reports. Except as required by applicable securities law, the Company undertakes no obligation to publicly update forward-looking statements, whether as a result of new information, future events, or otherwise.

In addition, during today's call management may make reference to non-GAAP financial measures, including adjusted operating profit and adjusted diluted EPS. These measures and their component parts have no standardized meaning prescribed by US GAAP and therefore may not be comparable to and should not be viewed as a substitute for US GAAP operating income and diluted EPS. Reconciliations of the non-GAAP financial measures to the most comparable financial results prepared in conformity to GAAP are provided in materials accompanying this morning's release.

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

Thank you, John, and good morning, everyone. Welcome to West's Second Quarter Earnings conference call. During our commentary this morning, Bill and I will again refer to a PowerPoint presentation to highlight our discussion points. The slides are available on our web site, www.westpharma.com, under the heading Investors and then Presentations. If for some reason you can not access the slides during the call, the information they contain is covered both in this morning's release and in our commentary that follows.

As we have done in prior calls, I'll give a high-level overview of our financial results for the quarter and provide an update to our strategic operations programs and new product development pipeline. Bill will then discuss our financial results in greater detail. We will then give an update on our outlook and guidance for the remainder of the year, followed by a Q&A session.

Beginning with the quarter, Slide Number 3 provides a high-level summary of our second quarter results. Consolidated revenues for the quarter grew 9.3% or 2.8% excluding the positive effects of currency translation to $307.9 million when compared with the second quarter of 2010. While sales growth was in line with expectations, higher material and energy costs in the quarter combined with a less favorable that forecast product mix and several customer issues in our North America operating region resulted in a 2% decline in our gross margin to 27.5%. Adjusted operating profit was down slightly versus 2010 to $30.5 million resulting in adjusted earnings per share of $0.62. In the Pharmaceutical Packaging segment, overall sales were higher, rising 10.6% at actual rates. Most of the increase was driven by the positive effects of currency as sales at constant rates rose 2.4%. Sales growth was solid in both Europe, up 6.1%, and in Asia, which increased 12.2% excluding the positive effects of exchange. Revenues in the Americas region were essentially flat as modest gains in South America after a strong first quarter were offset by a less than 1% decline in North America.

Despite sales gains in selected product lines and good international growth, gross margin in the Pharmaceutical Packaging segment was negatively impacted by two issues. We experienced significantly reduced production levels within one of our North America customer's facilities due to regulatory issues. In a typical year, this plant would consume approximate $8 million to $10 million of [coded] closure product, but in 2011 we reduced our forecast to less than $500,000 for the full year. Our North America results were also impacted by a change in packaging format from a unit-dose vial to a multi-dose vial for a high-volume drug used in dialysis treatment. This format change will result in 2011 sales for this drug to approximately $500,000 versus an expected $8 million to $9 million in a more typical year. These two issues combined with higher raw material costs accounted for 3.3% of margin decline and lowered operating profit by approximately $8.5 million or roughly $0.17 per share in the quarter. Increased sales in other product lines generated a lower average margin and thus were not enough to overcome the total operating profit deficit.

Sales in the Pharmaceutical Delivery Systems segment grew by 5.4% or 3.1% excluding exchange on continued strong demand for contract manufacturing services and sales of proprietary reconstitution system. Gross margins in the delivery system segment fell to 17.9% from 19.1% a year earlier, primarily a result of previously-discussed contractual price reductions in our European operations.

R&D expenses grew by approximately $1.2 million as we accelerated work on the SmartDose injection system due to rapidly-escalating market interest.

Overall the quarter was in line with our forecast in terms of revenues, but did not yield the desired margin [drop through] due to raw material cost increases and the sales issues in North America.

In looking at the first six months of the year, our results are in line with our expectations as outlined at the outset of the year. And through the implementation of some material-specific pricing actions, contractual price adjustments, and Lean programs, we fully expect to see improving margins through the end of the year. More on the full-year outlook in just a moment.

