#2 Lonza Group AG - Business overview

In the previous newsletter (#1 Lonza Group AG - Industry Dynamics and Competitive Landscape) I introduced the trends unrolling in the pharma industry which are transforming the biopharma landscape into a new business model where companies need to increasingly focus in R&D activities while manufacturing of the drugs its commoditized and outsourced.

As Easter break is approaching I have decided to break the remaining announced newsletter about Lonza Group AG in two: first part more qualitative covering Lonza’s history, business model, competitive advantages, etc; and a 2^nd one focused in the financial statements.

DISCLAIMER: This article is not a recommendation to buy or sell any financial instrument, the content is educational and my personal opinion. Each person has to make his own analysis. Any action or decision you take as a result of viewing this article is your sole responsibility.

Over a Century of Innovation: Brief History of Lonza Group AG

Lonza is the largest pure-play CDMO of the world. It was founded in 1897, when it was established in the Swiss canton of Valais, to initially expand the hydroelectric power generation capacity in the river Lonza for the manufacturing of electrochemical and electro metallurgical products. Throughout the 20^th century, Lonza continued to evolve, diversifying its product portfolio and expanding into new markets:

• In the 1910s - 1920s, Lonza started diversifying its business after the difficulties of having a concentrated product portfolio during the war. Moreover, they started targeting more value adding chemicals with higher margins.

• In the 1930s, Lonza expanded its operations to include the manufacturing of a larger variety of inorganic chemicals.

• The 1950s were a busy period; 1. The company switched from coal to oil, 2. Lonza started manufacturing of organic chemicals (vitamin B3), 3. The company started its international expansion, starting from the US.

• In the 1960s the company established itself as a global conglomerate with two complementary business: power generation as a utility company and chemical products manufacturing.

• In the 1970s, the company made its first steps into the biopharmaceutical industry by manufacturing the active ingredient of one of GSK drugs (GSK didn’t have enough manufacturing capacity to keep up with demand and Lonza offered theirs).

• The 1980s and 1990s saw Lonza further expand its global presence in the biopharmaceutical industry, with the acquisition of manufacturing facilities in North America, Europe, and Asia. In 1999, Lonza Group biotechnology segment demerge from the original industrial conglomerate.

• In the 2000s, the company expanded by substantially through acquisitions. Simultaneously, the company finally abandoned the utility business by selling the power generation plants to EnBW Energie Baden-Würtemmberg AG.

• From 2010 to present day, the business strengthen its position as a trusted life-science partner. Strategic acquisitions continued while divestments in least attractive segments and segments not aligned with the group strategy also occurred. Covid-19 pandemic constituted an outstanding boost for business which hangover has now been digested.

This summary of Lonza Group’s history its interesting due to:

1. 127 years of history → Lindy effect.

2. Evidence of long-term thinking embedded in company culture, exiting business in decline on not aligned with the group strategy in different decades and with different leadership teams.

3. Successful handling of innovators dilemma before, e.g. switch from carbide chemistry to petrochemistry and from traditional chemicals to life-sciences.

Business segments

Lonza Group AG is a company with global presence, with more than 30 sites. After selling the “Specialty Ingredients” business in 2021 for CHF 4.2 billion, Lonza operations are split in four different segments: biologics, small-molecules, cell & gene and capsules & health ingredients.

Biologics

Biologics are all the complex organic molecules which are usually manufactured from living microoganisms.

The Biologics division of Lonza is a one-stop shop for biopharmaceutical companies, offering development and manufacturing services for all stages of a drug's life cycle. They can handle everything from initial development to large-scale production, using various techniques like mammalian cells, microbes, and even mRNA. They also provide access to their own technologies and capabilities for making the final drug product

Largest share of revenue corresponds to biologics, accounting for 55.4% of the revenue in 2023. Moreover it is the fastest growing segment - 5Y-Revenue CAGR of 17.4% - and it has the largest CORE EBITDA margin, 36.8% on average.

Note: CORE metrics are Lonza’s alternative performance measurement (APM) in which metrics are adjusted excluding exceptional items > CHF 20M.

Small-molecules

This segment is comparable to biologics one but for small molecules, traditional drugs with lower development and manufacturing complexity.

The company outlines customers resurging interest in this business area, partially due to Lona’s portfolio shift towards high value adding and complex offerings. Average CORE EBITDA margin is 29.4% and 5Y-Revenue CAGR 8.3%.

Cell & Gene

Cell & Gene therapies are the group of treatments develop ted to treat genetic diseases. Genetic diseases are the ones caused by DNA genetic mutations, but they can also be related to damaged DNA sequences.

Cell therapy treats diseases by fixing or replacing malfunctioning cells. These cells can be grown or altered in a lab before being given back to the patient. Gene therapy aims to treat diseases by replacing, inactivating or introducing genes into cells. There is also the possibility to combine both by altering genes in specific types of cells and inserting them into the body.

C&G segment is subdivided intro three businesses: C&G technologies, Bioscience and Personalized Medicine. The former two subdivisions are offer CDMO services for C&G therapies while the third one - Personalized Medicine - develops systems and technologies to enhance manufacturing efficiency.

While C&G therapies are becoming increasingly popular, small patient pools for each disease and tough competition in the rare diseases space makes increasingly important to improve manufacturing efficiency to keep up in the competitive environment and address potential scale-up bottlenecks.

5-Y Revenue CAGR is 13.05%. However, segment margin is the lowest - 11.6% - as it is the most novel segment and the most severely impacted by R&D spending cut due to interest rates hakes and Covid-19 life-science super cycle end.

Capsules & Health Ingredients

Lonza’s capsules segment is the business related to the development and manufacturing of capsules for oral dosage of drugs. Its a more mature market with a larger dependence on customer end-market. Being current customer demand low, clients are now destocking after Covid-19. 5-Y sales have been plain while EBITDA CORE margin has been 32.4% on average.

