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Executives

Patty Eisenhaur - Executive Director IR

Paul Bisaro - President and CEO

Mark Durand - CFO

David Buchen - General Counsel

Analysts

Marc Goodman - UBS

Greg Gilbert - Banc of America

Adam Greene - RBC Capital Markets

David Buck - Buckingham Capital

Tim Chiang - FTN Equity Capital

Ken Cacciatore - Cowen and Company

Corey Davis - Natixis

Michael Tong - Wachovia Securities

Elliot Wilbur - Needham & Company

Scott Hirsch - Credit Suisse

Rich Silver - Barclays Capital

Ronny Gal - Bernstein

Caius Christoe - Morgan Stanley

Watson Pharmaceuticals, Inc. (WPI) Q1 2009 Earnings Call April 30, 2009 8:30 AM ET

Operator

At this time, I would like to welcome everyone to the Watson first quarter 2009 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. (Operator Instructions).

I would now like to turn the call over to Ms. Eisenhaur, Executive Director of Investor Relations. You may begin.

Patty Eisenhaur

Thank you, Kerry, and good morning everyone. I would like to welcome you to Watson's first quarter 2009 earnings conference call. Earlier this morning, Watson issued a press release reporting its earnings for the first quarter 2009. The press release is available on our website at www.watson.com, and includes a reconciliation of our GAAP and adjusted financial results and forecasts. Additionally, we are conducting a live webcast of this call, which will also be available on our website after the call's conclusion.

With us on today's call are Paul Bisaro, President and CEO of Watson, and Mark Durand, our Chief Financial Officer. Also present and available during the Q&A portion of the call are Tom Russillo, President of our Generic Division; Ed Heimers, President of our Brand Division; Al Paonessa, Chief Operating Officer of our ANDA Distribution Division; and David Buchen, our General Counsel.

During the formal portion of today's call, Paul will share highlights of the first quarter, including highlights on the performance of our three business segments. Mark will then provide some additional details of our results for the quarter. Paul will conclude our presentation with our outlook for the remainder of 2009. We will then open up the call for questions and answers.

For those of you participating in the Q&A, we request that you limit yourself to two questions, so we can get everyone's questions addressed. If we have enough time at the end, we will open up the queue for follow-up questions.

Please note that today's call is copyrighted material of Watson Pharmaceuticals, Inc. and cannot be rebroadcast without the company's express written content.

I would also like to remind you that during the course of this call, management will make projections or other forward-looking remarks regarding future events or the future financial performance of the company. It is important to note that such statements about estimated or anticipated Watson results, prospects, or other non-historical facts are forward-looking statements and reflect our current perspective of existing trends and information as of today's date.

Watson disclaims any intent or obligation to update these forward-looking statements, except as expressly required by law. Actual results may differ materially from current expectations and projections, depending on a number of factors affecting the Watson business. These factors are detailed in our periodic public filings with the Securities and Exchange Commission, including, but not limited to, Watson's Form 10-K for the year ended December 31, 2008.

With that, I will turn the call over to Paul.

Paul Bisaro

Thanks, Patty, and good morning everyone, and thank you for joining us today. I am pleased to be able to share with you our results for the first quarter of 2009, which I think reflects continuation of the positive growth and momentum that was built during 2008.

As is our practice, I will briefly review our financial results and provide an update of each of our three business segments and then Mark will provide some more details on our financials.

Taking a look at this morning's earnings report, we are pleased to announce that our first quarter finished strong and ahead of expectations. Our consolidated revenue for the quarter was a record $667 million and we posted strong first quarter adjusted earnings of $0.58 per share. Adjusted EBITDA for the quarter was a record $158 million and our cash flow from operations for the first quarter was $69 million.

Turning to our generic business, this was an exceptional quarter for our Generics Division and with us achieving all of the milestones we have set for ourselves. To begin, our Davie, Florida site performed very well, responding to the increased demand for potassium chloride, or generic Micro-K, and by the end of the quarter, we were able to meet all the customer demand for this important product. In addition, Florida is working on launch preparations for generic Toprol XL and generic Cardizem LA. So, our Florida facility will continue to be called upon to deliver important products for the remainder of the year.

At our other sites, we continue to make good progress on our global supply chain initiatives. Product transfers from our Carmel, New York facility to our India site will accelerate this year, as our Goa, India site expansion is now complete. We expect to produce over 2 billion units at that facility this year. Of course, as each product transfer is completed, additional manufacturing cost savings will be realized.