I'd now like to provide an update on several of our key programs. In terms of Daikyo, production at our Daikyo partner's operations in Japan remain largely unaffected by the tragic tsunami and Fukushima nuclear accident at the end of the first quarter. West along with Daikyo continues to carefully monitor radiation levels in both imported raw materials and finished goods and to date have identified no instances of increased radiation levels in either case. Daikyo orders continue to be very strong when compared with 2010.

In mid June we held a formal groundbreaking ceremony to kick off construction of our new compression molding facility in China. Our current expectation is that this facility will be up and running by late 2012 with first commercial sales of product following validation and testing in 2013. In India we finalized our site selection and have begun negotiations with the local economic zone authority for a land lease beginning in 2012. Both programs are fully on schedule.

One of the new product highlights in the Packaging Systems group during the quarter has been the uptake of our recently-launched Envision product, which grew from sales of $7.7 million in 2010 to $14.6 million through the first six months of 2011. Overall high-value product growth was solid versus prior year, although dampened somewhat by the previously-described customer regulatory issue.

Turning to Slide Number 4, we provide some highlights of our key development projects. CZ market activity continues to grow, driven by sample demand for both vials and syringes. We have started to see a rising number of requests for development of custom sizes and configurations, including syringes ranging from 0.5 mL to 5 mL and cartridges that can be incorporated into proprietary delivery platforms delivering volumes ranging from 3 mL to 5 mL as well.

Sales through the first half of the year are just over $4 million. We remain on track to complete the build-out and installation of the Scottsdale clean rooms for CZ syringe production by the end of the year and also expect to begin transfer of the Daikyo vial technology into the Arizona facility in mid August. This will give us both vial and syringe capability in a single facility in North America.

During the second quarter West also acquired the trademark SmartDose for the electronic-patch-injector system now under development and have accelerated our R&D investment in this program due to escalating customer demand for units to conduct large-scale clinical trials. Engineering efforts are now focused on the validation of all manufacturing processes with the goal of having units available for clinical testing in the early part of 2012. The SmartDose delivery system is unique in that it offers potential customers dosing flexibility when compared with other delivery systems currently in use or under consideration. An added benefit is that is also utilizes a custom-designed CZ cartridge, thus reducing the chance of container breakage and/or loss during manufacturing due to drug/glass compatibility issues. We're very excited by this system as evidenced by the level of interest in the market currently.

I'll now turn the call over to Bill Federici for a more detailed review of our second quarter results. Bill?

Thank you, Don, and good morning, everyone. We issued our second quarter results this morning, reporting net income of $20.1 million or $0.57 per diluted share versus the $0.62 per diluted share we reported in the second quarter of 2010. The second quarter results are summarized on Slide 5 of the accompanying PowerPoint presentation.

As explained in the release, results in both periods included restructuring charges and this year's quarter also included a charge for separation benefits for a retiring executive and a net gain for adjustments to our liabilities for contingent consideration for recent acquisitions. Excluding the effect of these items in both periods, second quarter 2011 earnings were $0.62 per diluted share versus the $0.64 per diluted share we earned in Q2 2010.

Turning to sales, Slide 6 shows the components of our consolidated sales increase. Consolidated second quarter sales were $307.9 million, an increase of 2.8% over second quarter 2010 sales excluding exchange effects. Packaging System sales increased approximately $5 million or 2.4% over same quarter 2010 sales excluding favorable FX.

Sales price increases in Packaging Systems contributed approximate 1.4% of the increase. Favorable sales mix and volume accounted for the remainder of the modest increase. Geographically increases were strongest in our Europe and Asia regions. North America sales declined due to the loss of approximately $3.6 million in sales from the prior-year quarter that Don mentioned.

We continue to benefit from additional customer conversions to our value-added washing, coating Envision inspection offerings, although to a lesser degree this quarter. High-value product sales increased just over 3% to $77 million. The most significant increases this quarter were for Envision components. Sales of disposable medical devices declined slightly in the quarter. Delivery Systems sales increased $2.5 million or 3.1% over sales in the prior-year quarter excluding exchange. The growth was driven by favorable product mix and volume, which was partially offset by contractually lower selling prices for two European customers. Sales of proprietary products represented 20% of this segment's revenues in the quarter, the same as in the prior-year quarter. Higher demand for various contract manufactured healthcare and surgical devices drove sales increases. Sales of reconstitution products were also higher, both in Europe and North America.

