Every year, the official Dividend Aristocrats list is updated with new companies that join the ranks, as well as others that are removed due to a dividend cut or a failure to raise dividends over the past year.

In turn, we provide an individual analysis of all Dividend Aristocrats each year. The next up in our annual Dividend Aristocrats In Focus series is West Pharmaceutical Services (WST).

The company has seen its shares explode upwards in recent years, based mainly on a combination of strong earnings growth and the market’s admiration for said earnings growth, which has resulted in substantial multiple expansion tailwinds.

West Pharmaceutical has also raised its dividend for 25 consecutive years, which means it is among the newest additions to the Dividend Aristocrats list.

West Pharmaceutical is a new Dividend Aristocrat for 2021. We previously covered another 2021 addition to the Dividend Aristocrats list in our review of International Business Machines (IBM).

This article will discuss West Pharmaceutical’s business model, growth potential, competitive advantages, and whether we view the stock as a buy for 2021.

Business Overview

West Pharmaceutical Services is a healthcare company that engages in the manufacturing and sales of medical packaging and medical components and is a contract-manufacturer for other medtech companies. Among others, its offerings include automatic medication delivery systems and medicine injection solutions. West Pharmaceutical Services was founded in 1923 and is headquartered in Pennsylvania.

Source: West Pharmaceutical Services presentation

Sales are mostly generated in the US and the MENA region. This is not a big surprise, as healthcare expenditures on a per-capita basis are among the highest in the US and Europe. Components make up roughly half of the company’s sales, while delivery devices, so far, are responsible for only 5% of sales.

West Pharmaceutical Services benefits from long-term growth in the healthcare industry. As an aging population requires more and more medical care, this leads to higher drug sales, which, in turn, benefits West Pharmaceutical’s business, as this allows for higher sales. The company has thus managed to grow its organic sales, which backs out acquisitions, by ~5% a year in the past.

More recently, it has managed to grow its revenues by double-digits during the last couple of quarters. For example, in the 2020 third quarter West Pharmaceutical’s revenues rose by 20% year over year, to $550 million.

Since marginal costs for many healthcare and medtech industry companies are not overly high, revenue increases usually go hand in hand with some margin expansion. This was true for West Pharmaceutical Services, which managed to grow its earnings-per-share by an outstanding 46% during Q3 on a year over year basis.

Growth Prospects

The whole healthcare industry will benefit from ongoing macro trends such as an aging population and increasing numbers of new therapies that seek to treat all kinds of ailments. As a result, West Pharmaceutical Services will likely continue to see ongoing growth from its core businesses, manufacturing, and parts production.

Management believes that West Pharmaceutical Services will be able to grow its revenues by 6% to 8% a year in the long run, on an organic basis, excluding the impact of mergers and acquisitions. West Pharmaceutical’s growth rate was a little lower than that over the last decade, but factoring in the very encouraging growth in recent quarters, it looks like the company has found a way to improve its growth potential. We estimate a high-single-digit sales growth rate can be achieved in the long run.

The compelling growth that was experienced in 2020 can be attributed to a strong performance of West Pharmaceutical Services’ proprietary product segment, which grew by more than 15% year over year. The company’s HVP (high-value products) segment grew by more than 20% year over year in 2020. Contract manufacturing also was a segment with above-average growth during the last year.

Going forward, West Pharmaceutical Services’ proprietary product portfolio could help the company in improving its organic sales growth rate in the long run. We thus believe that management’s guidance of a 6%-8% annual sales growth rate seems achievable, although there is of course, no guarantee that the company will hit that target.

Source: West Pharmaceutical Services presentation

The above slide shows that the gross margins across West Pharmaceutical Services’ business units differ quite a lot. Contract manufacturing, for example, is a rather low-margin business, although it should be noted that the company does not have a lot of risks and R&D expenses in that segment.

