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Cephalon, Inc. (NASDAQ:CEPH)

Q3 FY08 Earnings Call

October 28, 2008, 5:00 PM ET

Executives

Robert (Chip) Merritt - IR

Frank Baldino, Jr., Ph.D. - Chairman and CEO

J. Kevin Buchi - EVP and CFO

Lesley Russell, MB.Ch.B., MRCP - EVP and Chief Medical Officer

Robert P. Roche, Jr. - EVP, Worldwide Pharmaceuticals Operation

Gerald J. Pappert, Esq - EVP and General Counsel

Analysts

David Buck - Buckingham Research Group

Greg Gilbert - Merrill Lynch

Adam Greene - Stanford Group

Marc Goodman - Credit Suisse - North America

Eric Schmidt - Cowen and Company

Corey Davis - Natixis Bleichroeder

Jim Birchenough, M.D. - Barclays Capital

Annabel Samimy - UBS Investment Research

Bret Holley - Oppenheimer & Co.

David Windley - Jefferies & Company

Operator

Good day everyone and welcome to the Cephalon's Third Quarter 2008 Earnings Conference Call. Just as a reminder, today's call is being recorded.

At this time for opening remarks and introductions, I would like to turn the conference over to Mr. Chip Merritt, Vice President of Investor Relations. Please go ahead sir.

Robert (Chip) Merritt - Investor Relations

Thank you. Today, we will review Cephalon's financial performance for the third quarter 2008.

Before we begin, let me remind you that certain statements on this call may be forward-looking and are subject to risks and uncertainties associated with the company's business. These statements may concern among other things, guidance as a future revenue and earnings, operations, transactions, prospects, intellectual property, litigation, development of pharmaceutical products, clinical trials and potential approval of our product candidates.

The company may also discuss certain non-GAAP financial measures within the meaning of Regulation G during today's call. The information required by Regulation G is available in either the earnings press release or the Newsroom section of our website at www.cephalon.com.

Additional information or risk factors affecting the company's business and the financial prospects and factors that could cause Cephalon's actual performance to vary from our current expectations is available in the company's current Form 10-K on file with the SEC.

During this call, we will update full year 2008 guidance and introduce 2009 guidance. Please note that guidance will remain in effect unless the company provides subsequent modifications or updates. Our earnings press release is available on the Internet at www.cephalon.com.

Investors with further questions should contact me at 610-738-6376. This conference call is being webcast via the Cephalon homepage and it'll be archived for one week after the call.

Speaking on today's call will be Dr. Frank Baldino, Chief Executive Officer; and Kevin Buchi, Chief Financial Officer. Also joining us today are Dr. Lesley Russell, Chief Medical officer; Bob Roche, Worldwide Pharmaceutical Operations and Gerry Pappert, General Counsel. Following remarks by Frank and Kevin, we'll be pleased to answer your questions.

Now, Frank Baldino.

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Thanks, Chip and good afternoon everyone. The third quarter of 2008 was another impressive period for the company. Based on continuing physician appreciation and patient satisfaction with our products, Cephalon delivered double-digit growth of both sales and adjusted net income compared to the third quarter of 2007.

Sales for the third quarter of 2008 reached $490 million, at the high end of our guidance range and adjusted net income of $93 million exceeded the high end of guidance as well.

These solid results and our confidence in our current product portfolio enabled us to that raise our guidance for the remainder of this year. And this adjusted net income guidance numbers for 2009 that exceed today's First Call consensus.

We believe the exceptional product launches of AMRIX and TREANDA combined with the solid income and cash generation inherent in our business positions us favorably in today's market. Our business strategy enables Cephalon to gross sales and income, generate considerable cash for the foreseeable future, distinguishing us from many other publicly traded companies today.

TREANDA continues to be a tremendous success story for the company. After our successful Q2 launch, Q3 sales increased 71% to $24.6 million. Our market research based upon physician feedback and reimbursement trends indicate continued growth in use of TREANDA in the treatment of chronic lymphocytic leukemia or CLL.

The second opportunity for TREANDA will be an indication in relapsed indolent non-Hodgkin's lymphoma, or NHL. Later this week, we expect to hear from the FDA regarding our TREANDA NDA for this indication.

To-date in our NDA submission demonstrated durable objective response rates from patients who have progressed during or following treatment with Rituxan or Rituxan containing regiment

Hurdle rates, which are the subject of a special protocol assessment for both overall response rate and medium duration response, were exceeded. We anticipate a positive outcome by the end of the week.

Over the next several months, you'll hear a lot of exciting information about TREANDA. At our analyst day on November 5, the Head of our Oncology business unit will provide insights into the market and we have invited an oncologist to provide first hand experience with the use of TREANDA in her patients.

At the 50th Annual American society of Hematology meeting this December, we expect to see data from a number of clinical studies. In CLL, we expect data to be presented on TREANDA's use in combination with Rituxan in relapse patients. We also anticipate an update from Dr. Rummell [ph] on the still group study of TREANDA use in first line NHL.

Finally, we expect new data from a study in difficult to treat relapse progressive NHL patients. Clearly, there is a wide spread interest in this exciting new therapy.

In addition to TREANDA, we've created a multi-faceted oncology pipeline that should provide us multiple opportunities for growth in use ahead as well as meet the critical needs of patients suffering from numerous types of cancer. We intend to provide you with a full update on the status of these research efforts at our analyst day next week.

AMRIX is our second recently launched product that is also proving to be an important driver of growth. Prescription in the third quarter increased 32% over the second quarter, resulting in sales of $20.5 million. The market for skeletal muscle relaxants is large, with ample space for growth of an exciting new product like AMRIX. The benefits that AMRIX offers patients are clear.

Once a day dosing and low rates of some one from a molecule cyclobenzaprine which is the market leader. We believe AMRIX will continue to grow into a very sizable product. Our market research shows that AMRIX has been well received and physician satisfaction is among the highest in the category.

