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Cambrex Corporation (NYSE:CBM)

Q4 2008 Earnings Call

February 12, 2009 8.30 am ET

Executives

Greg Sargen – Vice President and Chief Financial Officer

Steven M. Klosk – President and Chief Executive Officer

Analysts

Dmitry Silverstein – Longbow Research

Ted Hillenmeyer – NorthStar Partners

Operator

Good morning. My name is [Kendra] and I will your conference operator today. At this time I would like to welcome everyone to the Cambrex fourth quarter conference call. All lines have been placed mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions).

Thank you. Mr. Sargen, you may begin your conference.

Greg Sargen

Thank you, [Kendra], and good morning everybody. Welcome to Cambrex's fourth quarter 2008 earnings conference call. My name is Greg Sargen and I am the CFO of Cambrex.

Before we begin, I will provide the customary, Safe Harbor comments regarding forward-looking statements. Today's discussion will contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and Rule 3B6 under the Securities and Exchange Act of 1934.

These statements may be identified by the fact that words such as expects, anticipates, intends, estimates, believes, or similar expressions are used in connection with any discussion of future, financial and operating performance. These statements are based on Cambrex's current plans and expectations and involve risks and uncertainties that could cause actual outcomes and results to materially differ from those included in the forward-looking statements.

For further information please refer to our reports and filings with the SEC. Yesterday's release includes tables reconciling non-GAAP amounts to GAAP amounts. Management believes that the adjusted amounts provide a more meaningful representation of the company's operating results for the periods presented due to the magnitude and nature of certain expenses recorded.

This conference call will last approximately 45 minutes. A replay of the call will be available shortly after we end today through next Thursday, February 19 by calling 1-800-642-1687 domestically, and 706-645-9291 internationally. Please use the conference ID number reference 84377791 to access the replay. A webcast will also be available on the Investor Relation section of the Cambrex website located at www.cambrex.com, and can be accessed for approximately a month following the call.

Today's call will begin with a business review by Steve Klosk, our President and CEO. I will follow Steve with a few comments on our fourth quarter and full year 2009 guidance before opening up the call for Q&A.

With that it's my pleasure to introduce Steve Klosk. Steve?

Steven M. Klosk

Thank you, Greg and good morning, ladies and gentlemen. I'll begin today's call with an overview of our fourth quarter 2008 performance, followed by commentary on key aspects of our business looking forward.

Our sales increased almost 1% excluding the impact of foreign currency, compared to the fourth quarter last year. Reported results were down 6.6% due to the stronger dollar. The currency adjusted increase was mainly due to our continued strong sales of DEA controlled substances, offset by delays in certain custom development projects, which we define as clinical and preclinical phase projects. And lower sales of our largest API due to the impact of a contractual price decline.

Gross margins for the quarter were 25% versus 35% in the fourth quarter of 2007. Currency had a minimal effect on gross margin percent although it did negatively impact gross profit by $1.4 million in the quarter. The decrease was due to lower pricing on our largest API, lower custom development sales due to project delays, increased bad debt reserves related to two insolvent customers and higher costs related to the validation of our new facility near Milan.

Increased sales of higher margin controlled substances in the U.S. partially offset the decline. Adjusted EBITDA decreased to $10.7 million, versus $13.9 million in the same quarter last year driven by the reduced gross margins I just described partially offset by reductions in selling, general, and administrative expenses at the operating sites. Research and development efficiencies, gain from the consolidation of our New Jersey technical Center into our Iowa facility and corporate spending reductions.

Corporate spending for the quarter before certain expenses identified in the tables in yesterday's release was $3 million, compared to $4.7 million for the fourth quarter last year. The reduction in corporate expenses was due to benefits from our recent corporate restructuring, tight controls over discretionary spending and higher bonus accruals in 2007. We are pleased to have the corporate restructuring behind us and believe the leaner headquarters cost center is now appropriately sized for our current business.

I'd like to make a few comments on fourth quarter performance versus our prior guidance followed by a few comments on the full year 2008. We came in a bit below the guidance we gave at the end of the third quarter due to our few unforcing events. We experienced delays on a couple of larger custom development products during the quarter custom development revenues were about $3.5 million lower in the fourth quarter, compared to our expectations coming into the quarter. Also compared to our most recent guidance, foreign currency negatively impacted our adjusted EBITDA by $1.5 million.

