#3 Lonza Group AG - Financials & valuation

After a very busy time in my life, both in the personal and professional spheres, I am getting the free time back to write about value investing and companies.

First task in the to-do list was to finalize Lonza’s third part of the thesis, which is focused on the quantitative aspect of the analysis: financials and valuation. Overall, most of the valuable insights have been provided in the previous parts (listed below) so check them out if you want to understand the industry and company.

1. #1 Lonza Group AG - Industry dynamics and competitive landscape

2. #2 Lonza Group AG - Business overview

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.

Executive summary

• Company earnings and margins are compressed due to the ongoing company transformation and industry headwinds.

• Lonza’s AG has a conservative and strong balance sheet.

• The company is ongoing a large CapEx cycle which peak has already been reached.

• DCF model shows the company is slightly overvalued right now.

Financials

Income statement

Lonza revenue has grown during the last 6 years at a modest 3.5% CAGR. However, during this time Lonza not only has been buying and selling different sites but also they have sold two business segments:

• In 2019, the Water Care business, which generated a revenue of CHF 74 million in 2020 and was sold by CHF 610 million.

• In 2021 Lonza announced the divestment from its Specialty Ingredients business segment. The segment generated CHF 1.7 billion in 2020 and was sold for CHF 4.2 million.

The company is highly dependent on the Western countries customers’, with more than 80% of its revenue coming from the USA and Europe exclusively. Asian customers revenue share has historically varied from 12-15%.

Regarding the company margins, we can see gross margin has remarkably decreased, being cut more than half during the last 5 years, from just over 60% to 30%.

Meanwhile, operating margin (≈20%), EBITDA margin (≈30%) and net margin (≈15%) haven’t changed remarkably, experiencing a peak during the post-covid years, as have many other pharma & biotechnology companies.

The margins have been compressed in the short-term due to inflationary pressures, rising raw materials cost and under utilization and transformation for the facilities. Looking more years back, Lonza is scaling-up its cell-and-gene therapies business, which is still a money losing segment. During the annual results presentation call, management expressed its confidence in improving margins steadily towards 2028.

Moving into the operational costs, from figure 4 it can be observed R&D expenses are representing approximately 1.5% of sales. CDMO’s business model does not require to invest large sums of money on new drugs discovery, activity which is performed by the pharmaceutical companies. This small R&D expense is probably related to the new and more efficient technologies Lonza is developing and commercializing in Biologics and Cell & Gene Therapies areas.

Regarding SGA expenses, despite having additional 2500 employees compared to 2018, the company has been able to cut 10% of its SGA expenses since that year.

Balance sheet

Lonza AG has a conservative balance sheet. The balance sheet gearing is low, with a Debt-to-Equity ratio > 0.4 and a Net Debt/EBITDA ratio of 0.76.

Most of Lonza’s long-term debt has been issued at fixed low interest, either in the form of notes or bonds. Moreover, with the exception of one bond (marked in yellow in figure 6) which matures in 2026, most of the long-term debt maturity is scheduled at the end of the decade.

Interest coverage on depressed earnings is close to 10 so I don’t think Lonza will have any problem meeting their obligations until bond maturity. In fact, it is among management plans to use further leverage during the coming years.

Finally, the working capital has slightly improved during the downcycle. Normally, when the order book decreases as a consequence of the downcycle, the working capital improves due to the lower provisioning of raw materials and work in progress.

Management commented about this phenomena during the 2023 Q4 call but they also emphasized the inventory reduction within 6 months in connection with ongoing improvement initiatives in that area.

Cash Flow statement

Lonza AG reported 2023 free cash flow (FCF) has been reported to be CHF 329 million. However, if calculated as OCF - CAPEX, then the company has generated CHF -294 millions in free cash flow.

Extending the analysis to the previous years until 2018, it can be observed that 2023 was the 3^rd consecutive year the company didn’t generate a positive FCF. I will further dig into this in the next section.