A couple of other highlights from the Generic Division in the first quarter. First, we were able to leverage our financial strength to buy a series of products from Teva that were divested as a result of their acquisition of Barr. Distribution of those products began in early January and had a positive impact on the quarter.

We also launched AZURETTE a generic version of Mircette bolstering our already strong generic oral contraceptive portfolio, and also launched mint-coated nicotine gum, a solid addition to our smoking cessation line of products. With AZURETTE, we now have 24 generic oral contraceptives in our portfolio.

A quick update on our generic R&D pipeline; we currently have approximately 60 ANDAs pending. We also have some significant pipeline events this quarter. First was the favorable district court ruling on the patent infringement case related to Concerta. We expect that case to continue on appeal and we will work to maximize the value of this important product.

Second, we recently announced three new Paragraph IV challenges; Generic Mucinex, Mucinex D, and Enablex. We believe, we were the first to file on the Mucinex D, and as well as first to file our shared exclusivity on Enablex. As you can see, our Generics Division is plenty busy and we will continue to manage that business to capitalize on these opportunities.

Moving to our Brand Division, obviously the biggest event in the Brand Division was the launch of RAPAFLO, our new selective alpha blocker for benign prostatic hyperplasia, or BPH. Much of the first quarter was spent preparing for the launch and our urology sales force started detailing to physicians on April 6. While it is too early to say how script trends are moving, early reports from the field are encouraging.

This launch marks an important milestone and coupled with the forthcoming launch of GELNIQUE in mid-May, demonstrates our commitment to Watson's urology franchise and our entire Brand Division.

Turning briefly to FERRLECIT, as you know, the arbitration hearing to determine the termination date of the current agreement was held earlier this month and is now concluded. The panel of three arbiters has informed us they will deliver their decision in mid-May.

Based on the proceedings and the information we have today, we remain confident that our distribution agreement with Sanofi terminates at the end of 2009. Of course, we also continue to work on new opportunities for our nephrology medical sales team for 2010.

Turning now to our distribution business, once again, ANDA was involved in significant product launches this quarter, including generic launches of generic versions of Depakote ER and Solodyn which were contributors to ANDA's success in the most recent quarter. Also, ANDA realized a sizable increase in gross margins this quarter, largely due to changes in market conditions for certain products. We expect ANDA's margins to normalize for the remainder of the year.

So as you can see, it was a strong quarter for all our divisions, and I would like to especially thank our employees that responded to the new opportunities within all our businesses and have helped us sustain the positive momentum and progress we built during the course of 2008.

With that, I will turn it over to Mark for some details on the financials. Mark?

Mark Durand

Thanks, Paul, and good morning to all. I will now review our underlying first quarter financial performance on a consolidated and divisional basis. As always, we have provided segment detail for you on our press release and I will now discuss the highlights and major components.

For the first quarter of 2009, net revenue was $667 million, an increase of 6% from the prior year period. 60% of the net revenue was from Generics, 23% is from ANDA Distribution, and 17% is from Brands.

Generics first quarter net revenue was $402 million. This is a 10% increase over the first quarter last year and 9% increase from fourth quarter 2008 levels. Generic product sales increased 15%, or $53 million from last year's first quarter, due primarily to strong sales of potassium chloride and growth from transdermal fentanyl.

However, Generic other revenue declined $18 million, due primarily to reduced royalties on the Sandoz sale of generic Toprol XL. Oral contraceptive sales in the first quarter were $88 million, up from $78 million last year, reflecting our continued strong market position and business performance.

Moving on to the Brand Division, net revenue was $112 million, a decrease of 3%, or $3 million from the first quarter of last year. Brand product sales consisted of $55 million in specialty product sales and $43 million in nephrology sales.

Brand gross margins in the first quarter were 78.4%, which is a 2.2% increase year-over-year and consistent on a sequential quarter basis as product mix was unchanged.

Finally, net revenue from the ANDA Distribution Division was $154 million, up 6%, or $9 million from the prior year due primarily to third-party product launches.

Q1 is consistent with the average quarterly run rate of last year, although lower than Q3 and Q4 in 2008, but recall that the second half of last year reflected significant new product launches. ANDA gross margin was 18%, a 2.8% improvement over the first quarter of last year. The increase was primarily a result of changes in market conditions brought about by certain product shortages. We expect margins to be lower than average in Q2, while full year 2009 margins are expected to be consistent with prior year levels of approximately 15%.