Finally, we recorded a reserve for approximately $500,000 at the end of the quarter to account for the weak financial condition of two small custom development customers. One of these customers had since filed for bankruptcy. For the full year 2008, sales were down 3.7% excluding the impact of foreign currency. Custom development revenues were down a little over 5 million and the remainder was primarily due to 10.6 million in price declines. Over half of which is attributable to one product, our largest API for which we negotiated price concessions in 2007 in return for a lengthy extension of the contract.

The most significant of the step-downs in price under this contract are now behind us. So, we currently expect overall price declines in 2009, compared to 2008 to be significantly lower than what they were this year. Sales volumes in total for 2008, were approximately flat with strong increases in our DEA controlled substances products offsetting weaker demand for custom development projects and lower sales of non-controlled substances generic APIs.

The decline in generic APIs was driven primarily by a reduction in volume of one large product. In summary, for 2008, we experienced a loss of several million dollars of expected revenue related to the recalled neurological product that we've commented on throughout the year, which coupled with the decline in demand for custom development projects resulted in lower profitability than we expected.

Now, I would like to update our progress on a few of our key operating initiatives. I would first like to discuss our custom development pipeline. We generated revenue from over 80 distinct projects in 2007 and roughly repeated that performance in 2008. Although, due to the impact of delays in certain projects as I just mentioned the revenue per project in 2008 was lower than prior year. As we discussed last quarter during the first half of 2008, we received a record number of requests for proposals in the U.S. and saw a decline in proposals from our key accounts in Europe.

The market for early phase projects in both the U.S. and Europe softened during the third quarter and that softening accelerated during the fourth quarter. The current feedback from our sales teams and their recent meetings with numerous current and potential customers and public comments that our competitors are currently making confirm that the market for early stage clinical development projects is soft as we start 2009. The most vulnerable of our current and potential customers are those that have near term needs to raise additional capital.

We also anticipate that customers with products in later stage clinical trials may slow spending to ensure that they do not need to access capital markets for as long as possible. This may take the form of customers delaying the clinical trial process or focusing on a smaller number of compounds. We expect the cost containment efforts of big pharma to continue. And in that that way, we expect them to continuously review their R&D pipelines in an effort to direct their spending on molecules with higher probabilities of success.

Early stage projects are labor intensive and highly competitive. And as such they tend to have low margins. Since most of our cost structure is fixed in any sort time period, we continue to closely monitor our incoming business levels in order to better manage resource levels as we assess the extent and duration of the current market slowdown. Our pipeline of 14 Phase III projects remains firm and we continue to expect a number of these products to be approved and result in long-term commercial supply agreements for Cambrex.

As we've said before, we believe a few of these products if approved will eventually result in between $5 million and $10 million in annual revenues per product and in some cases potentially larger amounts. We expect one of these potentially larger products to be approved in 2009, although we do not expect significant revenues from this product assuming it is approved until 2010. Our strategy going forward with respect to custom development projects will be to focus on later stage projects, including those that may already be commercialized. We will target projects where we can apply specific know how or patented intellectual property to develop superior synthetic chemical routes and processes that are not easily replicated by our competitors.

This should improve our success rate, our profit margins and minimize time spent on smaller less profitable projects. Our approach to the generic API market continues to be one focused on niche products that take advantage of our highly flexible manufacturing capabilities. We significantly upgraded our capabilities over the 2006 through 2008 timeframe. Adding new R&D labs in order to develop and scale up new products and a new state-of-the-art purification facility.

We are continuing the process of validating all products in the new facility and simultaneously working to fill this new capacity until such time as our new product pipeline starts to yield top line improvements in 2010 and beyond. In the interim, we will continue to expand into new geographic markets, particularly higher growth secondary and tertiary markets, where we already have our presence and we will also seek to grow our supplements business, where we become a secondary supplier of an API to customers, where we previously had no supply position.

