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Morningstar | West Reports Better-Than-Expected 2Q Results; Raising FVE

Wide-moat West Pharmaceutical Services reported a strong second quarter, putting it in a position to handily beat our estimates for the full year. While management maintained its guidance ranges on both the top and bottom line, we think the recent hire of a new chief financial officer has likely led to some conservatism in the firm's outlook. With revenue up 12.6% on a reported basis and approximately 9% in constant currency for the quarter (and nearly 10% and 6% year to date), the firm is well on its way to performing in excess of our 7.7% forecast for the year. By our estimate, improved volume and mix has accounted for nearly 5% of West's year-to-date sales increase, with pricing improvements accounting for a bit over 1%. We plan on raising our fair value estimate by a mid-single-digit percentage to account for this performance, along with lower-than-anticipated capital expenditure requirements for the business following the completion of its new production facility in Ireland.

Equally important to the West thesis is margin improvement, which performed largely in line with our thinking. Total gross and operating margin expanded nearly 40 basis points year over year, driven by the proprietary products segment that grew its gross margin to 37.2% versus 35.4% in the year-ago period. The contract manufacturing segment, while reporting robust growth, saw gross margin contract on both a year-over-year and sequential basis. This was largely attributable to restructuring programs and startup costs for new product programs—headwinds that will likely dissipate in the second half of 2018. Ultimately, we believe growth in high-value product volume is the most important metric to monitor for West, given the premium margin ascribed to these components. West's high-value product line grew 11.7% in the quarter, modestly above our full-year forecast, giving us confidence in our margin outlook that calls for nearly 650 basis points of gross margin expansion through 2022.

Finally, with management lowering its outlook for full-year capital expenditures and implying lower capital intensity for the business over the longer term, we continue to believe investors should turn their attention to future capital allocation priorities. By our count, the firm should generate over $1 billion in cumulative free cash flow over the next five years, with roughly $250 million required to fund its dividend barring any major changes in policy. Having exhausted its existing share repurchase authorization in the quarter and currently operating with zero net leverage, management is likely to turn to acquisitions as an avenue to deploy excess capital over the coming years. This would be a relatively new undertaking, as the firm hasn't completed any major transactions since bringing the contract manufacturing operation on board in 2005. We're hopeful that management will further articulate its expectations surrounding acquisition opportunities in the coming quarters.