Maintaining CHF 620 Fair Value Estimate for Narrow-Moat Lonza; Shares Undervalued

Business Strategy & Outlook:

Lonza Group has been a dominant player in the contract development and manufacturing space for decades. The company thinks the outlook for Lonza looks bright, especially as drug manufacturing becomes more complex with biologics and cell and gene therapies playing larger roles in the overall mix. Lonza’s 2021 CHF 4.2 billion divestment of its former specialty ingredients business to Bain Capital and Cinven as positive since it allows for an increased focus on further expanding its biopharma contract manufacturing business. Lonza’s specialty ingredients customers were large consumer goods and industrials players, which had significant bargaining power. As a result, this segment had lower margins and shorter contracts of one to three years compared with its lengthy contracts for its biopharma manufacturing business.

Lonza maintains an extensive network of partnerships with pharmaceutical and biotechnology firms that leverage its expertise and scale to optimize drug production and avoid the risks of in-house manufacturing. Company anticipates outsourcing penetration will continue to incrementally increase, driven by the complexities of biologic manufacturing. Only one-third of pharmaceutical manufacturing is currently conducted in-house while two-thirds are outsourced. Additionally, the customer relationships in Lonza’s contract manufacturing segment are sticky and long-lasting, as drug companies tend to stick with trusted suppliers with good track records of regulatory compliance. Biopharma customers are likely to continue outsourcing manufacturing in order to benefit from access to flexible capacity and manufacturing improvements.

Financial Strengths:

Lonza is in fair financial health, and company expects the business to continue providing a steady stream of cash. The company has historically utilized debt, particularly for acquisitions. The company ended 2017 with CHF 3.8 billion in debt after acquiring Capsugel with a mix of debt and equity. Since then, the company has steadily deleveraged. It is expected that the company will be able to meet its financial obligations with its free cash flow. Lonza also divested its specialty ingredients business in July 2021 for CHF 4.2 billion. Management is using the proceeds from the divestment to further improve its biopharma manufacturing capabilities. The management team has a continued record of returning cash to shareholders in the form of dividends, with a dividend of CHF 3.00 paid in 2021. The payout ratio as a percentage of adjusted earnings per share has varied between 20% and 40% over the last few years, depending on cash needed for capital expenditures. The payout ratio has trended down in recent years due to increased investment in new manufacturing capabilities. Due to the business’ strong cash flow, the management will maintain its dividend policy and utilize cash for dividend payments, debt paydown, internal investment, and opportunistic deals.

Bulls Say:

The pharma biotech and nutrition segment are a sticky business with long-term contracts and high switching costs for its customers.
As drug portfolios are increasingly made up of complex drugs like biologics and emerging therapies, Lonza’s biopharma customers will be more reliant on outsourced manufacturing.
With its global scale, Lonza is less dependent on any one customer or drug, which allows it to better absorb surprising late-stage failures or drops in demand

Company Description:

Lonza Group is a contract development and manufacturing organization, or CDMO. It operates under four segments: small molecules, biologics, cell & gene, and capsules & health ingredients. Lonza derives its revenue primarily from long-term supply agreements with pharmaceutical customers. The company provides a range of development and manufacturing services throughout the entire lifecycle of a product from drug research to commercial supply. The majority of Lonza’s customers are pharmaceutical and biotechnology companies, academic institutions, and government research organizations.

(Source: Morningstar)

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