The continued increase in generic prescriptions in the U.S., Europe, and emerging markets and the continued global emphasis on reducing healthcare costs should help grow this business along with planned new product launched. Our new product development pipeline for generic APIs is significant. With over 15 products planned for launch the first in 2009 and ramping up in 2010, 2011, and beyond. In addition, we believe we can work with our customers to develop differentiated specialty generic products using our drug delivery technology to produce taste masked modified release formulations.

All of these growth initiatives will help offset expected price pressures of approximately 2% per year, which is consistent with what we have seen over the last few years within this product category. One initiative that is closely tied to our generic API business is our strong and growing franchise in DEA controlled substances. We define controlled substances as those that must be manufactured in the U.S. and generally those falling under Schedule II within the DEA's classification system.

In 2008 our sales of these substances increased to over $18 million and we continue to expect double-digit growth heading into 2009. As we have discussed before the controlled substances market in the U.S. is the most significant market for controlled substance APIs. It is dominated by a small handful of domestic players that have been licensed by the DEA to produce or sell these substances and whom have little or no competition from foreign manufactures due to DEA requirements.

Cambrex's DEA registrations position us to produce a wide range of APIs for sale to end markets, our current products are focused on the attention deficit and hyperactivity disorder market and pain management. Pain management is a key therapeutic growth area and we are developing more products for this segment of the market. We expect sales of pain products to increase in 2009 and grow substantially in 2010. We continue to pursue new products and opportunities in the over-the-counter and prescription drug market segments utilizing our proprietary polymeric drug delivery technology, which encompasses taste masking, modification of drug release profiles, and improved drug stability.

While sales of our taste mask products overall were lower in 2008 than in 2007 due to certain regulatory relabeling issues and customer inventory management. We expect the overall business to rebound in 2009 and show good growth. Our pipeline of new products remains very broad and consists of a mix of customer driven initiatives involving new drug formulations and life cycle extensions as well as Cambrex proprietary R&D for new drug delivery systems.

We remain optimistic that we will be able to introduce at least three new commercial products in the next 12 months, with two of these products expected to be qualified by one of our large customers in 2009. One of these new products has the potential to generate a significant increase in revenues for our drug delivery business and to create a geographic expansion of this strategic initiative beyond our currently served markets.

During the fourth quarter, we announced a joint marketing and development agreement with Skinvisible, the agreement provides for co-development and marketing of new acne formulations based on Skinvisible's Invisicare technology and Cambrex's benzoyl peroxide or BPO API. Utilizing Cambrex's high grade BPO product with Skinvisible Invisicare technology enables us to offer controlled release of the APIs, which can result in less active ingredient, less irritation, and better efficacy. We intend to market these products to the dominant players in the topical cream market.

We have launched a global operational excellence program to focus on best practices within our manufacturing sites in order to identify areas to increase efficiency and reduce costs. This initiative is a key focus area for us and is particularly important during this challenging economic environment. Greg, will provide additional comments on this new process to improve profitability. I will now make a few comments on capital before closing with some comments on our expectations for 2009.

We will begin the initial qualification of our new mid-scale manufacturing facility in Karlskoga, Sweden in the first quarter of 2009 followed by qualifying the first API soon thereafter. This facility will be used to produce commercial product and a number of Phase III products that we hope will be approved in 2009 and beyond. Cambrex has spent a considerable amount of capital in the past three years to expand our capabilities and capacity to accommodate the growth of our small molecule businesses.

Heading into 2009, we are pleased to have that spending behind us and we are now focused on filling this capacity. We expect to spend significantly less capital in 2009, in the range of $13 million to $16 million, which approximates what we consider our annual maintenance capital to be. For 2009, we are currently projecting a low single-digit increase in sales and a slight decrease at least at the midpoint in adjusted EBITDA. We have included a wide range for 2009 profit guidance as we see significant uncertainty in the market for custom development projects and the overall potential for the macroeconomic environment to impact volume and pricing levels for those commercial products that use our APIs and advanced intermediates.

We expect controlled substances to continue to grow at double-digit rates. And we are optimistic regarding our total drug delivery business in 2009. The full year cost increase for 2009 for the new Italian and Swedish facilities is a little over $3 million with just over half coming from increased depreciation expense. We are aggressively seeking additional volumes to fill this capacity until such time as new products ramp up. In conclusion, I am cautious as most people are regarding the macroeconomic conditions and the impact on our business for 2009. But I am optimistic about our ability to grow our business in each of our key strategic initiatives. I will now turn the call over to Greg.