Turning now to operating expenses, R&D spending for the first quarter was $42 million, which is up about $4 million, or 11% compared to the prior year period. The increased investment in R&D was a result of increased spending in our Generics Division and reflects acceleration in our investments in biostudies and API.

SG&A for the first quarter was $135 million, which is an increase of $28 million, or 26% compared to the prior year period. $18 million of that increase is due to a legal settlement with Elan for naproxen sodium. The additional increase is the result of higher spending and preparation for product launches, particularly pre-launch activities surrounding RAPAFLO and GELNIQUE.

Amortization for the first quarter was $22 million, an increase of $2 million from the first quarter last year associated with the products acquired from Teva.

Adjusted EPS for the quarter was $0.58 per share and excludes $9.3 million in costs associated with our global supply chain initiative, which continues to track on or ahead of schedule. GAAP EPS for the quarter was $0.43 per share. Details on all of the adjustments can be found in the reconciliation tables in our press release.

Our adjusted EBITDA for the first quarter was $158 million, up 6% compared to the prior year period, and 10% from the fourth quarter of 2008.

Cash flow from operations for the first quarter was $69 million, which is comparable to $67 million we had in the prior year period. Capital expenditures for the first quarter were $15 million.

Our tax rate was 38.6% in the first quarter, reflecting the impact of the California tax law change in the first quarter. This was partially offset by reduction in the tax rate related to the R&D tax credit. We expect our tax rate for the full year to moderate between approximately 37% and 38%.

Our capital structure remains very strong and we remain confident that it can support strategic M&A activity in the future. The current debt position is $876 million, consisting of the $575 million convertible at 1.75% interest, a $250 million term loan, and the $50 million drawn on our revolving credit facility at LIBOR plus 75 basis points.

The debt to capital ratio continues to be below 30%, at 28.8%, and our debt to EBITDA ratio was 1.5. At the end of the quarter, we had $571 million in cash and marketable securities, as well as an additional $450 million available on our revolver.

With that, I will turn it back to Paul to provide an update on our 2009 forecast and concluding remarks.

Paul Bisaro

Thanks Mark. There are a number of factors that will influence our forecast for the remainder of the year. Some of these factors we can influence through solid execution, but others are out of our direct control, making it a bit more challenging than usual to provide you with a forecast. So first, I will go through a few assumptions and then provide you with the current forecast.

I want to start by reminding you that the forecast we provided you in February included only a modest contribution from generic Micro-K and generic Toprol XL. Today, based on the market intelligence that we have, we expect to be the only supplier of Micro-K until late this year. Regarding generic Toprol XL, we remain confident in the approvability of our generic product and anticipate FDA action in due course, but for forecasting purposes, we continue to maintain modest expectations for the product until we have further clarity on launch timing and competition.

As for generic Cardizem LA, we also expect approval of this product in due course, but anticipate it will be a contributor in the second half of the year, as FDA works through their backlog of products. Finally, we have not included anything for new patent challenges.

We have also assumed a full year of FERRLECIT sales. Regarding INFED, due to issues affecting the supply of INFED raw material, we may be unable to ship any additional INFED this year. So, based on these assumptions, we continue to estimate our full year net revenues at approximately $2.65 billion. Generic revenues are now expected to be between $1.5 billion and $1.6 billion.

On the brand side of the business, we continue to forecast net revenue between $445 million and $470 million for the year. However, due to loss of INFED revenue, we now expect to be at the low end of that range.

With the ANDA Distribution business, we continue to anticipate revenue between $660 million and $710 million.

For adjusted EPS, we are moving from an original range of $2.18 to $2.28 to a new forecast of between $2.40 and $2.52 per share. Accordingly, our adjusted EBITDA is now expected to be between $650 million and $672 million.

As you can see, 2009 continues to provide us with a number of significant opportunities and some challenges. I am very pleased with the focus and the effort we have shown capitalizing on these opportunities, and I am sure we will continue to execute on our business plan and continue to drive shareholder value.

With that, I will turn it back to Patty for questions.

Patty Eisenhaur

Great. Kerry, we will open up the queue now for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from Marc Goodman with UBS.

