#1 Schott Pharma - Qualitative Analysis

In the last article about the pharmaceutical packaging industry I compared the three most focused players on glass packaging and decided to continue further investigating Schott Pharma AG based on its consistently slightly better fundamentals.

After researching further during the past weeks, in the present article I am sharing with you the qualitative analysis in Schott Pharma AG. In the present write-up I will explore the company's business segments, strategic positioning, competitive advantages and management team. Let’s get into it!

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.

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Executive Summary

• Schott AG has over 140 years of history as a glass manufacturing company. Its IPO occurred a year ago, being one of the largest ones in Europe in 2023.

• Two Segments: Drug Containment Systems (DCS) and Drug Delivery Systems (DDS), offering a large variety of glass packaging solutions.

• Benefitting from several trends: rising demand for biologics, GLP-1 drugs, and ready-to-use packaging.

• It benefits from high switching costs, economies of scale, and regulatory barriers, but faces risks from supply chain disruptions and customer ramp-up delays.

Brief History

Schott Pharma AG is part of the SCHOTT Group. It has a rich history rooted in over a century of innovation in glass technology. Founded in 1884 by Otto Schott in Jena, Germany, SCHOTT initially revolutionized the glass industry with the development of borosilicate glass, known for its high resistance to thermal shock. This breakthrough became instrumental in various industries, particularly pharmaceuticals.

In the mid-20th century, SCHOTT entered the pharmaceutical packaging market, expanding its product line to include glass vials, ampoules, and syringes, critical for the growing pharmaceutical industry.

Fast forward, in 2022 SCHOTT AG spun off its pharmaceutical packaging division to form Schott Pharma AG. The creation of Schott Pharma marked a strategic shift, positioning the company to meet the rising demand for prefillable syringes, cartridges, and vials, particularly for biologics and complex therapies.

Finally, in September 2023 Schott Pharma launched an Initial Public Offering (IPO) of 23% of Schott AG stake in the Frankfurt Stock Exchange. Schott Pharma’s successful IPO was the largest German IPO of the year and one of the largest in Europe. The company was initially valued at €4.1 billion.

Business Segments & Product Portfolio

Schott Pharma operates through two main business segments: Drug Containment Systems (DCS) and Drug Delivery Systems (DDS). Each segment plays a crucial role in addressing the pharmaceutical industry packaging needs.

Drug Containment Systems (DCS)

The DCS segment primarily focuses on the core products of Schott Pharma, which include ampoules, vials, and cartridges. These products are designed to ensure the safe containment of a wide range of drugs, offering high-quality, reliable packaging solutions.

• Ampoules: These are sealed glass containers used to store liquid pharmaceuticals, especially for generic and essential drugs. Ampoules provide a low-cost, robust solution for drug containment and are often used in emergency medical treatments and vaccines.

• Vials: Vials are one of Schott Pharma’s most versatile products, offering a highly safe and adaptable solution for drug storage.

• Cartridges: Cartridges are cylindrical glass containers used in auto-injection devices or pen injectors. These are critical for therapies requiring frequent injections, such as insulin for diabetes, allowing patients to administer doses easily and safely.

In addition to these products, the DCS segment includes testing services, such as functional testing and documentation tasks, to ensure that all products meet regulatory safety and performance standards.

Drug Delivery Systems (DDS)

The DDS segment has a larger focus on high-value solutions (HVS) for drug delivery, particularly in the field of advanced therapies like biologics, biosimilars, and vaccines. HVS products combine high tech solutions such as special coatings with convenience: products which are already sterilized and ready for use.

In the DDS segment, Schott Pharma works closely with its customers to deliver tailored solutions. These collaborative services cover product design, customization, and sterile packaging.

One key challenge in the DDS segment is the need for cleanroom environments during production, which requires strict contamination control. This necessity increases the impact of operational downtime, particularly during planned maintenance or summer shutdowns, as the high standards of sterilization and cleanliness must be strictly maintained to ensure product safety. This is an important element to consider as it explains the seasonality between quarters.

Positioning & Strategy

Schott Pharma AG is not only positioned to profit in the known macro trends affecting the whole pharmaceutical industry but also to take advantage of other sectoral ones. These sectoral trends are:

• Favorable new drug types trend

  Their pharmaceutical industry has shifted towards biologic drugs. 80% of the 6000 molecules in clinical stage phase are biologics, making it one of the most dynamic segments within the pharmaceutical industry. Within the biologics market, injectables represent a particularly significant segment, with an impressive compound annual growth rate (CAGR) of 8%.

  Moreover, there are specific medications undergoing a great success cycle like GLP-1 drugs and mRNA-based vaccines whose preferred packaging option is glass containers.

  Glass packaging is the preferred choice for most of these drugs due to its inert properties, compared to alternatives like plastic, which help maintain the integrity and potency of these delicate compounds.

• Personalized solutions impacting dosing

  Treatment in fields such as autoimmune diseases or diabetes & obesity through GLP-1 medication are leading to the development of personalized solutions for the self-injection of drugs. Glass packaging is a great option to ensure & improve patient convenience as well as safety and compliance of user friendly packaging options.

• Customer shift to ready-to-use products

  Customers are shifting from in use sterilization and setup of packaging to plug-and-play solutions, externalizing these tasks to suppliers reduces the required CapEx and enables customers to focus on enhancing their core operations performance.