We received notification from Mylan Pharmaceuticals on October 20th regarding their abbreviated new drug application requesting FDA approval to market the generic version of AMRIX. Due to the legal environment in which we operate, this filing was not unexpected. In our opinion, the patent covering this novel technology is strong and we'll work to our end to vigorously defend this patent.

By the first quarter of next year, we'll increase the number of sales representatives detailing AMRIX by nearly 50% from 570 to 840. We'll continue to educate physicians about the advantages that AMRIX offers its patients.

On November 5th analyst day, we'll provide additional information about this exciting product and you will get to hear from a physician who will share his experience in treating the patients with AMRIX.

For PROVIGIL, the third quarter marked another record quarter, with sales of $259.2 million and also marked the first time that our quarterly sales took the product at over $1 billion a year run rate. We are pleased that this product has played a significant role in improving the lives of so many patients over the years. We believe our next generation product NUVIGIL will ultimately address an even larger market.

Our Takeda consumer-promotion agreement ends on November 1st. Over the next few months, we'll realign existing sales forces and bring on additional sales representatives. We believe this strategy will optimize sales efforts and provide all Cephalon representatives multiple product detailing opportunities. By early next year, we'll have a senior sales force of 730 representatives who'll be prepared to roll out NUVIGIL in the second half of 2009.

There are a number of major clinical studies underway examining other potential medical applications to further establish the therapeutic potential for NUVIGIL. Once such study, we expect to complete shortly is for the treatment of excessive sleepiness and patients with obstructive sleep apnea with comorbid depression who exhibit residual excessive sleepiness despite effective use of CPAP therapy.

Evidence suggest that obstructive sleep apnea and depression are strong associated. According to a prospective cohort study by [indiscernible] at around 2006 of more than 1400 patients. Those with moderate to sever sleep related breathing disorder are baseline and up to 2.6 fold increased risk of developing depression over a four-year follow-up period.

Primitive excessive sleepiness in the subgroup of obstructive sleep apnea patients maybe particularly challenging, and our study represents some opportunity to demonstrate the enhanced benefit of NUVIGIL.

If the results of our ongoing study are positive, we may have a new promotion claims around the time of our launch. Over the next few years, our goal is to obtain a steady stream a new indication for NUVIGIL.

In the third quarter, we kicked off our clinical program examining the effect of NUVIGIL on jet lag disorder. Patients screening is complete and we have begun flying patients from the U.S. to sleep centers in France. This is the first potentially acute indication for NUVIGIL. Positive results could lead to an indication for jet lag disorder by 2010.

Other studies are designed to support indications for excessive sleepiness associated with traumatic brain injury by 2011 after the treatment of negative symptoms associated with schizophrenia by 2012. For the patent that extent to 2023, we believe NUVIGIL has a potential to become a much larger product than PROVIGIL. And on analyst day, Dr. Lesley Russell will provide details on each of our ongoing studies.

In our pain franchise, we are working with the FDA to secure a path forward to expand this into a label. On September 15th we announced receipt of a complete response letter from the FDA. This letter requested that Cephalon implement and demonstrate the effectiveness of proposed enhancements of the current into our risk management program.

In anticipation of this request, we've been developing and plan to implement covers, a first of its kind initiative designed to minimize the potential risk of overdose by opiate naïve patients. The program will link to three critical stakeholders; the treating physician, the pharmacist and the patient to help ensure the appropriate use of this product.

We believe this program will improve patient safety, provide confidence to physicians and create a new risk minimization standard. The pain franchise continued to benefit from AMRIX growth and could further benefit from the potential expand, improved indication for FENTORA. We believe we can accelerate growth in this franchise over the next few years.

In summary, we are very pleased with the recent launches of our new products trend in AMRIX. These launches combined with the effective product lifecycle management of our existing products enabled us to deliver another quarter of excellent financial results, increased 2008 earnings guidance, introduced 2009 earnings guidance that exceeds today's First Call consensus, all the while continuing to invest in our pipeline.

Now Kevin will discuss our financial performance during the period and provide guidance for 2009.

J. Kevin Buchi - Executive Vice President and Chief Financial Officer

Thank you, Frank. Today we released our third quarter 2008 financial results. We reported sales of $489.7 million, which is a 14% increase over the third quarter 2007 and is at high-end of our previously issued guidance of between $480 million and $490 million. Compared to the third quarter of 2007, basic adjusted net income increased 28% to $92.9 million. This resulted in basic adjusted income per common share of $1.36, exceeding the high-end of our previously issued guidance of between $1.25 and $1.35. Third quarter basic adjusted income per common share grew by 26% year-over-year.

During the third quarter, we generated cash from operations of $162 million. As a result, we ended the quarter with cash on hand of $846.6 million; all invested in treasury money market funds and repurchase agreement collateralized by treasuries. Subsequent to September 30th, we have issued payments of $434.4 million to various government entities associated with our recent settlements. This leaves us with over $400 million in cash.

Our business continues to generate strong cash flow from operations.

During the quarter, CNS franchise sales increased 19% from the third quarter 2007, setting a new record of $273.7 million. In the pain franchise, AMRIX sales were $20.5 million, up 20% from last quarter.

Net sales of rapid onset opioids declined, due primarily to the continued decline in U.S. branded ACTIQ sales and to an increase in the reserve for returns of branded ACTIQ of $13.5 million.

Our products generally become eligible for return from retail pharmacies upon expiration. ACTIQ has a two years shelf life. In June and July of 2006, we manufactured a large number of batches of ACTIQ in anticipation of switching manufacturing to FENTORA to prepare for its launch.

The ACTIQ return in the third quarter felt within the normal range in terms of the percentage of batches made. The total dollar volume of returns was high, due to the large number of batches expiring. We expect some additional returns in the fourth quarter that we have incorporated into our guidance.

Our oncology franchise sales of $52.4 million increased to 131% over the third quarter of 2007, due primarily to the launch of TREANDA. TREANDA recorded sales of $24.6 million, an increase of 71% over the prior quarter. Our goal is to maintain distribution channel inventory levels of between two to three weeks for each of our key products. During the quarter, inventory levels were within this range.