Greg Sargen

Thanks Steve. I would like to add a few comments on the fourth quarter financial performance and 2009 guidance. And then we will open it up to questions. I first like to briefly describe the restructuring expenses and strategic alternative cost lines in the income statement. Restructuring expenses in the fourth quarter of 2008 included a $2.7 million charge for the lease and other costs associated with the consolidation of our New Jersey Technical Center activities into our Charles City, Iowa facility as well as some remaining charges primarily related to our corporate restructuring. We increased our reserve in the fourth quarter related to our exit of the technical center. To account for the negative outlook regarding our ability to sublease the facility we are currently assuming that we will not sublease the facility prior to the December 2010 expiration.

Strategic alternative costs in the fourth quarter consisted primarily of cost associated with our recent legal entity restructuring. The company ended the quarter with debt, net of cash of $91.3 million, a $1.5 million improvement during the quarter, net of the impact of foreign currency on cash balances. Given the current economic conditions and the general uncertainty as to how long the credit markets will remain tight. We are pleased to have significant capital projects behind us and to have a little over three years remaining on our revolving credit facility.

Cambrex had net interest expense of $1.1 million for the quarter versus $900,000 in the same quarter last year. The company capitalized $200,000 of interest into long-term capital projects during the fourth quarter of 2008, and $2 million year-to-date. Income tax expense was $1.4 million for the fourth quarter of 2008, and $7.1 million for the full year. The full year tax rate was 46%. Excluding restructuring and strategic alternative costs, and benefits related to the favorable resolution of certain tax items during 2008, the full year rate would have been approximately 40%. As we do not recognize tax benefits for losses in certain jurisdictions including the U.S., our effective tax rate has been and will continue to be volatile due to shifts in the geographic mix of income from one period to the next.

Now, I would like to discuss guidance for 2009. We are currently estimating 2009 sales net of the impact of foreign currency to increase between 2% and 6% and full year adjusted EBITDA to be between $42 million and $49 million. Adjusted EBITDA will exclude the impact of any M&A, strategic alternatives, or restructuring related expenses. We currently expect restructuring and strategic alternative expenses to be minimal for 2009. This guidance assumes the company's customer from an API used in a previously recalled neurological therapeutic, will place orders during the second half of 2009 to support the anticipated relaunch of their product in the U.S. Capital expenditures are expected to be between $16 million and $13 million and depreciation expense is expected to be $21 million to $22 million.

As Steve discussed earlier there was more uncertainty than normal with respective business conditions and this uncertainty carries over to our projections for 2009. Along these lines, I mentioned briefly last quarter where series of initiatives that we were kicking off to increase operating efficiencies and optimize our cost structure. We refer collectively to these initiatives as our operational excellence program. The program includes several teams that are analyzing the largest chunks of spending within our operations including raw material costs, working capital, the cost of quality assurance and control, waste environmental cost, health and safety, maintenance and the cost of manufacturing among others.

These initiatives will be combined with ongoing LEAN, Six Sigma programs and will cover all of the significant cost within our operating sites. We are in the process of setting internal targets for each of these initiatives and we will monitor the progress at each team throughout the year. I will finish with a few comments on corporate headquarters spending. Coming into 2008, we expect to spend a little over $16 million throughout the year we aggressively reduced cost to take controls of discretionary spending and additional restructuring activities, while incurring lower bonus accruals to finish the year with $12.5 million in corporate operating expenses. We do not currently foresee any further significant cost reductions at the corporate office and expect 2009 corporate expenses to be a little over $13 million.

I would now like to open up the call for questions, [Kendra]?

Question-and-Answer Session

Thank you, sir. (Operator Instructions). And your first question comes from the line of [Douglas Shady].

Unidentified Analyst

Good morning. Couple of questions, your gross margins remain under pressure, can you talk about, what is needed to achieve some stabilization here, I mean the levels we saw in the fourth quarter, do you think that's kind of hit bottom and you should see some improvement or you think you are looking at some more deterioration in the near term?

