Description

We believe WST represents a classic break-up investment with excellent risk/reward characteristics, where the sum of the parts is worth substantially more than its whole. WST is a company with 2 business segments; one is losing money due to significant R&D/growth investment, masking the good performance of its stable, highly recurring, visible and high barriers-to-entry core business. At face value, WST is being misperceived by the Street, which appears to be trading at almost 17X management's 04' guidance of $2.10 - directly contributing to the value opportunity in WST's current stock price. However, after a little bit of digging though, it becomes evident that investors are getting WST's dominant, core pharmaceutical business for substantially less than its fair value (11.9X EPS) and a free call option on the "home run" potential of the drug delivery segment.



The pharmaceutical systems segment (the core business) designs, manufactures and sells stoppers, closures, medical device components and assemblies. The pharmaceutical business has existed for over 80 years. It is a business with close to 80% US market share and a big position in the worldwide market. It is a business that has an extremely sticky customer. WST is a partner with pharmaceutical companies as they go through the FDA to get approval of their drugs. If a pharma company wants to change to a new provider of components, they have to go back through the FDA to get approval again - this drives the stickiness of the customer base. Although the original family no longer has a management role, they are still significant shareholders and will remain so as long as the company keeps paying a $0.80-$0.85 annual dividend. This dividend has increased by $0.04 cents each year for the last few years.



On January 29, 2003, a WST manufacturing plant had an explosion that caused fatalities and destroyed the facility. In the nearly 14 months since the explosion, the company has worked to restore operations to their pre-1/29 levels. The income statement for the last year has suffered from all the one-time charges of the explosion. The margin depression over the last year is a little less obvious. In response to the explosion, WST shifted many of its employees to a different facility in another state. WST flies employees back and forth every few weeks as well as pays overtime for 7-day work weeks. The machinery is probably worked a lot harder than it should be; and, therefore, probably does not perform up to optimum levels. There are many issues and variables from the explosion that have lead to depressed margins. The difference between the pharmaceutical division's EBITDA margin pre and post explosion is mid-to-upper teens versus low- to-mid 20s. The good news is that over the next few weeks the facility replacing the destroyed one should be completely operational. We expect margins to revert back to their pre-explosion levels by the end of 2004.



If we look at 2004, the company's pharmaceutical business should be able to grow revenues to around $520M, implying a high single digit organic growth rate. Pro-forma they should return to 22-23% EBITDA margins, or approximately $117M in EBITDA (assigns 80% of corporate overhead to this division). Subtracting $34M of D&A gives that business $83M of EBIT. Then subtract $8M for interest and tax at a 35% rate gives you $48M of net income or about $3.20 per share. Pro-forma margins should become evident as the year progresses but even on today's margins the core business should do $3.00 in 2004. If one puts a 15 -16 X multiple on that business, one could easily argue the core business is worth at least $45-$50 and the drug delivery is a free play.



WST's normalized capex should be around $40M, bringing free cash flow for the core business to about $2.75 per share. WST's maintenance capex, though, is closer to $22M. Some of the difference between capex and D&A is from a large European plant that was built in the latter part of 2003. The '04 numbers may suffer a bit from the final touches of the rebuilding process but as the year progresses the numbers will become crystal clear. Today with $175M of debt and $38M of cash, WST trades at approximately 5.6X 2004 normalized EBITDA of the core business.



The drug delivery systems segment is the real value wild card in this opportunity. The segment identifies and develops drug delivery systems for biopharmaceutical and other drugs. Currently they are focusing on nasal drug delivery opportunities. WST's core pharmaceutical business provides the drug delivery segment with a real advantage over all its competitors as they already have a relationship with every large pharma company. Management forecasts that it could potentially have 5 products on the market by 2005 and seven by 2008. For some reason, the street has given WST no value for the potential of these drugs even though it will address markets that currently have over $40B in sales. The first of these new offerings should be ready for launch by 2005. For comparison, Nastech Pharmaceutical ("NSTK") currently has a market cap of $157M with what we consider weaker fundamentals and opportunities. Adding $157M of market cap to WST for the value of drug delivery (which could prove to be very conservative) increases the stock price by $10.60 . For reference, WST has lost over $70M on drug delivery in the last 5 years. Management believes the return on investment will reward its sizable expenditure.



VALUATION SUMMARY


Core Business (solid, sticky, recurring 80% market share business):

Two ways to look at it:

1) 15-16X estimated normalized EPS of $3-3.15: $45-50 per share

2) 9X 2004 estimated normalized EBITDA: $50 per share


Drug Delivery:

$150+ million (could be a lot higher) $10.60 per share (see above)


Total WST Value $55-60+



The final piece here is management's lack of presence on the Street. The management team at WST is relatively new. The CFO joined in August, the head of drug delivery has been there less than 1 year and the current CEO took that position in April of 2002. From our due diligence checks, this management team has received high marks and we feel they are value creators. We expect them to tell their story in the same way we just described it. Management has indicated that it plans to be more aggressive on the IR front now that their attention is no longer focused on the plant explosion (they have not gone on an IR road show in well over a year). Importantly, if the market does not accord its core business and drug delivery business the appropriate values, we expect WST to unlock the inherent value within the next 1+ years through a spin-off/sale of the drug delivery segment.

Catalyst

Continued growth of core business with clean EBITDA margins moving back to 22-23%



Announcements of approvals and partnerships in the drug delivery business



Management to communicate its sum-of-the parts story out to the street in an effective manner: to focus investors on the value of the core business that generates EPS of $3-3.15 on a normalized basis, away from guidance of $2.10 of reported earnings which is being dragged down by spending on the drug delivery segment and non-normalized margins in the core business due to a "one-time" plant explosion.



Management announces a value enhancing/unlocking transaction (i.e. spin-off or sale) within the next 12-18 months for its drug delivery segment.



Announcement of “tuck-in” acquisitions for the core business helping to highlight segment’s value