Adjusted R&D in the third quarter of 2008 increased 12%, primarily due to increases in clinical trials expenses resulting from enrollment progress in a number of different NUVIGIL studies.

SG&A increased $9.3 million in the third quarter of 2008, primarily due to promotional spend for AMRIX, TREANDA launch costs and increased payments to Takeda associated with our PROVIGIL sales efforts.

Our adjusted tax rate for the quarter was 35.6%. During the quarter, there was several material adjustments made to arrive at adjusted net income. We excluded $24 million primarily associated with the ongoing amortization of intangibles. We excluded $26 million associated with the write-off of modafinil purchase commitments in excess of our anticipated commercial requirements. We excluded $27.2 million associated with the accrued sunset payments to Takeda related to early cancellation of the agreement.

We excluded $7.5 million associated with charges related to state settlements and $3.8 million in interest on the Federal settlement. We excluded $4.8 million associated with accelerated depreciation on our manufacturing facilities at Eden Prairie, Minnesota and Mitry-Mory France, and $1.5 million for restructuring at Eden Prairie. We excluded $29.3 million to reflect the tax effect of these pre-tax adjustments and $84.5 million for the settlement with the U.S. Attorneys Office for which the related expense was recorded in 2007.

Based on our current outlook, we are increasing our 2008 total sales guidance due to strong sales of our key products. Total sales guidance is now $1.9 billion to $1.94 billion. Our guidance for adjusted net income for the full year increases to between $354 million and $360 million. Consequently, guidance for basic adjusted income per common share increases by $0.10 per share to between $5.20 and $5.30, reflecting a basic share count assumption of 68 million shares outstanding.

On a franchise basis, sales guidance in the CNS franchise is between $1.02 billion and $1.04 billion, the paid franchise is between $500 million and $520 million, oncology is between $175 million and $185 million, and our guidance for other product sales is between $200 million and $210 million.

R&D and SG&A expenditures are targeted to be between $340 million to $355 million and $800 million to $815 million respectively. Our assumed tax rate for the year is approximately 35.5%.

We are introducing full year 2009 guidance based upon the following key assumptions. NUVIGIL is launched in the second half of 2009, a third generic version of ACTIQ is approved in early 2009, and TREANDA execute as an additional indication for the treatment or relapsed indolent non-Hodgkin's lymphoma in 2008. Based upon these assumptions, our 2009 sales guidance is between $2.175 billion and $2.25 billion, an increase of 14% overall increase 2008 sales guidance.

CNS sales guidance, which includes NUVIGIL, PROVIGIL and GABITRIL is between $1.15 billion and $1.8 billion. Pain franchise sales which include AMRIX, FENTORA, ACTIQ and generic ACTIQ are between $535 million and $560 million. Our oncology sales guidance for 2009 is between $265 million and $280 million. That includes U.S. sales of TREANDA and TRISENOX and European sales of ABELCET, MYOCET, TARGRETIN and TRISENOX. Our guidance for other sales is between $180 million and $205 million. Consistent with our previous periods, our sales guidance does not include other revenue.

Our SG&A guidance is between $840 million and $860 million and R&D guidance is between $390 million and $410 million. For full year 2009, adjusted net income is up 27% to between $452 million and $459 million, which equates to a basic adjusted income per common share of between $6.50 and $6.60 based upon 69.5 million shares outstanding and a tax rate of 35%.

In summary, companywide efforts have delivered another quarter of improved financial results. We again increased 2008 guidance and introduced 2009 guidance that exceeds current First Call consensus, all while continuing to invest in our existing brands in pipeline.

That concludes our opening remarks. We will now open this call to you and your questions.

Question And Answer

Operator

Thank you. [Operator Instructions]. We will take our first question from David Buck with Buckingham Research.

David Buck - Buckingham Research Group

Yes, thanks for taking the question. Just a couple. First on 2009, Frank, you mentioned the potential for promotional claims for individual. Is there potential... the potential launches that stand for 2009, whether or not you're successful in receiving those promotional claims?

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Yes, I think the message here David is that we've got a whole series of events coming over the next couple of years related to NUVIGIL. And we're going to launch drug as per agreement for our previously announced in the second half of 2009. And all this stuff helps make for a better launch, whether... even though which one of all these things, indications are going to happen on any particular timeframe, but we're pretty excited about having the opportunity to have so many choices in front of us.

David Buck - Buckingham Research Group

And just Frank, can you confirm whether CEP-701 is still in development?

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

David, I am going to with pleasure pass that question over to Dr. Lesley Russell who's been running that study for how long now, Les?

Lesley Russell, MB.Ch.B., MRCP - Executive Vice President and Chief Medical Officer

His favorite topic for me. Seriously, we are very near the end of enrollment.

David Buck - Buckingham Research Group

Okay.

Lesley Russell, MB.Ch.B., MRCP - Executive Vice President and Chief Medical Officer

And we'll complete enrollment this year. Now obviously we need to allow adequate follow-up time. So we would hope to have data in the second quarter of next year and assuming success, file shortly thereafter. But I am very pleased to say that we are nearing the completion of this study.

David Buck - Buckingham Research Group

Now to steal the thunder from next week's meeting, but okay. And finally, on TREANDA, is there any update on patent... potential patent filings?

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Jeff Vaught's not at this meeting, David. He'd be the guy to give you some detail on that. Suffice to say that we're leaving no stone unturned here. We are looking at opportunities on the manufacturing side, opportunities on the formulation side and opportunities on the crystal structure side. All these things are being explored aggressively and hopefully next week you will see Jeff. You should corner him at the meeting and then get a more detail explanation. Sorry, I can't give you more detail today, but I'm just not the guy to do it.

David Buck - Buckingham Research Group

Okay, thanks

Operator

We'll take our next question come from Greg Gilbert with Merrill Lynch.

Greg Gilbert - Merrill Lynch

Thanks. Good afternoon. Kevin, what's the net effect on SG&A of the termination of the Takeda deal and the expanded sales force on a go forward basis excluding the one-time items you pulled forward?