As provided on Slide 7, our consolidated gross profit margin for the quarter was 27.5% versus the 29.5% margin we achieved in the second quarter of 2010. Packaging Systems second quarter margins of 31.1% was 2.5 margin points below its second quarter 2010 gross margin. The decrease was due to higher raw material, labor, depreciation, and foreign exchange transaction costs and a less profitable sales mix. The sales mix was driven by specific customer issues that Don mentioned. These specific customer issues and increased raw material costs reduced Packaging Systems gross margins by 3.3% versus the prior-year quarter. These unfavorable factors were partially offset by plant, labor, and material efficiencies and the effect of increased sales prices. Delivery Systems second quarter gross margin of 17.9% was 1.2 margin points below its 19.1% prior-year margin due to increased raw material prices, the contractual decrease in selling price to two contract manufacturing customers, and wage increases. Those items were partially offset by reduced overhead costs mostly from restructuring-related labor reductions and manufacturing efficiencies. The contractual selling price decrease reduced Delivery Systems gross margin by 2%.

As reflected on Slide 8, consolidated SG&A expense increased by $600,000 in the current quarter versus the prior-year quarter excluding the $2.1 million cost of separation benefits provided to retiring exec. The increase reflects a $1.7 million impact of foreign exchange, an $800,000 increased in stock-based compensation costs due largely to the second quarter 2010 reduction in the Company's share price, and a $400,000 increase in commissions related to higher sales of reconstitution products. These increases were partially offset by lower incentive compensation costs and reductions in various other SG&A costs throughout the organization. As a percentage of sales, second quarter 2011 SG&A expenses excluding the special separation benefit were 15.1% versus 16.3% in the second quarter of 2010.

Slide 9 shows our key cash flow metrics. We generated $39.7 million of operating cash flow in the second quarter, $8 million more than in the prior-year quarter, with the difference due to lower pension contribution so far in 2011. Capital additions of $23.8 million were made in the quarter, $9.4 million more than in the prior-year quarter. $8.7 million of the capital was spent on new products and expansion efforts and included $3 million for expanding capacity for manufacturing CZ syringes at our Scottsdale, Arizona facility. Much of the remaining capital was spent on equipment upgrades at our global manufacturing sites. We're expecting to spend approximately $115 million to $125 million in capital this year excluding the accrual of approximately $27 million of costs associated with our planned new corporate and research building, which will be funded upon its completion in 2013.

Slide 10 provides some summary balance sheet information. Our balance sheet continues to be strong and we're confident our business will provide necessary future liquidity. Our cash balance at June 30 was $110 million, equal to our December 2010 balance. We had another $15 million invested in short-term securities at June 30, 2011. Debt at June 30 was $373.5 million, $15 million higher than at year-end with nearly $10 million of the increase due to foreign exchange. The remaining $5 million was due to additional net borrowings on our revolving debt facility. We now have $18 million in outstanding borrowings under our $225 million revolving credit facility. Our net debt to total invested capital ratio at quarter-end was 27.4%, slightly lower than the year-end ratio due to increases in equity from income and foreign exchange effects. Working capital totaled $317.7 million at June 30, $51 million higher than at year-end with $11 million of the increase due to FX. Much of the remaining increase was due to increases in accounts receivable and inventory. The increase in receivables was mostly due to higher sales levels in the current quarter versus the fourth quarter of 2010. Inventories continue to be higher than normal due to increased raw material costs and to support a higher anticipated level of sales.

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

Thanks very much, Bill. Turning to our outlook for the second half of the year, our current committed backlog, order patterns, and projected mix for the third quarter, we believe the gross margin decline experienced in the second quarter is a transient issue and will improve in the second half of the year due to continued sales growth in the packaging segment despite ongoing higher raw material costs. The situation is somewhat analogous to that we faced in the second half of '08 as our contractual pricing mechanisms lagged the spike in oil prices, but turned positive later in the year and in the early part of 2009.