The strategy of Schott Pharma AG to capitalize on this trends is based in three pillars:

1. Increase HVS revenue share

   The reported share of HVS in 9M 2023/2024 was 52%, being the company’s mid-term objective to reach 60% with the consequent margin improvement.

2. Expand manufacturing capacity

   80% of company CapEx is allocated to manufacturing capacity expansions, with new facilities being built in Germany, Hungary, Switzerland and the USA. Moreover, 70% of the CapEx is dedicated to the DDS segment where HVS products belong.

3. Drive Operational Excellence

   Optimization of supply chain, equipment, internal procedures & digitalization to improve the operational margin.

Management team

Andreas Reisse, who is the CEO of SCHOTT Pharma since its spin-off in 2022 from the parent company, has had almost his whole professional career within Schott AG. His career at SCHOTT began in 1987, and he has since held roles spanning logistics, sales, and executive management. In between roles at SCHOTT, he had a stint at Volkswagen AG, as Head of Procurement.

The CFO, Dr. Almouth Steinkülher, joined Schott Pharmaceutical Systems in 2022 as VP of Finance & Controlling, becoming Schott Pharma AG Chief Financial Officer.

Both of them are originally from Mainz, hometown of Schott Group.

They do not own a remarkable stake in the company. However, it has not been disclosed the size of their holding which could have brought light to understand if the stake they might earn was remarkable compared to their yearly salary. So far, they have just made a small purchase of shares after the IPO.

Ownership

As mentioned above, 23% of Schott Pharma AG is public, retaining the parent company Schott AG 77% of the equity. Schott AG is a private company controlled by the Carl Zeiss Foundation.

The Carl Zeiss Foundation is a significant shareholder of both Schott AG and Carl Zeiss AG. It was established in 1889 by Ernst Abbe, a physicist and entrepreneur, with the support of Otto Schott, the founder of SCHOTT. The foundation's primary goals are to ensure the long-term success of these two companies and to promote scientific advancement (very similar to what we have discussed in previous newsletters regarding Novo Nordisk Foundation).

Incentives

Long-story short, I don’t like the incentive structure. See the remuneration structure framework approved one year ago below:

Firstly, only the long-term incentive programme (LTI) is stock-based remuneration. Hence 70% of management remuneration is granted in cash.

Secondly, if we take a closer look into the LTI, only 60% will be directly related to long-term value creation parameters which have not been disclosed yet, meaning only 18% of the total management remuneration will be potentially linked to metrics related to long-term value creation.

The short-term incentive plan is relatively lenient, with a revenue growth target of 5% and a ROCE target of 13%, being the threshold values even lower. Additionally, the focus on a one-year net productivity improvement (measured as the change in average selling prices relative to production costs) could encourage short-term strategies. This might involve raising prices in ways that strain customer relationships or cutting production costs in ways that compromise product quality.

Competitive Advantages

The main competitive advantages I have identified are:

1. Switching costs

   A key competitive advantage lies in the stringent regulatory requirements of the pharmaceutical industry. These regulations create a high barrier to entry, hindering the establishment of new market players. Let’s examine this in further detail.

   Firstly, the drug packaging is part of the drug approval process as it will be part of the registered documentation submitted to authorities. Consequently, procedures have ben established to audit & certify the supplier, systems collecting all information for traceability have been put in place, certifications & risk assessment have been performed, etc. If the packaging design works, the incentive to change it are very small

   Moreover, being one of the main players on an oligopoly gives Schott a privileged spot to dictate industry standards, e.g. dimensions of vial opening that cap manufacturers have to follow. Any new vial manufacturer will have to follow that dimensions because cap manufacturers are already following that industry standard¹.

2. Economies of scale

   Pharmaceutical glass manufacturing, as well as traditional glass manufacturing, is an energy and equipment intensive activity. Moreover, Schott is the largest manufacturer in the world of some products of its portfolio.

3. Proprietary technology, specialization and know-how

   Industry trends favor innovative products. Schott Pharma AG's expertise in glass packaging, coupled with its parent company's 140-year legacy in the glass industry, provides a distinct competitive advantage. The company's extensive network, supplying packaging to 75% of approved biologics, positions it strategically to understand and meet customer needs.

Identified Risks

There are algo risks the company will have to face. Among the most significant concerns I have identified:

1. Capacity build-up by competition might lead to price pressure

   I view this risk as unlikely because glass packaging constitutes a small portion of customers' overall production costs. Additionally, the high switching costs and prevalence of long-term supply agreements in the industry enhance revenue visibility and predictability.

2. Supply chain disruptions or customers ramp-ups delays

   I find this risk likely to materialize. Geopolitical tensions do not seem to vanish any time soon and customers ramp-up are complex engineering projects likely to experience some delays. Moreover, early stage pharmaceutical companies might not get their drug approved, losing a potential long-term customer.

3. Falling behind competitors in the R&D

   A new trend in the pharma industry might emerge, making glass packaging a less viable solution. Within the established players, I think it is unlikely that one will disrupt the others considering it is a stable sector where a remarkable chunk of R&D is done in collaboration with customers to meet their needs.

Hope you enjoyed this qualitative analysis of the company. The second part will focus on the company financials & fundamental analysis as well as including my valuation of the business. So don’t miss out!

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1. Above described situation is a fictional example I ignore if that is the exact case for caps.