J. Kevin Buchi - Executive Vice President and Chief Financial Officer

It's a bit of a mixed bag. The Takeda arrangement will continue through the end November, at which point in time we will essentially stop paying them for their promotional activities. As you recall from the deal that we entered into, the cost of the Takeda copromote actually increased every year that the transaction went forward because their compensation was based upon a percentage of above a fixed base. And as sales grew, their compensation grew. Obviously, we won't be paying them any compensation next year. I think Bob can probably address this as well. I think our belief was that it was... given the need to promote AMRIX, given the need to launch NUVIGIL, I think it was a wise move for us to terminate Takeda to move on and to put in place our own sales organization, which we think will be very effective in that regard.

Greg Gilbert - Merrill Lynch

Lesley, based on your interaction with the FDA and I guess consistent with Kevin's comments about guidance, do you fully expect the final approval for NHL on Friday?

Lesley Russell, MB.Ch.B., MRCP - Executive Vice President and Chief Medical Officer

Well we are cautiously optimistic that we are going to get an approval on Friday. You never really know until you've got the letter in your hand, but everything is going well.

Greg Gilbert - Merrill Lynch

And lastly on that front, Bob, can you share with us your latest data on TREANDA usage by indication or setting? Thanks.

Robert P. Roche, Jr. - Executive Vice President, Worldwide Pharmaceuticals Operation

Right now, the vast majority of our usage, Greg, is in CLL as you would anticipate. And as we launch the product in iNHL, then we are sure that we are going to get a really solid uptake and a strong trend there as well.

Greg Gilbert - Merrill Lynch

Thanks.

Operator

We'll take our next question from Adam Greene with Stanford Group.

Adam Greene - Stanford Group

Thanks. Bob, it's actually a follow up on that last question on TREANDA. How much of has the compendia listing with NCCN helped sales and what type of change, if any at all, could we see going forward now that CMS has deferred the reimbursement decision for category 2B drugs to local carriers? Do you have seen impact from that at all

Robert P. Roche, Jr. - Executive Vice President, Worldwide Pharmaceuticals Operation

Well we were really pleased with the NCCN listing and have probably seen an impact on that that's in the kind of the small to medium range. With the really terrific profile that the product has, it's not surprising that you've seen people jumping on board here in the earlier stages. I think as we get the new indication in NHL that that's going to have a really strong driving force in allowing us to build the business there and then keeping the strong upward trend of TREANDA moving.

Adam Greene - Stanford Group

Okay. So the decision, the change last week from CMS doesn't really change anything in your view?

Robert P. Roche, Jr. - Executive Vice President, Worldwide Pharmaceuticals Operation

I don't believe it does.

Adam Greene - Stanford Group

Okay.

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Sort of has a Phase IIb assessment, right?

Adam Greene - Stanford Group

Yes, the category IIb, exactly.

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

I think that's... the pattern [ph] would be label then actually then NHL coming in the label hopefully later in the week I think when that will be resolved.

Adam Greene - Stanford Group

Okay. And if I could just ask Kevin one other question. Can you just remind us of your nearest debt obligations? I think you have some converts that are puttable to you next year. What are the assumptions in the guidance and what type of impact can we expect from that?

J. Kevin Buchi - Executive Vice President and Chief Financial Officer

The actual earliest puttable date is 2010, middle of 2010, $200 million. I think our current plan would be do what we did with the last set of converts when they were puttable/callable. I think most likely, no guarantees, but most likely, we would call them and pay them off with cash.

Adam Greene - Stanford Group

Great. Thanks.

Operator

: We will take our next question from Marc Goodman with Credit Suisse.

Marc Goodman - Credit Suisse - North America

On FENTORA, I guess first question is, can you talk about the number of the pills per prescription? Second of all, can you talk... did you mention the timing of the risk plan, when that's going to go into effect? I don't remember if you said that in --

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Well, one question at a time, Marc. I'm getting old here. We can't keep up with you young guys out there. The FENTORA units per script has been improving and we have a number on that, Jeff, or somebody.

Unidentified Company Representative

Yes. We are looking at 83 pills per script during the quarter.

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Did you get that, Marc, 83 per script, 83 units.

Marc Goodman - Credit Suisse - North America

Thank you. And then --

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

You still with us Marc?

Operator

: We will take our next question --

Unidentified Company Representative

Just bored by that answer.

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Boy, did we close him down with one answer?

Operator

: We will go next to Chris Shaw [ph] with JPMorgan.

Unidentified Analyst

Great, thanks. Just a comment on, another question maybe on FENTORA. Just relative to your assumption of a third generic ACTIQ approval coming next year, some of the work your are doing at the covers program, can you just... thoughts about that being applied to all rapid onset Sentinel products.

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Yes, this is a really good question. We've been forecasting another generic coming in for actually probably for the last two years. Yes, this is wild guess as we put them in the model. Kevin what do you have in the model now for that?

J. Kevin Buchi - Executive Vice President and Chief Financial Officer

We assumed another version, generic version of ACTIQ comes on early next year, not because of any specific knowledge. But we're just being kind of rolling it out, it didn't happen last quarter. So we rolled it out another quarter. It doesn't look likely to happen in the fourth quarter. So we are just rolling it out.

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

And the other question that was a good question about the coverage program and if it's successful will be applied to other products in this space, I think that was your question, am I right, Chris?

Unidentified Analyst

Yes.

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Lesley, you want that?

Lesley Russell, MB.Ch.B., MRCP - Executive Vice President and Chief Medical Officer

I mean I think that certainly it would no inherent sense not to include all rapid onset Sentinels under such program because the risk of overdoes in an opioid naïve population is same for all the drugs

So our assumption is and our plans would be that we would put... implement coverage for FENTORA with a view to requiring ACTIQ and its generics to go on the same plan. But to tell you, that's something we have to discuss with the agency and it's certainly our intent to do so.

Unidentified Analyst

Great, thanks. And just one another quick question, could you talk about the corporate integrity agreement you entered into as part of the DRJ settlement on PROVIGIL. First, is there any significant cost associated with setting that up and maintaining it? And then second, does that pose any problems when we think about launching NUVIGIL and the ability to market things like the sleep apnea depression study?