Greg Sargen

Yeah, I mean again we don’t tend to guide to the gross margin level, but I will say that the fourth quarter was I don’t know perfect storm is the right phrase to use, but there were several events there that even this shortest three or four months ago, we didn’t anticipate so I do think the fourth quarter margins are not indicative of where we expect the future to be, but we think we have most of as Steve discussed, and I touched on, we had a big chunk of the price declines on one of our major APIs behind us. So, that impact will mitigate and we will continue to carry some of the cost of the new larger facilities than we might want to support the current level of revenues, but in order to handle the growth, we needed to bring those costs on ahead of time. So, we do expect the margins to bounce back from the fourth quarter in 2009, but I’m going to shy away from giving you any specific guidance on that.

Unidentified Analyst

Okay, that's certainly helpful. I guess secondly, you mentioned the bulk of the contractual price stepped and are now behind you, have you seen any trends where customers are trying to adjust in this environment renegotiate at lower prices or, do you think there is any risk for that trend increasing as we go forward?

Steven M. Klosk

This is Steve. We certainly continue to see some pricing pressure on the older generic products. And we talked about that we kind of forecast that to be or assume it's going to be roughly in the 2% a year range.

Unidentified Analyst

Okay.

Steven M. Klosk

On custom development projects where we are working on new clinical phase products, it's definitely competitive market particularly in the early phase products. End customers are probably going to start to push back on Phase II and Phase III and the way it works is, when we produce product for them in Phase I that’s a development agreement. They put it in patients, they hopefully get good data, they come back and negotiate with us, the development agreement for Phase II and Phase III. So, this is going to be pushed back there. Once they're in Phase II they, almost a 100% of the time come back towards the Phase III. So, I see less give and take there. In terms of supply agreements, where we've got pricing locked in, generally its locked in they may want to come back and talk because they are under pressure and everybody is generally, we are going to push back and say we need volume. If we are even going to consider those types of price discussions or new products. So, it's got to be a give and take to have discussion.

Greg Sargen

Let me just add a comment there on the custom manufacturing side most of our relationships are longer term in nature as far as the supply agreements go. So, whether folks will come mid-term on contracts, and start to seek pricing declines is yet to be seen, but obviously in this macroenvironment nothing will surprise us. We do have one contract that comes up for renewal in September of 2009, its not a huge contract, but it’s a nice contract for us roughly $10 million I believe we sold in 2008 under that contract. We expect to renew that contract, but there is no guarantees and, we may have to renegotiate on price as we renew it going forward. So, other than that, one kind of relatively small contract, but profitable contract, the rest of that custom manufacturing base should be pretty stable short of people getting desperate.

Steven M. Klosk

Okay. Then I will just add on that contract. We have some IP.

Greg Sargen

Yeah.

Steven M. Klosk

That will help us.

Unidentified Analyst

So, is it fair to say, your guidance for 2009 of 2% to 6% ex-currency, pricing is going to be down a few percent, so, basically all of that's coming from volume and offsetting a little bit of a decline in price?

Greg Sargen

That's right.

Unidentified Analyst

Okay. Thank you very much.

Greg Sargen

You bet. Thanks, Doug.

Operator

Your next question comes from the line of Dmitry Silversteyn.

Dmitry Silversteyn – Longbow Research

Good morning. I just was loving if you can update us on what's going on with a new [prop] just as far as you talked about expectations of second half of '09 beginning to see some volumes as they get ready to launch, have they gotten the FDA approval and is it just a matter of some paperwork or they're still waiting on something?

Greg Sargen

They've said publicly that they will approach the FDA in late '08, early '09 they had a release out in the middle of December, regarding their conversation, and I guess the process was kind of more or less blessed, that they will present data over the first half of '09. And I think right now at least our analysts I don't know if the company specifically commented that I can find, their analysts seem to believe that it's in early 2010 launch with the U.S. in the FDA. So, they won't get FDA approval till later in '09, and that's kind of why we put a big caveat on our guidance given the share volume of that contract for us.