Capital allocation

Lonza Group AG is currently undergoing a large restructuring and expansion cycle. The company is decommissioning two factories: one in China and another in the USA, which will drag margins until 2025 while decommissioning is ongoing. CapEx cycle peaked last year, when CAPEX/Revenue ratio reached 30%, and according to guidance it should decrease to high teens range by 2028. According to management, 70% of the CapEx spent is dedicated to expansion and growth projects while the remaining 30% is maintenance CapEx.

Regarding net working capital (NWC), as it can be observed in figure 8, the period after covid-19 was characterized by a remarkable increase contributed by supply chain disruptions. In connection with NWC increase, the company started initiatives to reduce inventories last year, decreasing inventories by 13% YoY. Management expects to gain further efficiencies related to these initiatives in the following year but to a lesser extent.

It is worth mentioning Lonza approved its largest buyback programme in history this year, CHF 2.0 billion. The programme was approved 2023.03.31 and initiated on 2023.04.03. 13 months after management informed 1.3 billion have already been executed. Average share price of the first CHF 1.0 billion has been reported to be CHF 443.87 per share. As you will see later the price is a little higher in my opinion. Hopefully, the following CHF 300 million were executed at a more attractive price.

Finally the dividend, dividend per share of 4 CHF per share, resulting in a 44% dividend payout. According to the mid-term guidance, dividend payout is planned to be on the range of 35-45%.

Capital efficiency

Lonza’s returns are not extraordinary as it can be observed in figure 9. However, low returns are not impeding Lonza from creating value as ROIC > WACC. See Figure 10. This low returns can be partially explained by the continuous M&A and divestments activity of the company. Acquired companies and sites need time to be fully integrated and reach maturity, dragging returns meanwhile. A good example of this is Danaher ($DHR).

As figure 10 shows, ROIC-WACC spread is positive, with the exception of last year during life sciences downcycle. This low returns and the capital intensity required to operate a CDMO business prevents new competitors from entering in the CDMO space and widens Lonza’s AG group.

Extended Dupont analysis

Dupont analysis does not reveal any interesting insight, apart from a lower contribution to shareholders return due to balance sheet gearing in the recent years.

Valuation

I have built a 10 years DCF model to evaluate the company. The assumptions I have used conservative and plausible. The assumptions fed into the model are the following ones:

1. WACC → 12%. My opportunity cost.

2. g → 4%. Larger than global GDP growth which I consider reasonable.

3. Revenue growth → Flat in 2024, 12% from 2025 to 2028 (low range of the guidance) and 9% from 2029 to 20233 (the industry average).

4. CapEx → Progressive decrease from 25% this year to 17% by 2028, to later stabilize at 15%.

5. D&A → CapEx depreciation on a 10 years straight line.

6. CORE EBITDA margin → 32%. Low range of the company guidance.

7. EBIT margin → CORE EBITDA margin minus calculated D&A.

8. YoY investment in net working capital → 2.0% of revenue.

9. SBC/Revenue → 0.70%. Historical average.

10. Tax rate → 18%. Increase to current effective tax rate due to Pillar II rules implementation.

Fair value of Lonza’s share is estimated to be 405.57 CHF per share to obtain a 12% CAGR (+ dividend yield, < 1.0%) over the following 10 year period.

Conclusion

Overall I think Lonza AG group is a great company with strong competitive advantages in a very attractive industry with strong headwinds and a privileged positioning which I believe it can take advantage of.

I hope the new appointed CEO, Wolfgang Wienand, brings stability to the ever changing executive management of the company. It would also be great to see capital allocation metrics gaining weight on the long-term incentives programme (LTIP) to ensure management alignment with shareholders and improve capital returns to the extent possible.

I started my position in Lonza at around my estimated share fair value. Although, based on the DCF model valuation, I do not consider the current price as an attractive one to acquire more shares so I will keep holding my shares.

With this 3^rd newsletter covering Lonza the thesis is finally completed. I apologize for the delay but the last 2 months have been quite hectic at home and work so I really hope the wait has paid off.

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