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Let me give you like a 30,000 foot answer and I will turn it over to Gerry Pappert to give you a little more detail. I think fundamentally, there is cost associated with everything you do, right? So we got it, it's not a material cost, it's additional cost associated with managing and implementing our CIA. And part of those costs is building a stronger and more effective department of compliance under Valli Baldassano that we have done. So yes, there is additional cost, but certainly not material to us.

The other question about what's involved in this program and how it impacts our performance, I think we've been telling you, all you the collective of you for quite some time and we've been sort of changing operations over time over the last two years. I think we have checked effectively changed our compliance program, we retrained sales reps, we've done everything that was anticipated to be in the CIA agreements. And I think we have done an effective job of that, and the sales you see today reflect full implementation of that CIA. And we don't anticipate anything in that CIA to affect performance. We just hope it helps us to focus on compliance and meet the standards that's set by the regulators in this department.

Also my answer to you earlier on the sale... on the cost of implementing such a program, obviously all costs that will be... that we are going to incur here is included in our guidance going forward. Gerry, does that sort of the color on the question on CIA, is there something more specific we can add?

Gerald J. Pappert, Esq - Executive Vice President and General Counsel

No, I think it does cover. Clearly, there are internal costs to absorb with respect to the kind of additional training, training above what we are... we are already conducting and with some technology that's needed to make sure that we adhere to all the requirements. Those costs are undetermined but as Frank correctly pointed out, not material.

And look, we have restructured the entire compliance function here. And a lot of what we anticipated to be in the CIA has been already addressed. While, there is some obviously new provisions which as you know with each CIA, the relevant federal agencies are including newer and newer provisions, so while there are things that we hadn't already implemented ourselves, we were poised to do so, we were ready to do so, and they won't affect how we do business. They will just lead to an even better trained sales and work force.

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Hopefully that answers your question.

Unidentified Analyst

It does, thank you.

Operator

We'll go next to Eric Schmidt with Cowen and Company

Eric Schmidt - Cowen and Company

Yes. Another question for Bob Roche. Assuming things go well this week, later this week, I'm not talking about Phillies, but rather TREANDA. How do you hope to impact prescribing habits with this new label? What kind of promotional efforts do you have planned and how aggressively can they be implemented?

Robert P. Roche, Jr. - Executive Vice President, Worldwide Pharmaceuticals Operation

Thanks very much for the question. I think that our promotion efforts are going to be really exciting and very aggressive with the appropriate audience for the product. Our launch meeting is already scheduled and unlike the Phillies who planned their parade before they won the game, I think that little bit our strategy is okay here.

We are going to be launching into the sales force in the next few weeks and going after the positions that are the appropriate targets immediately. Thereafter upon receipt of the final label, it will be the primary focus of attention of the sales team. They've had good solid six months now with the CLL message on its own and are really chomping it a bit to get out there with the data NHL data and the approved claim.

So, we are not expanding the size of the sales force, Eric. I think we've got the right sized team in place today to be able to do this. And I am really, really excited about the prospects for the product will go through the end of 2008 and throughout next year.

Eric Schmidt - Cowen and Company

Thanks. Just a couple quick questions for Kevin also. Kevin, could you quantify the Q3 return impact on ACTIQ?

J. Kevin Buchi - Executive Vice President and Chief Financial Officer

Yes. It was... we increased the reserve by $13.5 million in the third quarter.

Eric Schmidt - Cowen and Company

Okay. And do you expect the Q4 tax rate to be lower due to the R&D tax credit?

J. Kevin Buchi - Executive Vice President and Chief Financial Officer

I think it'll be marginally lower, but we're not expecting a massive impact on the R&D tax credit there.

Eric Schmidt - Cowen and Company

And last question on the guidance for other products next year. I see it could be a little bit down year-over-year. Is there some patent expression in the SEMO [ph] line or anything else we're looking at there?

J. Kevin Buchi - Executive Vice President and Chief Financial Officer

I don't think so. I think it's just normal stuff of the business. I don't think there is anything unusual going on in there.

Eric Schmidt - Cowen and Company

Okay, thanks.

Operator

We'll go next to Corey Davis with Natixis.

Corey Davis - Natixis Bleichroeder

Thanks. Maybe I'll ask the question that Marc got shut out on. There was a second one. Just when would you anticipate that REMS is fully up and running for FENTORA?

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Well, Lesley, why don't you lay out the strategy and where we are in the process and what your expected roll out is?

Lesley Russell, MB.Ch.B., MRCP - Executive Vice President and Chief Medical Officer

We're currently arriving at submission to FDA. We hope to secure some time with them towards the end of the year assuming they buy into the program and we know that they're very interested. We would like to implement the covers part of the program in the first quarter of next year.

Corey Davis - Natixis Bleichroeder

Okay. And with respect to your SG&A guidance for '09, it's less than... of an increase that I would have expected given all the stuff you've got planned. But did I just do my modeling poorly or is there something else?

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

I think both. I think that's really your question Marc and I'm glad you noticed that. We've been... we've had a concerted effort over the last couple of years to improve our operating margins. Corey, sorry.

Corey Davis - Natixis Bleichroeder

I'm sorry, we're the same anyway.

Unidentified Company Representative

Although he was asking a question before.

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Right, that's what confused me. So, look, yes, I think we've been... as you've heard me say this, you've heard Kevin say this for sure on the road for a lot of years that one of our overall goals to improve our operating performance, and you saw a little bit of it last year, there is even more of it this year going forward. And it's in our guidance of 2009, and yes, we're deciding to do more for less and we're pretty happy about it.

Corey Davis - Natixis Bleichroeder

So pushing even further for 2010 directionally, can we assume continued improvement?

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Absolutely. Our operating margin will continue to improve.

Corey Davis - Natixis Bleichroeder

Okay. And back to Kevin on the $13.5 million increase in reserve for returns, was that on just ACTIQ or was there also an increase for your generic ACTIQ?