Steven M. Klosk

And Dmitry let me just add. Again as Greg said, what we know is what they've put in press releases and of course discussions with them trying to forecast volume and production schedule for the year. My understanding is that they did receive a complete response letter from the FDA. So, what they have got to do then is schedule a meeting with them or respond to that response letter, show them data that they have been collecting that will show that, the product is stable as they have been able to show with the EMEA. And again, our assumption will be launch of new patients in early – in the first half of '09 for the customer in Europe and then we are not assuming a launch in the U.S. until 2010, but of course we are hoping to support that launch in '09.

Dmitry Silverstein – Longbow Research

Right. You don't have much to do with the European production right?

Steven M. Klosk

No we produced everything for them Dmitry.

Greg Sargen

Global.

Dmitry Silverstein – Longbow Research

So, their first half '09 European launch will impact you positively then?

Steven M. Klosk

Well we're certainly planning and will be producing product for the EMEA launch.

Dmitry Silverstein – Longbow Research

Okay. So, the European part of the production is in your guidance of $42 million to $49 million EBITDA, but the U.S. portion isn't.

Greg Sargen

No, we have their full global market is in our expected production based on.

Dmitry Silverstein – Longbow Research

Okay.

Greg Sargen

So, it's but it's the, there is differences in the time that they will launch. So, the volume tends to come ahead of the perceived launch. So, in the back half of '08 we made some volume that will be used for their front half of '09 European launch. So, in the back half of '09, if things go according to plan, we will be producing and shipping material to them to support in early '10 U.S. re-launch.

Dmitry Silverstein – Longbow Research

Right. Okay

Steven M. Klosk

And we do expect Dmitry to be that that will be for the first approved neurological indication as well as the second indication that they filed for in Europe and we hope the same to the U.S.

Dmitry Silverstein – Longbow Research

All right. Okay. Can you remind us how big this business is when it gets going in terms of at least how big it was before it was pulled I guess is a better way of asking the question because with a new indication, we really don't have any much of an idea of how big it can get?

Steven M. Klosk

Well, this is Steve. And Greg, if you want to chime in, I would direct you to analyst reports on the company and the product if you believe, that product, and I think if you look at those analyst reports and what they expect sort of commercial levels to be in the U.S. and Europe, and convert that to U.S. dollars, it's probably a $700 million to $800 million product for them, they are hoping. So, we have got the exclusive agreement to supply a 100% of that API. We are going to be ramping up that API in our new mid-scale facility that we have been talking about. So, if the analysts are correct and our customer gets to where they hope to get, this would be a large product for Cambrex.

Dmitry Silverstein – Longbow Research

Right. Okay. And it’s a good profit product for you. Correct?

Greg Sargen

Sure

Steven M. Klosk

It is.

Dmitry Silverstein – Longbow Research

It is, okay. I just want to make sure I understand the answer you gave to the previous question on the gross margin pressures because…

Greg Sargen

Okay.

Dmitry Silverstein – Longbow Research

Gross margins are being in the 20s for a company producing high value products such as you are doing, there is, at least in my opinion there needs to something structurally different about the business model going forward, and maybe there is structurally something going on with the business model why the margins are as low as they are. So, you continue to experience pricing pressure, it sounds like that's going be characteristic of the industry going forward indefinitely? The growth in your proprietary products is certainly helping that you've put enough bunch of new capacity in all three of your facilities in ‘08 that's going to be expensed in '09. So, at which point and how do we get to a stable gross margin or whatever stable level is and how do we start seeing it expand back towards 40% that we saw back five years ago or are we never going to get to that point has that the paradigm in the industry changed so much that we should be happy with 30% gross margin.