In addition, effective July 11, we've implemented a surcharge on certain key product lines containing synthetic and natural rubber and will also benefit from several contractual price adjustments that will start in the fourth quarter. We are also forecasting higher contributions from our Lean initiatives in our operation, which taken collectively should improve margins in the packaging segment over the next six months.

Orders booked for the third quarter currently stand at more than 80% of forecast on average and the total company backlog of firm committed orders grew 9% to $274 million versus the same quarter in 2010 at constant exchange rates.

As illustrated on Slide 11, we've revised our full-year 2011 guidance in this morning's release. We base this guidance on an exchange rate of $1.45 per euro, the same rate we used in our April guidance. Full-year sales expectations have increased by approximately 1% to reflect our Q2 results and our current visibility into second half sales.

Consolidated gross profit margin for the full year is expected to decline slightly from previous expectations to 28.6% versus the 28.8% achieved in 2010. These estimates take into consideration our second quarter results, the mix of sales, our current backlog composition, and estimated raw material costs, including currency transaction effects and production cost increases. The estimate also includes the full-year impact of the two North America issues that had such a significant impact on our recent quarter.

Adjusted diluted earnings per share are expected to be in a range of $2.30 to $2.40 per share, an increase of 49% at constant exchange rates when compared with the 2010 earnings of $2.10 per share.

The state of our backlog, our current efficiency gain projections, and the pricing actions recently implemented give us a high level of confidence that we can deliver on these earnings numbers for the full year.

This concludes our formal remarks for today and Bill and I would now be pleased to answer questions that you might have.

(Operator Instructions). Your first question comes from the line of Arnie Ursaner with CJS Securities. Please proceed.

Good morning.

Good morning, Arnie.

Good morning, Arnie.

My questions start with the new information regarding a change in product format by a customer and the regulatory action at another's production facility. When were you made aware of these issues relative to let's say the guidance you gave last quarter?

Well, with regard to the issue at the customer plant, it's been an ongoing issue since the end of last year. But our forecasts were based on the information given to us as to when they might restart production. The fact is that they haven't been able to address the issues that were raised by the FDA in the time they'd originally estimated. And thus the restart of production has been pushed out. So we really didn't know about that until the second quarter.

With regard to the vial format, we had been talking to the customer about this at the end of last year. Formal decision hadn't been made. They had some inventory, but the full effect, again, came in at the end of the first quarter, beginning of the second quarter. And it's a big hitter because they went from basically a vial that is a unit dose as we said to one that is ten doses per vial. So volumes going forward are going to be one-tenth of what they were originally.

Okay. And you quantified the impact of both of these as $0.17. What was the impact -- that was the impact --

(multiple speakers)

-- that includes raw material impact as well.

Ah, okay. Can you separate those three out and try to --

Yes, absolutely, Arnie, if you look -- if you think about the two customer issues, it's really the smaller part of the story. That's only -- in terms of dollars, it's smaller, and in terms of the effect on the margin, it's about 0.7% of the margin, 3.3 margin point decline that we talk about. The big hitter is the raw material increases, which reduce margins in the quarter by 2.6% in Packaging Systems.

Okay. But, again, going back to Packaging Systems, your typical lag is about four months from when the commodity price increases, so clearly this is something you knew two, three, four months ago was going to be an issue. What changed? What was different when you got to the end of the quarter?

Well, I don't think it was that when we got to the end of the quarter. During the quarter and in fact raw materials have been increasing. The prices to us, yes, we do have a lag, but they have been cumulatively increasing. We did put into effect some measures to slow down those increases, not only contractually, but we did put a hedge into effect. But the rate of increase of the volatility is basically what has caused it.

So in addition, it's not just the one oil where we have synthetic polymers that we have the contract on that gives us the delay. There's a bunch of other raw materials involved in the process, too. We spend about $150 million, Arnie, on raw materials in Packaging Systems each year. And yes, the synthetic butyls are big -- the biggest part of that, but there's been volatility in all of the other ones. The biggest one that's really hurt us recent in the second quarter especially was natural rubber. And there were a number of other raw materials as well that have shown significant volatility that has hurt us.