J. Kevin Buchi - Executive Vice President and Chief Financial Officer

Well, look, I was just on ACTIQ. We manufactured a large amount of ACTIQ June, July of 2006 in anticipation of shifting manufacturing over to FENTORA. The product has a two year shelf life. That material then started coming back this quarter. So it was purely associated with that. It's just timing of manufacture.

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

But the percentage of return is the same, this just happens to be a larger --

J. Kevin Buchi - Executive Vice President and Chief Financial Officer

That's right. It's just more batches, same percentage as normal came back. If I can answer Eric's question as well on the other revenue, that was a significant impact, Eric. The dollar euro exchange has moved a lot.

Corey Davis - Natixis Bleichroeder

And last question just back to TREANDA and the IIb status?

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Corey, it's not Eric or Marc. Remind me, Corey.

J. Kevin Buchi - Executive Vice President and Chief Financial Officer

I'm sorry. You've got at least three names, Corey. You are a generic analyst.

Corey Davis - Natixis Bleichroeder

This is Phil asking a last question. And TREANDA IIb status for NHL, but does the compendia or does the CMS distinguish between iNHL and say first line NHL usage? And if you do see first line usage, would it still be reimbursed?

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Corey I think the Phase IIb status... first of all, I think CMS is sort of a moving target with all these things as you know. I think once we get the label for NHL by the end of the week, I think it will resolve the matter for iNHL, your indolent form of NHL. And November 5th, I think you have Liz Barrett in the room who is responsible for the business, and she will give you every detail you need to know about reimbursement. In fact, we reviewed here presentation today, there is an entire section related to reimbursement that will answer your questions and further detail on that.

Corey Davis - Natixis Bleichroeder

Okay, great. Thanks Ted, Bill and John.

J. Kevin Buchi - Executive Vice President and Chief Financial Officer

So long Fred.

Operator

We will go back to Marc Goodman with Credit Suisse.

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Marc is back.

Marc Goodman - Credit Suisse - North America

Okay, let's see.

Unidentified Company Representative

You were 83 bills per script.

Marc Goodman - Credit Suisse - North America

Yes, thank you. I'm trying to remember what else I got here. Can you talk about PROVIGIL justice for as stocking in the quarter? It looked like that was a little bit higher than what we would have thought and also AMRIX, any stocking there for either one of those products?

J. Kevin Buchi - Executive Vice President and Chief Financial Officer

It is nothing significant. Inventories always move around a few days here and there, really just depending upon kind of when the quarter ends. But we are within the normal two to three weeks of inventory that we would expect to have at the end of the quarter. You may have seen some increased dollars stocking because of the price increase on PROVIGIL.

Marc Goodman - Credit Suisse - North America

Okay. So a little bit on PROVIGIL, that's what you're saying. And can you talk about business --

J. Kevin Buchi - Executive Vice President and Chief Financial Officer

I just assume [ph] it's price.

Marc Goodman - Credit Suisse - North America

Alright. Can you talk about business development a little bit? There was a deal, maybe you can talk about that a little bit, the one from a day or two ago. And then also, just what's happening out there? Obviously, there is a lot of small companies, private companies not able to IPO because of the capital markets. Obviously, they need cash. I mean are there just a lot of opportunities here and we should expect something from you guys soon or --

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Yes, Marc, on your first question, the Acusphere deal you are talking about, the little one we did?

Marc Goodman - Credit Suisse - North America

Yes, what is that?

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Well, they have a product we are excited about. They've got a formulation for injectable CELEBREX and we think would compete in the hospital segment, that's sort of competing with existing Tordal market. Tordal is a generic drug that does north of $4 million in sales, and it's a great marketplace. And we think, yes, injectable CELEBREX will do well there and they've got a patented formulation, IND ready to go, so we're going to take over that clinical development plan for a very little money we are able to bring that in the fold.

But for a lots of reasons, we also thought we could get a little more value for shareholders by doing a broader scope deal with them that would sweep in there emerging products as well if that were to come to pass. They've got a PDUFA date pending and they have got a advisory committee meeting pending and hopefully that goes well, we'll have either more to talk about in the CELEBREX opportunity that we really signed up for.

Now the other question was relating to BD, and I think you are right if not just the IPO market being poor. The ability to raise money has been increasingly difficult especially in this financial run that we're in, and a lot of companies simply can't complete the trials that they started. So, there are great many opportunities out there. And we're looking at many of them and the fact that we have such a positive cash flow business that we can spend that cash on these opportunities. And Kevin, do you want to add a little to that since you're knee deep in that?

J. Kevin Buchi - Executive Vice President and Chief Financial Officer

No, I think you are absolutely right, Frank. We are looking at a whole lot of things, there is a lot of activity out there right now, lot of companies needing to raise capital unable to raise capital, so it's a great opportunity for us. The challenge is just sorting through all the stuff and trying to separate the wheat from the chaff so the things that we acquire are things that make sense for our business and things that we think would like to get approved and have good commercial opportunity. But we're looking actively at a number of things.

Operator

Mr. Goodman, was there anything further?

Marc Goodman - Credit Suisse - North America

I think I am finally done.

Operator

We'll go next to Jim Birchenough with Barclays Capital.

Jim Birchenough, M.D. - Barclays Capital

Yes, hi guys. Couple of questions. Just on cost of sales, if I back up the cost of sales adjustments this quarter and last quarter, it looks like the underlying cost of sales actually went down this quarter and on a percent basis went from 14.8% to 13.6%. Just wondering what was driving that, and we should expect that to continue to improve?

J. Kevin Buchi - Executive Vice President and Chief Financial Officer

I don't believe... as you say, once you back out the adjustments, I don't believe there was anything unusual in the cost of goods numbers other than just normal mix.

Jim Birchenough, M.D. - Barclays Capital

Are the changes in product mix that should improve gross margins, or is that just a one-time thing on... over the quarter?

J. Kevin Buchi - Executive Vice President and Chief Financial Officer

Yes, I'm just showing 30 points... difference of 13.7% and 14% in cost of goods period-over-period. So, again nothing there that I see that that's anything other than just normal mix issues.