Other business units, however, such as the HVP components business, come with significantly higher margins. The growth of these segments could easily lift company-wide margins over the coming years, which is why it would not be a surprise to see net profits grow at a somewhat steeper rate than the company’s revenues.

With a sales growth rate forecast in the 6%-8% range, earnings-per-share could reasonably grow by 8%-10% a year in the long run, as margin tailwinds will likely lead to a somewhat improved bottom-line growth rate relative to its sales growth. We will therefore calculate our total return forecast using an estimated earnings-per-share growth rate of 9% annually.

Competitive Advantages & Recession Performance

West Pharmaceutical Services is not among the largest healthcare companies in the world. However, its main competitors are not companies such as Johnson & Johnson (JNJ), but rather other parts producers and contract manufacturers. Among those, West Pharmaceutical Services is the smallest by far. Peers such as Cooper Companies (COOP) or Alcon (ALC) are of a similar size.

West Pharmaceutical Services has a wide range of manufacturing facilities in different countries around the globe. This competitive advantage allows the company to supply to the markets where its products are needed directly, while saving on transportation costs. The company also holds more than 300 patents that were rewarded during the last two years alone, which is the result of its investments in R&D when it comes to the company’s proprietary products offerings.

In that regard, West Pharmaceutical Services’ investments could pay off in the long run, through an above-average growth rate and a product portfolio that is well-protected against potential new market entrants.

Healthcare is a recession-resilient industry, as demand for medication and treatments does not depend highly on the strength of the economy. That is why West Pharmaceutical Services also did not feel a lot of pressure during the Great Recession of 2008-2009. During the Great Recession, West Pharmaceutical Services’ earnings-per-share declined by just 15% peak-to-trough. This is an attractive performance, both on an absolute basis, as well as relative to the big profit declines that were experienced by many other companies with more vulnerable businesses.

During the coronavirus pandemic of 2020, West Pharmaceutical Services again performed well. During 2020, the company managed to grow its earnings-per-share, based on current estimates for the fourth quarter (Q4 results have not been released so far). This, once again, showcases the strong resilience of the company’s business model during times when the economy is in a recession. Resilience during economic downturns makes West Pharmaceutical Services an attractive choice for risk-averse investors, at least on a fundamental basis.

Valuation & Expected Returns

In the recent past, West Pharmaceutical Services has delivered highly attractive returns, as its shares rose by a massive 400%+ over the last five years. This was, at least partially, the result of a steep increase in its valuation. West Pharmaceutical Services currently trades for ~65 times this year’s expected earnings-per-share, based on current consensus estimates.

That is a quite high valuation, both in absolute terms, as well as relative to how the company was valued in the past. Up through 2014, West Pharmaceutical Services mostly traded at a high-teens earnings multiple, although the valuation range has expanded since then. Right now, shares are the most expensive they have ever been, which does not bode well for the company’s future returns.

We believe that shares would be fairly valued at 22 times EPS. As a result, we view the stock as severely overvalued, even when factoring in the forecasted earnings-per-share growth of 9% per year. With a very low dividend yield of just 0.2%, West Pharmaceutical Services is still expected to generate negative total returns over the coming five years, estimated at -11% a year.

This is a very weak projected total return figure and shows the potential danger in buying stocks with extremely elevated valuation multiples. Overall, we do not deem the stock attractive at current prices.

Final Thoughts

West Pharmaceutical Services is an attractive company on a fundamental basis. The business is recession-resilient, the company benefits from macro growth tailwinds, and the company’s near-term revenue and earnings growth outlook are compelling.

However, the stock’s valuation is very high, and we believe that shares are massively overvalued at current levels. We thus think that West Pharmaceutical Services is a company that is not suitable for investment at current valuation levels, even though we like many of the underlying properties of the company.

The very high share price also is the reason why West Pharmaceutical Services’ dividend yield is very low, at just 0.2%. Despite the fact that the company has recently become a Dividend Aristocrat, we do not deem it worthy for income investors at current prices.