West Pharmaceutical Services

Moat: 3/5

Understandability: 3/5

Balance Sheet Health: 4/5

West Pharmaceutical Services, Inc. (WST) is a global manufacturer of packaging components and delivery systems for injectable drugs and healthcare products, offering a wide variety of products such as stoppers, plungers, seals, and cartridges.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview:

WST operates within the global healthcare industry, specifically in the pharmaceutical and biotechnology sectors. They do not produce the drugs, but the essential components, packaging, and delivery systems, that are required to ensure the drugs are safe and sterile for usage. Their business segments are:

Proprietary Products: These are their internally developed, proprietary components such as stoppers, plungers, seals, and cartridges which are produced for drugs and medical devices.

Contract-Manufactured Products: These include standard parts and custom-designed components made to their customers’ specifications. They have a global manufacturing and supply chain with operations located in North America, Europe, and Asia.

This division in two is important because of their varying impact on the overall valuation.

Revenues Distribution:

  • WST primarily generates revenue through the sale of its proprietary products to pharmaceutical and biotechnology companies (87% of revenues in 2022), while around 13% of revenues come from contract manufacturing which usually comes with lower margins.

  • Geographically, the company’s revenue distribution is highly diversified, with approximately 46% in the Americas, 43% in Europe, Middle East, and Africa (EMEA), and 10% in Asia Pacific in the fiscal year ended December 31, 2023. This is further broken down to Proprietary Product sales of 43% in the Americas, 40% in EMEA, and 10% in Asia Pacific for the nine months ended Sep 30, 2023. For contract-manufactured product sales, Americas make up 45% of revenues, while the EMEA and Asia Pacific regions contribute 35% and 20% respectively.
  • Their customers range from large, global pharmaceutical firms to small biotech start-ups, and they serve over 1,000 clients across different sectors.

Industry Landscape and Competitive Advantages

The pharmaceutical and biotech industries are high-growth sectors. WST operates in a niche segment by providing packaging solutions for these sectors. Demand is driven by population growth, increased healthcare spending and, importantly, the production of new injectable and biotech drugs.

Here’s an overview of WST’s competitive advantages (moat):

  1. High Switching Costs: WST products are designed to provide a crucial role in a drug’s delivery system. They are tightly integrated with their client’s processes, and changing suppliers would require expensive revalidations, regulatory hurdles, and production disruptions. Since the packaging is usually a small part of overall costs for pharmaceutical companies, their customers are usually not focused on price and instead care more about quality, and reliability. As such, switching costs are high and create a moat.
  1. Proprietary Technology and Manufacturing Processes: WST has over 100 years of experience and expertise in the production of drug delivery systems with their manufacturing capabilities and proprietary technology, this knowledge creates some of the most complicated items for the market and is something most competitors would struggle to replicate.
  1. Strong Customer Relationships: The company has long-standing relationships with its customers with most being recurring, providing them with greater insight into client needs. They have a strong brand name that is trusted by its partners and are considered to be a quality partner by most, strengthening their moat.

Moat Rating: 3 / 5 WST has a moderate moat. The high switching costs, coupled with proprietary technology and their strong client relationships provides them with a meaningful moat that helps them achieve above average profitability. However, the manufacturing segment is more commoditized which can bring a drag to overall returns, and the company needs to innovate to keep its edge in the market.

Legitimate Moat Risks and Business Resilience

While WST possesses a solid moat, certain risks could impact the moat’s sustainability and the business’ resilience:

  • Regulatory Changes: The pharmaceutical and medical device industries are heavily regulated. Changes in regulatory standards or compliance requirements could add costs or disrupt production that might hurt profit margins.

  • Technological Disruption: Technological advancements in drug delivery systems could make WST’s current offerings obsolete. While they have the expertise to make new solutions, they must be on the leading edge of research to compete.

  • Customer Concentration: Although they have a wide customer base, a significant portion of WST’s revenues comes from large pharmaceutical companies. A loss of sales from any large customer or mergers could adversely affect revenues.

  • Supply Chain Issues: Disruption in the supply chain can affect production, as seen in past couple of years. In addition, the prices of raw materials, particularly certain polymers, will impact profits.

  • Economic Downturn: Reduction in healthcare spending or a delay in new drug approvals due to economic downturns can affect sales.

  • Product Quality issues: WST products are often utilized in life-saving medication and as such are prone to high amounts of regulatory scrutiny. Any major fault of their products can have grave consequences.

WST has shown a good ability to navigate these challenges with their experience and by forming long-term relationships with their customers. They have also invested heavily to expand their production capabilities and product development, which allows them to expand into new markets.

Financial Analysis

WST’s financial performance is generally strong, characterized by consistent growth and profitability.

  • Revenue: WST has shown a history of steady revenue growth, driven by both organic expansion and acquisitions. In 2023, their net sales were $2,988.9 million, up from $2,879.4 million in 2022 and $2,668.6 million in 2021. This represents a compound annual growth rate of 6% over the last three years.
  • Margins: WST enjoys a high level of profitability, with strong gross margins. Their operating margins have trended downwards from 22.4% in 2021, to 22% in 2022 and 19.2% in 2023, which was driven in part due to acquisitions, which came with lower margins, and the cost inflation. For long-term viability, these margins need to trend back up, though the management is working towards improvements.
  • Cash Flow: WST consistently generates positive free cash flow, which provides them flexibility in capital allocation decisions such as R&D, new capacity, or acquisitions.
  • Debt: Historically, the company has low levels of debt, but they are taking on higher debt levels because of recent acquisitions. Long-term debt increased from $1.1B in December 2021 to $1.8B in December 2022. As of September 30, 2023, long term debt is at around 1.6B. They are, however, well capitalized and should be able to manage these debts.
  • Return on Invested Capital: Return on Invested Capital (ROIC) has been healthy and averaged around 16% over the last decade, although the trend has been decreasing in recent years, which is mainly driven by their reduced margins.

Balance Sheet Health: 4 / 5 WST’s balance sheet is good, with a decent cash position and fairly manageable debt levels. However, a close eye must be kept on increasing debt levels and maintaining or increasing their profit margins.

Understandability: 3 / 5 WST’s business model is moderately complex, as they operate in the niche segment of drug delivery and pharmaceutical packaging. Although these products are essential, they are not very well-known to the average investor and there is a substantial amount of technical complexity involved in developing and producing these products. However, the underlying drivers of their business such as revenues, margins, and cash flows are generally easy to understand.

Recent Concerns/Controversies and Management Discussion

  • Supply Chain Issues and Cost Inflation: The company has faced challenges with supply chain disruptions, increased costs, and inflation. Management has been trying to address this with pricing actions and cost-cutting measures. The company has reported the most amount of impact was from increased raw material costs.
  • Acquisitions: WST has acquired a number of companies recently. The management has reiterated the goal is to enhance the business and to expand on their technology and manufacturing capabilities. They have discussed they want to use this to expand their presence in high-growth areas.
  • Guidance for 2023: The company recently lowered their outlook for full year organic growth to 2 to 4 percent, and also reduced its guidance for full year adjusted earnings per share to $6.68-$6.83. They have cited economic slowdown and higher interest rates in Europe as some of the drivers. They seem confident in their long-term growth drivers, but they are focused on controlling costs and increasing their profitability.