Jim Birchenough, M.D. - Barclays Capital

Okay. And may be been very specific to broader, every quarter I get the question of what's the right number to focus on basic adjusted or fully diluted, may be you guys could just explain again why you focus on the basic adjusted number and as well just on the converts that are outstanding, I have to believe they will be probably trading at a pretty deep discount, any interest in going out and purchasing them on the open market?

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Lets answer your first question first and then I'll let Kevin answer the second question. I think we guys are basic adjusted because the basic shares don't change as stock price changes. Remember, the outstanding converts of stock price goes up, the number of shares changes and it's very difficult to guide through a number that's dependent on share price. So we made a decision several years ago to guide the basic because that number doesn't change. That's a GAAP number of basic and it's reported on the GAAP and its reliable and if some of you guys could take the number against that's unchangeable.

Kevin, you want to talk a little bit about the convert issue you brought out?

J. Kevin Buchi - Executive Vice President and Chief Financial Officer

Sure. I mean the only other thing I would add to Frank's comment on the basic number is that the fully converted number because the way you have to handle the cost spread on the convert has no economic value, it's a pure garbage number, that's a bias the accountant speaking.

It terms of buying back coverts, you are right. The converts are trading... they are trading at a premium to parity, they are trading. But they are trading at kind of a discount to the present value of the ongoing coupons. Having said that, in the current environment, I am not sure that we would probably use the cash we have on hand for business to develop the opportunities rather than using it to buy up the convertible debt. And so I think it is most likely that we will leave it outstanding for the time being.

Once it starts maturing in 2010, I think we'll use the strong cash flow that we have to purchase back the cash at the that point in time, but right now I'm not even particularly pressured to do anything with it.

Jim Birchenough, M.D. - Barclays Capital

Just one quick clinical question, just on the obstructive sleep apnea and concomitant depression study, are you just looking at excessive sleepiness endpoints or are you looking for a claim for any improvements in depressive symptoms?

Lesley Russell, MB.Ch.B., MRCP - Executive Vice President and Chief Medical Officer

The actual efficacy end points around the wakefulness, excessive sleepiness, we do have... we are looking at a depression scale predominantly more as a safety measure to ensure that we don't for whatever reason and I think its highly unlikely made that depressive symptoms worse, but that is incorporated as a safety endpoint.

Jim Birchenough, M.D. - Barclays Capital

Great. Thanks for taking the questions.

Operator

: We will go next to Annabel Samimy, with UBS.

Annabel Samimy - UBS Investment Research

Hi thanks for taking my question. Just a few questions. First, do you have any plans on working on the managed care formulary position for AMRIX? Has there been any improvement there or do you have any strategy going forward to improve that?

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Bob, why don't you try to answer that?

Robert P. Roche, Jr. - Executive Vice President, Worldwide Pharmaceuticals Operation

Yes. AMRIX, as you can imagine does have some prior authorization issues with it. But those are not unexpected for a product of its caliber and then in its class. Cephalon has not historically done much in the way of managed care dealing or planned dealing if you will, Annabel but that's certainly something that we are continuing to look at for 2009 as we continue to grow and continue to become an even more important player in the area.

Having said all that, we are getting good coverage, the product is being reimbursed. We are using mechanisms at the pharmacy that allow patients to get a discount on their co-pay and this has not been seen thus far anyway as any kind of a really significant barrier to at the product usage.

Annabel Samimy - UBS Investment Research

Okay, great. If I may, can you just go over how you are reallocating sales now that Takeda is moving off? You are adding sales reps to certain sales forces. Can you just go through that again?

Robert P. Roche, Jr. - Executive Vice President, Worldwide Pharmaceuticals Operation

I'll be happy to do that, Annabel. As we go through the end of 2008 into 2009, there will be three Cephalon sales forces within the CNS and pain care arena. Our additional sales force obviously in oncology, and our continuing efforts in the addiction area. But let's focus on CNS and pain.

With the Takeda deal going away, and the 500 sales people that were promoting PROVIGIL are going away with it, we have determined to reallocate and reorient our teams as follows. First of all, our 390 persons CNS sales force will have as its primary focus PROVIGIL and AMRIX in a slightly secondary position going through the end 2008. We are increasing the size of our inVentiv sales force from 120 to 340. And let me focus on the sales force here for a minute.

We've had a terrific deal in place with inVentiv Healthcare over the last year. So, which has allowed us to utilize one of their contract teams in an exclusive fashion for the promotion of AMRIX, and this has been a really positive experience for us and one which is really driven us I think to recognize the positive impact that they can have especially in primary care.

These are really good sales people, who are highly motivated and who do their jobs very, very well. And we are excited about the continued partnership with inVentiv. This team will grow as I mentioned from 120 to 340. It will actually be led by Cephalon employees in the director level positions who report directly into our VP of Sales and will be utilized through the end of '08 and through the early part of '09 as our primary care sales force with principal responsibility for AMRIX. At the time of the launch of NUVIGIL, that product will be added into their promotional array. The CNS sales force as I mentioned will continue to sell AMRIX and PROVIGIL and clearly be the primary driver in the launch of NUVIGIL into 2009. And that leaves the pain care sales team, which throughout 2008 has numbered approximately 60 sales people, we are nearly doubling that team to 110 as we go through the end of '08 and into '09. And their primary responsibility as well as AMRIX and their secondary product is FENTORA.

So hopefully, that lays out the three sales force array that we have got and gives us the, I think, the really good ability to impact the proper number of physicians the proper number of times to get our products used in the way that we see fit.

Annabel Samimy - UBS Investment Research

Okay, great. Thanks for that. And if I may, one more. In terms of the conversion strategy for PROVIGIL to NUVIGIL and now you can choose to answer or not, but I mean you've talked about pricing strategies to help with that conversion. Is there any plan to pull the drug at some point in the future and just have NUVIGIL out there and do you have any ultimate targets for conversion?