Marc Goodman - UBS

Paul, can you just give us little more flavor on what is going on with INFED, and also, Micro-K? Just give us an idea of how much was shipped in the quarter. I mean, obviously, we can see the script trends, and we have an understanding of how big the market is, you have talked about in the past, but how much was up front in the quarter that could potentially take away from the second quarter and things like that just? Thank you.

Paul Bisaro

Sure. I will try to deal with the second question first. I don't think you will see any major change in Micro-K quarter-over-quarter. As we filled sort of the pipeline, it took us a number of weeks to do that, but there is sort of a normalization now on the run rate and also there was some product in the channel that had to work its way through. So, I think a combination of those things will move you to sort of a more normal and steady Micro-K sales and revenue for the next several quarters.

Marc Goodman - UBS

So, second quarter should be radically bigger than the first quarter is what you are telling us?

Paul Bisaro

No, I think it should be about the same on the Micro-K.

Marc Goodman - UBS

Okay.

Paul Bisaro

Your first question again? I am sorry.

Marc Goodman - UBS

On INFED, what happened?

Paul Bisaro

Yes. Our raw material supplier experienced some FDA issues and we have to work our way through those. We are working with them to try to resolve those, but out of sort of abundance of caution and prudence, we decided to remove the INFED revenue from our guidance for the rest of the year. It is certainly possible that we can get the product back and we will do everything we can to get it back, but right now, we decided to take it out for the remainder of the year.

Marc Goodman - UBS

Should we be assuming that it will be back for next year?

Paul Bisaro

I think for sure it will be back next year. For sure is a strong word. I would say with reasonable certainty, we should see it in 2010.

Marc Goodman - UBS

Fair enough. Thanks.

Operator

Your next question comes from Greg Gilbert with Banc of America.

Greg Gilbert - Banc of America

First, for Paul and maybe Tom, can you comment on the generic pricing environment in the US in the quarter relative to the erosion rates you tended to assume in the past? And secondly, Paul, can you comment on your willingness to issue or use stock in conjunction with an acquisition? Thanks.

Paul Bisaro

Sure. Well, Tom, I will start on the erosion and you can fill in. I think we are seeing erosion rates where we sort of projected them to be, roughly we are still using the 10% model for the year and that was what we pretty much saw in the first quarter. We did see a little bit of activity with some additional new bids being put out. That always has a tendency to effect erosion. We will have to see how that plays out for the second quarter, but right now we are expecting sort of normalized erosion. Tom?

Tom Russillo

I think you covered it.

Paul Bisaro

Okay. As to our willingness to use stock, Greg, I think in that transaction, depending on the magnitude of that transaction, we probably would use some component of stock. We would want to be prudent about how much stock we use, because we do understand that perhaps the multiple environment that our stock is trading in right now is a little lower than we would like it to be, but I do think for a transaction of reasonable size, we would anticipate to use some portion of stock in that transaction.

Operator

Your next question comes from Adam Greene with RBC Capital Markets.

Adam Greene - RBC Capital Markets

Actually following up on Greg's question, Generic gross margins were obviously strong this quarter, the strongest in a long time. I mean, we know about the price increases on Micro-K and Tiazac. Excluding those, what are you seeing across the board?

Are you benefiting from others pricing coming up on the other product lines as well? Where would margins have been excluding those two parts?

Then also on ANDA, as ANDA gets more into branded product distributions, how do we see that going forward in terms of margins and type of mix going forward? Is there kind of a goal that you are setting to distribute more brand products going forward as well?

Paul Bisaro

Well, on the generic margins, I will start and feel free to jump in guys. What we saw really is product mix more than anything else. As strong sales of Micro-K and other products have replaced the ongoing, or the older AG products that we used to have, you see us driving higher margins.

We also have seen improvements in our cost position, as we have taken advantage of our global supply chain initiative, as well as our work internally in the US to sort of pull costs out of the system. So, we are seeing improvement on the margins sort of on both fronts.

I wouldn't say that there is a trend in price increases in the generic industry, so I wouldn't take it to that point, but I think that is what is kind of driving the margins. We are pleased that our margins continue to increase or at least to remain strong and we expect that to continue.

Regarding our distribution, our ANDA Distribution business and the use of its growth in brands, we actually believe that that is just to give ANDA the opportunity to be more competitive with some of its other competition out there. One of the things we have been doing for sometime is we have a full line of C2 narcotics, including brands, and by broadening the offering that ANDA has, we make them basically more competitive.

