West Pharmaceutical Is Too Richly Valued

In my November 25, 2022 West Pharmaceutical (WST) post, I disclosed a new position in WST with the purchase of 100 shares @ ~$225/share in one of the 'Core' accounts within the FFJ Portfolio. I would have acquired a larger number of shares, however, I stated:

'In recent posts, I mention the purchase of a second home and my liquidity, therefore, being much lower than I anticipated. I am not, therefore, looking to make any significant equity investments. I am, however, open to initiating a new position and/or adding to existing positions in profitable companies that have temporarily fallen out of favour with the broad investment community if they:

• are growing;
• generate strong free cash flow (FCF);
• have a strong competitive position; and
• have no/minimal debt'

My liquidity improved in early 2023 thus prompting me to revisit WST in this February 17 post; WST had just released Q4 and FY2022 earnings and FY2023 guidance. Unfortunately, WST's share price had risen to ~$320 and I determined shares to be too richly valued.

WST has now recently released its Q1 2023 results and has updated its FY2023 guidance. Regrettably, WST's share price at the May 1 market close is ~$367 and WST's valuation is well beyond the level at which I am prepared to acquire additional shares.

Business Overview

WST is the global market leader in primary packaging and delivery components for injectable therapeutics.

While I provide a Business Overview in my November 25 post, the best source of information to learn about the company is the 2022 Annual Report and Form 10-K.

CEO and NEO Compensation

I reference the Corporate Governance Documents and Policies section within WST's 2023 Proxy Statement; this commences on page 21 of 55.

I am particularly interested in understanding how a company's CEO and Named Executive Officers (NEO) are compensated; I want to see the percentage weighting of each compensation element that comprises the target Total Direct Compensation (TDC). If the long-term incentive component makes up a large percentage of the TDC, I envision that a company's CEO and the NEOs will make decisions that are closely aligned with the interests of long-term shareholders.

The chart below illustrates the percentage weighting of each compensation element that comprises the 2022 target TDC for the CEO and the average for the other NEOs.

For 2022, 87% of WST's CEO's pay was at risk and subject to the attainment of specific performance goals.

In FY2022, the most important Financial and Non-Financial Performance measures to link compensation 'actually paid' to WST's CEO and other NEOs to company performance are:

• Earnings per Share
• Revenue
• Operating Cash Flow
• Consolidated Gross Profit
• Sales Compounded Annual Growth Rate
• Return on Invested Capital

Financials

Q1 2023 Results

Please refer to WST's Q1 2023 Earnings Release and Earnings Presentation.

In Q1, WST reported low single-digit organic sales growth and a decline in operating profit and diluted EPS compared to Q1 2022.

COVID-related net revenues were ~$23 million in Q1 2023 or a ~$88 million reduction compared to Q1 2022.

Proprietary Products' organic net sales remained flat. High-value products, which made up more than 70% of Proprietary Product sales in Q1, declined by low single digits due to the reduction in COVID-related net revenues.

• The Biologics market unit reported a double-digit decline due to a reduction in sales related to the COVID-19 vaccine.
• The Generics market unit delivered high double digits growth led by sales of Westar components.
• The Pharma market unit experienced low double-digit growth led by Envision and Westar components as well as Admin Systems.
• The Contract Manufacturing segment experienced double-digit net sales growth in Q1. This was primarily driven by an increase in sales of components related to injection-related devices.

Organic sales growth in Q1 was led by sales price increases which contributed $38 million. Offsetting this, was a negative mix impact of $21.3 million, primarily due to a reduction in COVID-19-related net demand and a foreign currency headwind of ~$20.1 million.

Consolidated gross profit margin of 37.9% was down from 39.5% in Q1 2022.

Proprietary Products' Q1 gross profit margin of 42.5% was 90 basis points lower than the margin achieved in Q1 2022. The key drivers for this decline were an unfavourable mix from a reduction in sales related to COVID-19 vaccines and continued inflationary pressures on labour, raw materials and overhead costs. These factors were partially offset by sales price increases and production efficiencies.

Contract Manufacturing's 17.6% Q1 gross profit margin was 250 bps below the margin achieved in Q1 2022, primarily due to the mix of products sold.

Operating cash flow in Q1 was $138.1 million, a decrease of $13.1 million (8.7%) compared to Q1 2022. This was primarily due to a decline in operating results.

Capital spending in Q1 was $82.1 million or $16.3 million higher than in Q1 2022. This increase is attributed to WST increasing its high-value product manufacturing capacity within existing facilities in the U.S., Germany, Ireland and Singapore.

Working capital of ~$1.4B at the end of Q1 2023 is similar to FYE2022.

The cash balance of $886.3 million at the end of Q1 2023 is $8 million lower than at FYE2022. The decrease is primarily due to WST's share repurchase program and higher CAPEX.