Corporate

Revenue related to group non-operating businesses, e.g. investing activities.

Management

Last April 2023 Lonza announced the exit of the previous CEO after three years. Pierre-Alain Ruffieux position as CEO will be temporarily held by Albert M. Baehny (Chairman of the Board) as interim until the appointment of a new CEO.

During the last 5 years, four different CEOs have been in charge of Lonza Group. In 2019, Richard Ridinger suddenly retired from the company after 7 years in charge. Mark Funk (CFO ) was then promoted and lasted just nine months in the job. Differently to Pierre-Alain Ruffieux who hasn’t report any work related activity in the last year, Ridinger and Funk continued in other projects they were onboard or soon after started in new positions according to my LinkedIn research. Definitely not something I liked to find out.

Regarding the compensation, it consist in three different parts: fixed salary & bonus - both in cash - and long-term plan incentive (LTIP) in vested shares. Moreover, CEO has to hold at least three times it's salary in company shares while other executives only twice to align their interest with shareholders ones.

In general I like the metrics chosen to evaluate management performance: sales growth, operating cash flow, EPS and ROIC. CORE EBITDA does not excite me but it is a current practice in the sector to show a performance measurement with less impact from investments and divestments. No comments on ESG target

In this regard I find discouraging the fact that most of the yearly compensation is in the form of cash (61% vs 39% shares compensation on average per executive board member in 2022) depending only 16.5% of the yearly compensation in obtaining high capital returns, meaning only 16.5% of compensation linked to ROIC. Hence, despite of linking remuneration to some powerful metrics, the weight of each limits their effectiveness as an incentive.

Finally, it is important to highlight the low skin in the game of the management team, which I believe is influenced by the instability experienced during the last 5 year period.

Competitive advantages and risks

There are a combination of overlaid competitive advantages over which Lonza has built its moat.

Economies of scale

With the exemption of Cell & Gene, scale benefits a industrial business like Lonza. Some examples of this competitive advantage would be: operating a 1m³ bioreactor requires the same number of operators & engineers than a 3m³ bioreactor, it is more efficient to transport a fluid through larger pipes/hoses than to smaller due to the lower surface/volume relation, more centralized purchase of raw materials leading to bargaining power, etc.

Smaller players are trying to scale as fast as they can to close the gap in terms of economies of scale, maintaining a competitive position which would prevent the need for a sell-off under the ongoing CDMO market consolidation.

Switching costs

3^rd party drugs manufacturing is a recurring and sticky business model.

Firstly, Lonza with its large service offer is well positioned to help organizations develop & scale-up its new drugs. Later, thanks to its wide service offer and thanks to the accumulated knowledge while developing the process in previous stages Lonza is on an outstanding position to commercially produce the drug.

Secondly, biopharmaceutical regulations imposed strict requirements to the transfer of an approved process from one manufacturer to another in the form of reproducibility & robustness studies, inspections and other bureaucracy. If desired, manufacturing process transfer between CDMOs can take between 2 - 4 years.

Hence, there are little incentives to change established relations with a CDMO which has proved itself as a reliable supplier, establishing multi-year agreements which can last for decades.

Brand recognition

In the CDMO industry efficiency is not the primary characteristic searched by customers but capability meaning reliability & consistent execution preventing supply disruption from happening.

Moreover, IP protection is a must. Chinese companies in a wide range of industries are already suspicious of not respecting IP confidentiality. In this line, the BIOSECURE Act might be enacted in the USA in the following months.

Lonza's reputation makes it a trusted partner to manufacture 3rd party drugs. We could say no one has ever been blamed to outsources manufacturing to Lonza.

Know-how and proprietary technology

With the shortage in qualified workers, Lonza’s highly-skilled workforce is a differentiating asset. Once built, this highly skilled workforce can easily be repurposed from terminated projects to new ones and put into practice their accumulated expertise. A good example of the advantage of this knowledge is the expertise CDMOs to adapt to new processes cutting down the time needed to bring new drugs to market.

Additionally, Lonza is also developing its own technology for Cell & Gene area providing an edge over less technologically developed CDMOs. However, R&D expenses are not specially remarkable so the gap might be “easily closed” by competitors. Examples: automation and continuous production technologies.

Risks

Considering the strong macrotrend towards outsourcing the pharma industry is experiencing and the competitor’s headwinds - which I explained in the previous newsletter - I can only think in risks coming from the inside the company.

Executive management instability

As above explained, executive management in the present decade has been renewed, being specially challenging to maintain stability in the CEO position (4 different CEOs in the last 4 years).

If this trend continues there is a risk of losing focus on core business related activities, with a deteriorating capital allocation and company culture.

Loss of brand recognition

In the event of drug supply disruption, Lonza’s capabilities might be put in doubt, losing contracts in favor of 2^nd tier CDMOs eager to scale their business further. As a consequence, the company might incurr in potential market share losses.

Undisciplined M&A

The importance of scale and the dynamic competitive landscape, with multiple acquisition opportunities for consolidation, might lead to acquisitions with a lower return. I think ROIC presence among the remuneration plan metrics reduces this risk significative.

Albert Baehny has emphasized before the importance of allocating capital in opportunities providing “attractive returns on capital in areas of high market growth and sustained customer demand”. However, instability in CEO position and Mr. Baehny stepping down as Chairman of the Board in 2024 bring uncertainty about the continuation of this execution approach in the future.

This will be Lonza’s Group AG business analysis. During April I will make a third and last part talking about the financials and any details related which I might have not included in the previous ones. Until then, I will take some holidays during Easter and, due to my busy schedule, maybe write about a different topic in between. In the meantime, please comment, like and share!

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