Of course that will take overall margins for ANDA down, because the distribution of the brand products will take margins off a bit, but that was what we said at the beginning of the year and we still anticipate that. This quarter was more of an anomaly, which drove the margins up to about 18%. We don't expect that rate to continue. We expect it to come back for the year to be more in the range that we gave, I think, which was somewhere around 15%.

Operator

Your next question comes from David Buck with Buckingham Capital.

David Buck - Buckingham Capital

First, couple of quick ones. First, on the oral contraceptives business, can you just remind us what happened that led to the strength and whether you see that as a sustainable run rate for the year? Then can you give a little more clarity on what issues you are seeing with generic Toprol XL in FDA, obviously you expected it late last year and I want to see if you are confident that that will actually come to the finish line I guess this quarter. Concerta, what is the assumption in the new guidance, if any, and what is the confidence in getting an approval this year? Thanks.

Paul Bisaro

I will start with the OC. The OCs were strong again this quarter principally for a couple of reasons. We launched AZURETTE as I mentioned in the opening that had a positive impact on the quarter. Any time you put a new product out there, you get market share, you are going to drive some additional value.

Also, like we have said in the past, the OC line is really sort of subject to outside events and the change in costs and pricing will be effected when there is either some intervening event, like another competitor coming in or other changes like that, and since we didn't see any of that in the first quarter, don't really expect to see anything now in the second quarter.

We would anticipate OCs to remain roughly in the range of where we were this quarter, maybe a little less, depending on how things work out, but again, another strong quarter for oral contraceptives.

I think the next question was on Toprol XL. With that, I think there are several things working here on at the agency. One is the agency's backlog of activity that they have got to do. I think at the most recent GPhA meeting, we talked extensively about working with the agency and to try to find ways to help them overcome this backlog, user fees, all kinds of things we are discussing.

Then I think our Toprol sort of caught up in that, but it is also caught up in the fact that there is clearly has been issues with Toprol XL, generic Toprol XLs from other competitors, and I think the agency is taking a second look at all of the applications before they approve them.

We are moving on the product. We do expect approval, but again, for prudence purposes, we did keep the contribution for Toprol XL in our guidance moderate or modest because, frankly, we just don't know what the competitive situation will be when we get the approval.

So, I do expect the approval to come in. I can't guarantee when it is going to be. It is really in the hands of the agency and as they work through what they perceive to be their concerns, and we are of course working hand in glove with them to get that done.

Then I think your third question was on Concerta. I think your question was whether there was anything in the model for Concerta, and the answer is no. Like all of our patent challenges, until we have some guarantee or some certainty around when the product would be available or might be available, we don't put it in the model.

So, it is not in the model. We expect the case to be appealed and we continue to work with the agency to get our approval. So, some issues to work through with the agency on the Concerta, but we are hopeful that we will get that product out.

Operator

Your next question comes from Tim Chiang with FTN Equity Capital.

Tim Chiang - FTN Equity Capital

I wanted to get your thoughts on this arbitration now that it is completed. I mean, what sort of contingency plans do you have in place in the scenario that arbitration panel rules against you? Looks like you are not going to have INFED until next year. Is that an issue for you at all? Just your thoughts.

Paul Bisaro

Well, on the FERRLECIT arbitration, just to remind everybody that the panel is deciding that issue right now even as we speak. We do expect to hear from them in the next couple of weeks, probably mid-May I think is when we expect to hear from them. If they rule against us and if the agreement is terminated, we will, of course, turn the product back to Sanofi and move on.

Our nephrology medical sales team will focus on other products that we have, things that we can focus them on immediately would include our TRELSTAR product for oncology and other areas that we are looking to evaluate and expand our presence in those spaces anyway. So, sort of a re-tasking of that group would occur basically instantly.

As to INFED, you would be shocked to hear me say I wasn't disappointed in the INFED situation, but those situations occur from time to time. They are out of our control, and we have to work through the issues that our raw material supplier faces. Once we do that, our team will get back to marketing the INFED, but until that time, we will have to wait and see.

As to other contingency plans, we have a lot of moving parts on the contingency front. A lot of them depend on what happens in the arbitration. So, I am not going to go into a lot of detail around all those plans, but rest assured, we have not been sitting idly by waiting for FERRLECIT to end either at the end of the year or earlier if that is what the arbitration panel decides.