FY2023 Guidance

WST's previous FY2023 financial guidance was:

• net sales of $2.935B - $2.960B;
• adjusted-diluted EPS of $7.25 - $7.40; and
• CAPEX of ~$0.35B.

Expectations were for FY2023 overall organic sales growth of ~3% - ~4%. This included a $0.303B YoY decline in pandemic-related sales ($0.388B in FY2022 to $0.085B in FY2023). Excluding this impact, management expected mid-teens overall base organic sales growth with proprietary products growth in the high teens and high single-digit growth in contract manufacturing.

WST's FY2023 financial guidance has now been revised to:

• net sales of $2.965B - $2.990B;
• adjusted-diluted EPS of $7.50 - $7.65; and
• CAPEX of ~$0.35B (this is unchanged).

There is an estimated full-year 2023 tailwind of $15 million based on current foreign exchange rates compared to prior guidance that included a $30 million headwind.

Organic sales growth remains unchanged at ~3% - ~4%.

WST continues to expect mid-teens Proprietary Products base organic sales growth for the year.

Contract Manufacturing is now expected to be double-digit growth compared to the prior high single-digit outlook. WST expects continued demand for certain injection devices as witnessed in Q1.

FY2023 COVID-19-related sales are expected to be ~$60 million compared to prior guidance of ~$85 million. Net sales guidance also includes an $8 million reduction resulting from an expected divestiture of a European facility that produced standard Proprietary Product components.

The FY2023 adjusted diluted EPS guidance range includes an estimated FX tailwind of ~$0.02 based on current foreign currency exchange rates compared to prior guidance of a headwind of ~$0.11. The updated guidance also includes EPS of $0.15 associated with a Q1 2023 tax benefit from stock-based compensation.

In FY2019, WST posted a 16.1% operating margin. In 2023, WST expects an operating margin of 23%, which is an increase of ~800 basis points over 4 years.

Free Cash Flow (FCF)

In FY2012 - FY2022, WST generated FCF of (in millions of $): 55, 65, 71, 81, 49, 133, 184, 241, 298, 331, and 439. In Q1 2023, WST generated ~$56 million of FCF versus ~$85.4 million in Q1 2022.

Credit Ratings

No rating agency rates WST's debt. However, WST's cash flow and balance sheet metrics reflect a prudent use of debt.

I reference Note 8 - Debt in WST's Q1 2023 Form 10-Q (page 11 of 37) wherein we see details of the company's various credit facilities.

Note 10 in WST's FY2022 Form 10-K (page 68 of 108) provides additional information about WST's various credit facilities.

Various financial covenants in WST's debt agreements include the need to maintain established interest coverage ratios and to not exceed established leverage ratios. The agreements also contain other customary covenants, none of which are considered restrictive to WST's operations. At the end of Q1 2023, WST complied with all debt covenants.

The same metrics WST provided when it released FY2022 results are provided below for comparison.

Dividends, Share Repurchases, and Stock Splits

Dividend and Dividend Yield

WST's dividend history currently does not reflect the Q3 2023 dividend of $0.19/share to be paid on August 2, 2023 to shareholders of record as of July 26, 2023. That dividend will mark the 4th consecutive $0.19/share quarterly dividend.

I anticipate WST will declare a $0.20/share quarterly dividend in October for distribution in November. This $0.01/share increase is consistent with prior dividend increases.

When I wrote my November 25 post, WST was scheduled to distribute its second $0.19/share quarterly dividend in early February. With shares trading at ~$225, the dividend yield was ~0.34%.

At the time of my February 17 post, I expected the next 4 quarterly dividend distributions to total $0.78 (($0.19 x 2) + ($0.20 x 2)). With shares trading at ~$320, the forward dividend yield was ~0.24%.

The next 4 quarterly dividend distributions should total $0.79 (($0.19 x 1) + ($0.20 x 3)). Shares now trade at ~$366 so the forward dividend yield is ~0.216%.

This low dividend yield is likely to dissuade some investors from investing in the company. Investors, however, should focus on an investment's total potential long-term investment return. The bulk of WST's future total investment return is likely to continue to be predominantly in the form of capital appreciation.

Share Repurchases

WST's weighted average shares outstanding in FY2012 - FY2022 are (in millions of shares) 71.8, 71.4, 72.8, 73.8, 75, 75.8, 75.4, 75.4, 75.8, 76.3, and 75.8. The diluted weighted average shares outstanding in Q1 2023 is 75.7.

In February 2023, WST's Board approved a share repurchase program under which up to $1.0B in shares can be repurchased. This new program will provide for a continuation of WST's share count-neutral strategy, which is assumed in the FY2023 financial guidance.

The share repurchase program does not have an expiration date and the number of shares to be repurchased and the timing of such transactions will depend on a variety of factors, including market conditions.