Greg Sargen

Yeah, I mean, I think answer of that question touches on a lot of things. So, I will just kind of briefly touch on them, there is a mix issue there. So, we are – as we commented with respect to controlled substance polymeric drug delivery products and then hopefully products like disneurological and handful of others that we are going forward that we think, once we get a product that ramps up to those kind of volumes. We can really get some economies of scale going in our manufacturing operations. But, that's primarily a mix issue. How do we change the mix within our business the custom development business. When the volumes aren't there, but the costs are there, as we saw in the fourth quarter you just have a lot of unabsorbed overhead that just kind of flows through your P&L with no revenues to offset it. So, in the short-term, very high contribution margin negative impact there. As we talked about, we are going to have a pretty intense focus on cost, we don't think there is anything structurally deficient in the business there are some headwinds that we are facing right now. And we had a large product for which we expected to sell several million dollars more this year and a softness in the custom develop market, where we think frankly we would have been right smacked at in the middle of not at the high end of the original guidance we gave at the beginning of the year. So, things that, I don't anybody envision the market getting a softness it did on the back half of the year and there is no way we could have projected the neurological to get pulled back. So, if you take those events and kind of normalize for them again that's, I understand that you can't take the bad things out of your business, but if you do, our margins look pretty good for 2008. And they are not all that different than 2007. So, we think if we can get that product back on track, get some cost efficiencies through some of the programs we are putting in place, get new products into our generics business stream, which we really haven't had for a quite a while for a variety of reasons, and improve the mix by discontinuing the focus on new polymeric drug delivery products in controlled substances, we think we can start yanking that that margin back up.

Dmitry Silverstein – Longbow Research

Okay.

Greg Sargen

Its kind of all over the board, but your questions, really impacts every aspect of the business.

Dmitry Silverstein – Longbow Research

Right. Okay, thank you.

Greg Sargen

Thanks Dmitry.

Operator

(Operator Instructions). And we have a question from the line of Ted Hillenmeyer.

Ted Hillenmeyer – NorthStar Partners

Hey, guys.

Greg Sargen

Hey, Ted.

Steven M. Klosk

Good morning.

Ted Hillenmeyer – NorthStar Partners

Can you talk about allocation of cash flow, it looks like if CapEx is going to come down from the $33 million to whatever you said. $13 to $16 you have kind of the excess $18 million or so that will be [enabled] in your way?

Greg Sargen

Yeah. When you say allocation of cash flow. Let me just clarify qualify what you are asking for so I can kind of help you get there.

Ted Hillenmeyer – NorthStar Partners

Just in terms of the free cash flow that you expect to generate in '09, where do you expect to put it is it into new product is it to pay down debt?

Greg Sargen

Right now. We are anticipating, just using that to pay down our debt. And our guidance presumes that if we are pumping it into new products, and we have made some allocations here and there to spend money on developing new controlled substances, polymeric drug delivery to apply for intellectual property, et cetera. If we see M&A come along the way, it's kind of impossible to predict that so pushing any M&A opportunities aside, our most of that stuff that I talked about will through the P&L and impact the numbers in the guidance that we saw, and we planned for a certain amount of that. So, to the extent that we have free cash flow in 2009 and we do expect to be positive right, now we're anticipating just paying down debt and or accumulating cash in our European facilities depending on which makes more sense at the time.

Ted Hillenmeyer – NorthStar Partners

Okay. And then on the debt side, you had a number of projects that you had cash on the balance sheet, but you expect it to pay off over time. Have most of those flown through or do some of those still exist where you have some payoffs to make?

Greg Sargen

You mean historical obligations that will flow through cash flow through the balance sheet but not the P&L in '09, is that what you're asking?

Ted Hillenmeyer – NorthStar Partners

Yes.

Greg Sargen

Yeah. We have a handful of items in '09. Some related to historical litigation settlements, where we will make the payment when someone tells us we need to make the payment, frankly that may or may not happen in 2009. And there is probably about between $3 million and $4 million of such items. We took a charge in the fourth quarter related to the tech center for, and if you look at one year's cash flows in 2009 again for something that's already absorbed in our P&L that's about $1.5 million. We will pay out close to $900,000 in dividends related to restricted shares that vest during 2009. Again shares were put in, certain restricted shares that vested as a result of the bio-business sale or that have vested since then when we paid the $14 dividend, the dividend related to those shares became payable eventually that will come out of the company's cash flows in 2009. And there is probably about a $1.5 million of payments related to severance and mostly severance related to the some later in the year corporate restructuring activities. So, there are some lingering cash items there, but even with those items, we still expect to be positive cash flow for the year assuming, we are taking in at the midpoint of the range as a discussion point.

Ted Hillenmeyer – NorthStar Partners

A one point I think you mentioned debt of $95 million to $100 million, it sounds like with the $91 million where you are now, it's potentially more in the lower end of the $95 million?