So, I think we are in a good position with our nephrology medical team, and we will have them ready to work hard on a bunch of new products if we need to.

Tim Chiang - FTN Equity Capital

If the panel were to rule against you, would your guidance have to be revised at least on the branded segment at all for this year?

Paul Bisaro

Potentially on the branded segment, we may need to revise the revenue projections; that is correct. As to overall guidance, that would depend on a number of factors. So, I think we are in a pretty good position on the overall guidance, but certainly on the Brand Division revenues, you are right. We would probably be lower than we anticipate.

Operator

Your next question comes from Ken Cacciatore with Cowen.

Ken Cacciatore - Cowen and Company

Paul, real quick one to follow-up on Tim's comment. You did say, and I don't want to parse your words, if the arbitration doesn't go in your favor, you will move on. Does that mean that there is no chance of extending the agreement or is that kind of putting too harsh language around what you said? That is the first question.

Then the second question, maybe you could articulate a little bit about your acquisition strategy? I know Greg asked you the question about potentially using stock. Can you just give us a broad sense of what you are thinking as you have gone through a lot of assets have been put up for sale, I am sure you have been looked at them all. Can you give us any updated thoughts on size, scope, scale, what you are trying to accomplish as you look at some of the assets that are available? Thank you.

Paul Bisaro

Yes, maybe I did put too fine a point on the FERRLECIT. I still think there is an opportunity for us to work with Sanofi in the future, but that is really now in their hands. We need to come to an agreement, and as you know, we have been working at that for sometime and basically we have been unable to do that.

So, perhaps after the arbitration, we will be able to reach an agreement and we will stand ready to have and continue to stand ready to have discussions with them, but like anything, it is a two-way street. So, we will have to wait and see about that.

As to the acquisition strategy, I think it is fair to say we have done a lot of looking. There has been a lot of moving assets out there. I think our strategy remains one that we started with, which was to try to do a prudent acquisition to expand our footprint, and we didn't feel the need to go into, not to oversimplify it, but to be in 40 countries overnight.

What we are looking to do is find a company that is a strong company that we can put easily into our organization or make part of our organization and then build off of that. It is probably a bit more prudent. We think it is a bit more prudent to go that way, sort of limiting our integration risk and also the execution risk, if you do it with a reasonable size company.

So, we are looking at like I said, sort of reasonable size companies to build a footprint for ourselves and we don't feel the need to be in 30 countries overnight. So, we will look to go that way.

Ken Cacciatore - Cowen and Company

Great. Then on your Concerta comments; just trying to figure out what has changed since Andrx made their filing back in 2003? In 2004, there seemed to be no real regulatory or legal issue why there couldn't have been an approval, except for the Citizen's Petition and then the patent showed up a lot later.

So, trying to understand what would have changed between the time that the agency had a long look at reviewing Concerta then to now that makes you feel any more or less confident that we will see an approval from that product?

Paul Bisaro

Well, I will attack that question from several parts. First of all, just to be clear, one of the questions that remains as whether or not this is an old rules case or a new rules case under the new MMA guidelines. In the event, you may remember that impacts Teva was first to file on this product potentially, particularly with the first patent. Then their case sort of went away.

So, we also haven't seen any activity out of impacts on their application, and under the new rules, it would be pretty clear that since they didn't get approval in 30 months, that they have waived the 180 days, so that wouldn't be blocking our ability to get approval.

There is some discussion around whether or not, it is an old rules case and whether or not they have abandoned their application and the like, so there is a series of questions now around is there exclusivity, who has it, or has it been lost? That is sort of the first point.

Second point is, on the Citizen's Petition, there is a Citizen's Petition pending. Like any other Citizen's Petition at the agency, since they have so many of them, they really don't pick them up and start thinking about them until they have to.

We believe they are starting to think about this one now, because we have asked them to give us an approval and we will work with them to try to overcome any issues they have with respect to our application and get that application approved, but there is a series of issues that we have to address.

Of course, when the agency does review something in 2004, now being 2009, I think it is fair to assume that they are going to take a look at the application, even though they looked at it once in 2004. So, I don't think they would believe it would be acceptable to sort of go on what they did in 2004. Also, this would be a first approval and so first approvals generally get an extra level of scrutiny. So, there is some issues to work through on this product, but we will continue to fight the good fight here.