And one of the reasons we guided to the full year on our April call, Arnie, and not the second quarter was that we weren't sure where oil prices were going to go. We suspected we were going to see this, so we put into effect the plans for the pricing surcharge on the synthetic rubber towards the end of May, the beginning of June.

My final question is your raw material costs clobbered you this quarter, you know, over 2% in margin, yet your price relief was less than -- about 0.5% in terms of improvement. You mentioned you put in a July surcharge. Are you -- when you're -- with your dialogues with your customers, do they understand they're not even allowing you to earn a reasonable return on the massive capital you invest? And what do you intend to do about it?

Well, they don't like it, but they understand it. So they're facing many of the same issues. To date we have had hard pushback from only one customer with the surcharge. And we expect that the total magnitude of that to recover almost all of the raw material price delta that we're going to see in the second half of the year.

In the back half, right.

Yes. And when you couple that with a couple of the contracts where we'll have the automatic adjustors in the fourth quarter, that's the reason that we've got confidence that we're going to see improvement as we go through the end of the year.

Yes. And then, again, Arnie, and you know this, that the contracts with the customers are on a delay in terms of the increase from a purchase price adjustment, so -- for the underlying commodity. So next year, if those -- as Don said, when they start to kick in in the fourth quarter and through the beginning of 2012, we'll be getting price increases commensurate with the underlying increase in the materials. That will basically take effect then and be around for 12 months at that point. So we get hurt when the volatility increases like it has and prices go up very sharply. We have a lagged effect in terms of our ability to pass those on. But then as -- once we do get the ability to pass those on, if prices stabilize at that point, then we're actually benefiting at that point.

Thank you very much.

You're welcome, Arnie.

Your next question comes the line of Andrew Hilgenbrink with Jefferies & Company. Please proceed.

Thanks for taking the questions.

Good morning, Andrew.

Good morning.

Good morning. One question on the surcharge, is that a fixed surcharge or is it variable with your community prices?

It is fixed. The surcharge is a fixed percentage. And, again, it's based on what we anticipated based on current levels of pricing today for those underlying commodities. So if we should have a significant change again, yes, you're right, we would be -- we would not be capturing that in the surcharge. But based on what we believe today -- and, again, it's anybody's guess what'll happen with the underlying commodities -- but based on what we know today and where the prices are today, as Don said, the surcharge will cover the effect -- most of the effect in the second half of 2011.

Yes, and I think it's important to point out it is a variable surcharge depending on synthetic versus natural rubber. Given what's happened to natural rubber, that surcharge is roughly double what the synthetic surcharge is.

But it's a -- it's not -- it doesn't go up if those underlying commodities go up any more. We do not capture any of that additional increase.

And then on the issue with your customer and the plant and regulatory issues, does that customer currently have sufficient supply of that product? Or is it I guess running low and as this process plays out you're actually losing sales because the customer can not produce? So I guess the question is once that customer's plant comes back online, do you expect inventory levels to be elevated to resupply their current product?

Yes, they use a broad range of products in this plant. And it's only certain lines that are shut down due to the FDA issues. Our expectation is that they'll begin ordering again to replenish orders -- or to be ready for orders that are going to come in once they get the go ahead to produce.

But the issue will be, you know, it will be a function of when they are allowed to come back online. And we certainly don't have any better information than we're giving you today.

Yes, this is not unique to this customer. I mean, I think it's fairly well-known that the FDA is getting very active with regard to operations in cGMP compliance.

One question on the Delivery System segment -- have the price reductions from the contract manufacturing component, is that just follow through from what was (multiple speakers) went into effect last quarter?

-- what we discussed in the first quarter.

Yes, that's correct. It was about $3 million.

All right. And then lastly, I'm not sure he mentioned CZ sales, but what were the CZ sales in the quarter?

-- $2 million in the quarter.

-- $2 million in the quarter.

$4 million year to date.

And still expecting that to be roughly $10 million or so for the full year?

Yes. Between $8 million and $10 million.

All right, thank you very much.

Thank you.

(Operator Instructions). And there are no questions at this time.

In that event, thank you very much for your time today. We look forward to speaking with you again at the end of our third quarter.

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect and have a great day.