Greg Sargen

I think we will, again depending on a little bit, it gets to be somewhat arbitrary at the end of the quarters or the year when you talk about inventory and receivables and how sales commence here, your working capital can get you at around by a few million dollars pretty easily. We would say we be at $95 million to $100 million, there was a change in control payment the cut made in early January that I had previously assumed will be made in late December. And I will call it change in control, and any kind of lingering payments related to the retirement of our Former CEO. Call it $5.5 million that went out of the door in early January, then I had initially presumed. So, that $91 million in change of debt net of cash would have really been in that $96 million range kind of right where we expected it to be. So, when you look at 2009, again if we can generate some positive free cash flow like we are expecting to, we would expect to see that number come down a bit, net debt net of cash number.

Ted Hillenmeyer – NorthStar Partners

And on the gross margin questions how is higher raw materials affecting you?

Greg Sargen

Higher raw materials affected us throughout the whole year. We are hoping, I would say that for the full year, that number, if you look at versus what we said is our manufacturing standards going into the year that's a big number, its probably $4 million to $5 million impact, negative impact to us for 2008. So, some of our Six Sigma programs and other stuff have kind of partially offset that going in the other direction from a production cost perspective, but hard to overcome $4 million to $5 million of that nature. We are hopeful that going into 2009, that the world market conditions will mitigate that negative impact, and we will see some of those prices return to I don’t know recession levels, if you will, but we do have a handful of products are larger raw materials, which are byproducts of the construction industry. And frankly we are seeing some steep price increase in a handful of our raw materials, which are offsetting some of the savings we expect on some of the more commoditized ones. So, we expect and hope for some stabilization if not savings in 2009, but we are cautious right now.

Ted Hillenmeyer – NorthStar Partners

And the delays on the two large projects I didn't catch whether you named, what type of projects those are?

Greg Sargen

We don't name them, our contracts are such that we never name the.

Ted Hillenmeyer – NorthStar Partners

Are you able to give kind of why they got pushed and they got delayed?

Greg Sargen

Well we are seeing, its a combination of things, and when we say there is really a pervasive impact there, there is two projects in particular that were largest and then there is a handful of projects where we are seeing a general slowdown, folks are trying to preserve cash so they are not pushing, they are not pushing us to hit milestones quickly get product out the door to them. So, there is a general slow down. On the two larger ones, I think one of them was due to just difficult chemistry and some issues that we had and trying to achieving it and the other one really is the customer backing off timetables. But it's really a little bit of the combination of the two across several projects in the fourth quarter.

Ted Hillenmeyer – NorthStar Partners

Okay. And then finally you mentioned the contractual impact of I assume the gastro project, in the press release it says [$11.9 million] I think you said $10.6 million, are you able to say how much of that will impact you in the….

Greg Sargen

Let me clarify that the $11 million is compared to 2006. So, it's been a little over $5 million in 2007, and then another $5 million in 2008. The $10 million of price decline that we referred to for all of 2008, includes about $5.5 million of that product, and then roughly $5 million across generics and all other products. Just to be clear that $11 million is not the same as the $10.6. Did that make sense?

Ted Hillenmeyer – NorthStar Partners

Yes.

Greg Sargen

Okay.

Ted Hillenmeyer – NorthStar Partners

And in the large project?

Greg Sargen

The large project going in 2009 should be a couple of million bucks of negative price impacts.

Ted Hillenmeyer – NorthStar Partners

Okay. With the remainder kind of yet to be seen based on negotiations?

Greg Sargen

Remainder yet to be seen with respect to all other products.

Ted Hillenmeyer – NorthStar Partners

Right.

Greg Sargen

Yeah. So, I mean we have a number in our forecast it's significantly lower than the $10.6 million, we experienced in '08, but it is still a negative number.

Ted Hillenmeyer – NorthStar Partners

Okay. Thanks Greg.

Greg Sargen

Okay. Thanks, Ted. Anybody else in the queue [Kendra].

Operator

There are no further questions, sir.

Greg Sargen

Great. With that we will wrap up the call. Thanks everybody for your time and have a great day.

Operator

Thank you for your participation. This concludes today's teleconference. You may disconnect at this time.

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