During Q1 2023, WST purchased 183,360 shares of common stock under the program for $60.1 million, or an average price of $327.90/share. During Q1 2022, WST purchased 390,000 shares of our common stock under the program for $147.1 million, or an average price of $377.23/share.

Stock Splits

WST initiated a 2-for-1 stock split in September 2013.

Valuation

WST's FY2012 - FY2022 diluted PE levels are 23.80, 31.65, 32.46, 47.05, 45.85, 39.47, 47.82, 49.29, 68.60, 58.12, and 28.53.

In FY2020, WST generated $4.57 and $4.76 in diluted EPS and adjusted diluted EPS. The 52-week intra-day low/high was $124.53 in March 2020 and $305 in November 2020. Using this data, WST's diluted PE range was ~27 - ~66.7 and the adjusted diluted PE range was ~26.2 - ~64.

In FY2021, WST generated $8.67 and $8.58 in diluted EPS and adjusted diluted EPS. The 52-week intra-day low/high was $253.86 in March 2021 and $475.35 in September 2021. Using this data, WST's diluted PE range was ~29.3 - ~54.8 and the adjusted diluted PE range was ~29.6 - ~55.4.

At the time of my November post, WST had generated YTD2022 diluted EPS and adjusted diluted EPS are $6.36 and $6.80. Management's FY2022 adjusted diluted EPS guidance was $8.15 - $8.20. Based on the $8.175 mid-point and the current ~$225 share price, the forward adjusted diluted PE was ~27.5. I estimated WST would generate $1.30 in diluted EPS in Q4, thus giving us FY2022 diluted EPS is ~$7.66. Using this and the ~$225 share price, the forward diluted PE was ~29.4.

Few brokers cover WST but using the adjusted earnings estimates that were available, the following were the forward-adjusted diluted PE levels:

• FY2022 - 6 brokers - mean of $8.17 and low/high of $8.15 - $8.20. Using the mean estimate, the forward-adjusted diluted PE is ~27.5.
• FY2023 - 6 brokers - mean of $7.35 and low/high of $6.54 - $8.05. Using the mean estimate, the forward-adjusted diluted PE is ~30.6.
• FY2024 - 3 brokers - mean of $8.72 and low/high of $8.11 - $9.20. Using the mean estimate, the forward-adjusted diluted PE is ~25.8.

WST ended up generating $7.73 and $8.58 in diluted EPS and adjusted diluted EPS in FY2022. The 52-week intra-day low/high was $206.19 in October 2022 and $468.05 in January 2022. Using this data, WST's diluted PE range was ~26.7 - ~60.5 and the adjusted diluted PE range was ~24 - ~54.6.

When I reviewed WST in February 2023, management's FY2023 adjusted-diluted EPS guidance was $7.25 - $7.40. With shares trading at ~$320, the forward adjusted diluted PE range was ~43.2 - ~44.1.

The forward-adjusted diluted PE levels using the current broker estimates were:

• FY2023 - 8 brokers - mean of $7.24 and low/high of $7.10 - $7.33. Using the mean estimate, the forward-adjusted diluted PE is ~44.2.
• FY2024 - 7 brokers - mean of $8.25 and low/high of $7.96 - $8.57. Using the mean estimate, the forward-adjusted diluted PE is ~38.9.
• FY2025 - 3 brokers - mean of $9.18 and low/high of $8.76 - $9.44. Using the mean estimate, the forward-adjusted diluted PE is ~34.9.

Shares now trade at ~$366 and management's FY2023 adjusted-diluted EPS guidance has been raised to $7.50 - $7.65. This gives us a ~47.8 - ~48.8 forward adjusted diluted PE range.

The forward-adjusted diluted PE levels using the current broker estimates are:

• FY2023 - 8 brokers - mean of $7.67 and low/high of $7.57 - $7.93. Using the mean estimate, the forward-adjusted diluted PE is ~47.7.
• FY2024 - 8 brokers - mean of $8.68 and low/high of $8.36 - $9.34. Using the mean estimate, the forward-adjusted diluted PE is ~42.2.
• FY2025 - 5 brokers - mean of $9.66 and low/high of $9.40 - $10.35. Using the mean estimate, the forward-adjusted diluted PE is ~37.9.

Earnings estimates have been revised higher from those earlier this year. However, the surge in WST's share price has led to the forward valuation levels being even higher than before.

Final Thoughts

If I assign a generous ~32 forward-adjusted diluted PE and use the upper end of management's $7.50 - $7.65 FY2023 adjusted-diluted EPS guidance, a share price below the mid-$240s would place WST's shares at an attractive 'buy' level.

As much as I would like to increase my WST exposure, I can not justify acquiring shares at the current level.

I wish you much success on your journey to financial freedom!

Note: Please send any feedback, corrections, or questions to [email protected].

Disclosure: I am long WST.

Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.

I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with any company mentioned in this article.