Operator

Your next question comes from Corey Davis with Natixis.

Corey Davis - Natixis

First question; Paul, I think last quarter you said being optimistic that an aspirational target for 2010 could show about 10% growth in EPS, but given that you are bringing up your guidance so much right now, do you still think that is achievable?

Paul Bisaro

Well, it depends. When you do these, we don't always do long range forecasting every quarter. When we did the last long range forecast, we did it at the end of last year, and when we looked at the numbers based on the information we had, we were comfortable that we could grow the business on a 10% basis year-over-year.

Depending on how we do this year and depending on market conditions around Micro-K and Toprol and what opportunities may present themselves for 2010, we will have to base our decision on 2010 at the time sort of when we get closer.

However, from an internal perspective, we have been talking and I have been talking about continuing to look for ways to grow the business; a 10% growth rate I think is something that we would like to aspire to, but as you point out, it really does sort of depend on if you have a spectacular year, it is going to be a little hard to grow off of that with the generic business, just the way the generic businesses work. So, it is still an aspiration on our side to have that kind of level growth year-over-year.

Corey Davis - Natixis

Second question; script trends look good on your generic opioid portfolio, and Endo just announced yesterday they saw a big benefit from shortages at I think K-V and [Malancrav]. Did you see a similar type benefit in revenue, and if so, do you think that will continue through, say, Q2 and Q3?

Paul Bisaro

We did pick up some additional business in the, particularly in the hydrocodone area. That was due to some product unavailability shortages really. Some of that was probably related to quota. Some of that was related to disruptions in other products that required people to sort of, I think, change their manufacturing strategy, but nonetheless, we did see some pick up in that category.

We are in a pretty good inventory position and we do expect Q2 to be strong as well, probably leveling out in Q3 and Q4, as people increase their own production capacity. We are very good at manufacturing narcotics. You know that is one of our key strengths and we do that in Corona. The facility works very, very well and we stand ready to fill any hole if one exists.

Corey Davis - Natixis

Was that pick up material or am I thinking too much about this?

Paul Bisaro

I don't think it was certainly not as material as Micro-K, but it was not insignificant, but I wouldn't say it was dramatic.

Operator

Your next question comes from Michael Tong with Wachovia.

Michael Tong - Wachovia Securities

Couple of questions; first one, actually a follow-up on the Concerta situation. When would you know whether it is old rules or new rules and whether you have shared exclusivity on the 129 patent or sole exclusivity on that patent?

Paul Bisaro

Well, if we have shared exclusivity or sole exclusivity, it is probably irrelevant on the 129 patent, because that wouldn't block our ability to get an approval. Regarding the first part of your question, I guess, we will know, depending on what the agency grants us, if they grant us a tentative approval, we will know they think we are blocked by something. If they grant us a final approval, we are not, but we are having discussions with the agency. We are obviously making our opinions known about what we think the situation is and we will try to help them reach the right decision.

Michael Tong - Wachovia Securities

Then you also mentioned that you don't want to be in 40 countries overnight. If you were to name five countries that you want to be overnight in, what would those be?

Paul Bisaro

I would like to be in countries that have obviously a strong generics business, certainly one of the things we will look for in an acquisition partner is a company with a solid base that we can grow from and when we have reviewed countries in the past and as we look at them now, we look to the status of that company in that country. We like to be in the top group in those countries or have a plan to get there and that is the way we think about it.

I don't think there is any particular countries we like to see growth countries, but also perhaps even the more mature countries have added a lot of value lately. As you see the world economic conditions change dramatically, countries that were once thought to be substantial growth countries are now either zero or negative. So, there is value in being in the more established markets with clear defined generic reimbursement programs and distribution channels, because those businesses are more solid in rough economic times.

Michael Tong - Wachovia Securities

Any country you would rather not be in?

Paul Bisaro

No, not particularly. I don't have any. You are trying to get me in trouble here, but no. There is no country where…

Michael Tong - Wachovia Securities

Antarctica.

Paul Bisaro

Yes, we like to have people. That is the key. No, there is nothing that I would think that. We do have an operation in China. We do sell product in China. We are looking to figure out how to maybe grow that business. That can be an interesting market. It is one of the markets that is still expected to have substantial growth. So, we are not really afraid of being in any market. It is just finding the right partner.

Operator

Your next question comes from Randall Stanicky with Goldman Sachs.