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

I think... Annabel, this is Frank. We are going to align the economics of the products with our goal of shifting our business to the NUVIGIL as well as growing NUVIGIL to much bigger larger market place. We will not pull NUVIGIL off the market... PROVIGIL rather off the marketplace. A lot of patients depend on PROVIGIL and our first priority is to take care of our patients. And we think they are going to do well on their PROVIGIL until they switch over to NUVIGIL and hopefully do better on NUVIGIL at that point of time. And we think what we got a lot of competitive advantages here, there's real competition in this space. We got leverage with NUVIGIL going forward.

We have got differentiation built in that label today that we can use to launch as well as all the stuff that we talked about in the past in more detail for you and R&D meeting coming up, studies giving information on NUVIGIL coming in the near future that should allow us to shift our business in an orderly fashion and also grow it to a much bigger marketplace. So there isn't any one thing that's going to dictate success here. I think you should look for an orderly transition to NUVIGIL and growth into new and bigger markets going forward over time. Hopefully, that answers your question.

Annabel Samimy - UBS Investment Research

Yes, thanks so much.

Operator

We will go next to Bret Holley with Oppenheimer.

Bret Holley - Oppenheimer & Co.

Yes, thanks for taking the question. I guess at this point why do you still believe that there is going to be a third generic version of ACTIQ, if there hasn't been yet? And how much of a disincentive do you think it might be to have a covers like program? And you guys know the cost of the program or the potential cost of the program. Is that potentially holding people back do you think?

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

I think, first of all, we don't have any knowledge that you don't have about any pending generics coming forward. So we just think it's prudent to model it in, and that's what we do. And we have been modeling in it for about two years and we keep moving it out because there is no activity in that space.

As far as covers, we have got to be really careful here, because covers is not designed to prevent competition. Covers is designed to make sure patients use these products and the physicians write for these products in a responsible enough way so that their safety is first and foremost. And we think yes, it's complicated for some organizations to get involved in the covers program. And we've made it clear to the agency that if covers is adopted as the new national standard here, we will work with these companies to make sure that they can use their drugs in a safe and beneficial way for patients.

Is it a competitive advantage to have it in place? Sure it is. Is there something we can do to help some of the competitors utilize this and use it in a functional way? Sure, and we are going to do that. But it's just not designed to prevent competition. I think it's really important, it's designed to have the drug used appropriately.

Bret Holley - Oppenheimer & Co.

Okay. And then a question on TREANDA. What's built into the guidance and the assumptions for the oncology franchise for TREANDA in frontline uses, assuming that we see positive follow-up data from that German [ph] trial at ASH going into 2009? I imagine that there will be some momentum and some interest in using earlier line NHL?

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

I think that's always hard to answer that particular question about sales for off-label use of products. And I don't think we want to get into that in any major way. I think certainly physicians will see data presented by the German group at the upcoming ASH Meeting and that the reimbursement plans will deal with them... deal with it differently. We don't see much use for first line today, let me tell you that. And I don't expect a whole lot of use in the near future for that. The study should be... Leslie, is there a date of completion on that study that, Rummell [ph] study?

Lesley Russell, MB.Ch.B., MRCP - Executive Vice President and Chief Medical Officer

We are expecting an update at ASH at this year. But clearly, progression-free survival in these patients is considerable. So I think with medium progression-free survivals of four years or something, we'll continue to see updates. But hopefully, we get some insights into where the study is going at this ASH.

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Yes. I think the goal overall is to get this data... hopefully, they will join the steel data [ph] The consortia of data is excellent. Leslie is going talk on November 5th about our studies in first line and you can talk to her in detail about it at the meeting in November. And hopefully, they are all successful and we can get this in the label, and that's really we're going to see a big bump in sales in first line.

Bret Holley - Oppenheimer & Co.

Thanks very much.

Robert (Chip) Merritt - Investor Relations

Any more callers, operator?

Operator

: Yes, sir, we will go next to Dave Windley with Jefferies & Company.

David Windley - Jefferies & Company

Hi, thanks for taking the questions. Couple of small ones. On the risk minimization plan, how long do you expect... or how long you think you would have to have that in place before you'd be able to go back to the FDA and take up substantial discussion about label again?

Lesley Russell, MB.Ch.B., MRCP - Executive Vice President and Chief Medical Officer

Well, clearly, it's something we're going to have discuss with them. So I don't have a real answer for you today. But I think it's going to take sometime. And so I certainly wouldn't anticipate approval of a broader indication before 18 months from now.

David Windley - Jefferies & Company

Okay. So my next question was going to be is there any assumption in the '09 guidance, so obviously not, correct?

Unidentified Company Representative

Well the assumption is there is no broad label in 2009.

David Windley - Jefferies & Company

Right, for FENTORA?

Unidentified Company Representative

That's correct.

David Windley - Jefferies & Company

Right. And on NUVIGIL, on this first study that the OSA and co morbid depression study, Frank, I think you indicated that data you expect to come fairly soon. And I guess I was wondering time line to cycle that through the FDA and see potential approval on that.

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

Remember, this is a promotional claim, not a new indication. Leslie, why don't you walk him through that?

Lesley Russell, MB.Ch.B., MRCP - Executive Vice President and Chief Medical Officer

Yes, we plan to have data available in a promotional form for the launch of NUVIGIL.

David Windley - Jefferies & Company

Okay.

Lesley Russell, MB.Ch.B., MRCP - Executive Vice President and Chief Medical Officer

This is a subset of our approved indication. Now clearly our promotional materials require DDMAC approval. And we'll certainly submit them. But it's not like this is a new indication.

David Windley - Jefferies & Company

And would you expect... would you wait for DDMAC approval before you go out with that or --?

Frank Baldino, Jr., Ph.D. - Chairman and Chief Executive Officer

I think we are going to leave it to our best judgment in the process and talking to the FDA the whole time.

David Windley - Jefferies & Company

Okay, thank you very much.

Robert (Chip) Merritt - Investor Relations

Okay, 6 O'clock, it's been one hour, so we have... we are out of time. This concludes today's conference call and we thank you all for joining us.

Operator

Once again that will conclude our teleconference. Thank you all for your participation. Have a great night. .

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Source: Cephalon Inc. Q3 2008 Earnings Conference Call Transcript
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