Unidentified Analyst

It is actually Bob on for Randall this morning. Just a follow-up question. Obviously the better 2009 looks, that is going to make 2010 growth obviously challenging. Does this increase the sense of urgency around trying to get a deal done in the near-term?

Then just quickly on the branded side, obviously with RAPAFLO out there in the market now, can you give us a sense of early uptake? I know it is early, but just a sense if that is in line with expectations? Then on just pricing and formulary coverage around RAPAFLO too, that would be great. Thanks.

Paul Bisaro

Okay. Well, as to sense of urgency, no. I think we certainly have enough assets to help us grow in 2010, even with all the changes we have talked about. It is hard to know how long Micro-K may last, what Toprol XL will look like through 2010. In fact, then we start thinking about contributions from patent challenges. There is still many possible upsides for 2010. So, I don't feel any sense of urgency to do a deal to cover 2010, if that is the base of the question.

Regarding RAPAFLO, I think as I said, we are encouraged on the product. We have seen some early returns and we have heard some anecdotal evidence from our sales reps and it is encouraging as I said. I think we have positioned the product very, very well. We were at AUA just earlier this week and a number of podium presentations on RAPAFLO. There was quite the buzz. We were the first booth when you walked in.

So, there was a lot of excitement in the urology community about having a new product that as fast acting as this one is. That is something that has been important and remains important for patients and this is by far the fastest acting product on the label claim basis that is out there.

So, we're very excited about RAPAFLO and what it can do, but we also recognize and I have said in the past that this is a growth story. It is going to be a slow ramp, as we fight against Flomax of the world, but it is also a category that once you get a script, you tend to keep it for a very, very long time. So, it will be a compounded growth story year-over-year. So, we are pleased so far there.

Unidentified Analyst

Just on RAPAFLO then, just anything around the pricing strategy compared to the competitors? You mentioned Flomax, just how you guys are approaching that?

Paul Bisaro

When we launched the product, we were sort of at parity with Flomax and UROXATRAL in the marketplace. I think Flomax has perhaps taken a price increase since our launch and we are evaluating sort of the next move on that front. It is not our intention right now to be the market leader in pricing, but we will probably be an aggressive follower.

Operator

Your next question comes from Elliot Wilbur with Needham.

Elliot Wilbur - Needham & Company

First question, just wanted to try and connect a couple of dots in terms of some of the changes to your guidance for the year. I mean it looks like basically the only thing that changed outside of EPS was a $50 million increase in generic product sales, yet we were looking at a pretty nice bump up in EPS. I am just wondering, is it as simple as taking something like Micro-K at 80%, 85% margin and dropping the benefit to the bottom line? Is that essentially the key dynamic behind that?

Paul Bisaro

Well, that is part of it. I mean it is certainly a big part of it, but there is also margin improvement across the line on the generic side with cost improvements, as well as some additional product sales. I would say, Elliot, I think probably a little stronger than expected OCs. Those continue to remain strong.

Everybody always, as you know, has been talking about the demise of the OC franchise for probably the last seven years and still continues to go strong and we expect it to continue to go strong, but those probably are the big contributors. We saw a slight increase, as expected in SG&A due to sales activity around the launch of RAPAFLO and GELNIQUE, but overall, I think you have hit the highlights.

Elliot Wilbur - Needham & Company

Okay. Just to follow-up to that Paul. Outside of the issues at K-V, how much of visibility do you actually have on potential addition competition on Micro-K and sort of what are the best sources of competitive intelligence in terms of trying to figure out who else might be in that market? I assume customer feedback is probably the place where you would hear it first. I am just wondering if there is anything else out there that you can sort of count on to?

Paul Bisaro

Well, I think why you are right. The questions around K-V are a little murky. It is hard to know what is really going on at the moment, but customer feedback has been the principal area that we find for intelligence in this category.

We were just at the NACDS meeting two weeks ago and obviously lots of buzz around Toprol XL and Micro-K and the narcotic products and other products that have been facing sort of shortages. Then of course in our portfolio is the Cardizem LA. Everyone is obviously very excited about that. That could be a pretty significant driver for the second half of the year as well, as we have 180 days of exclusivity on that and right now we don't know of anyone else that is actually even filed on that.

So, there are a couple of things that could move pretty positively for us in the second half. We didn't feel that it was prudent to put a lot of numbers in around the Toprol XL because we just don't frankly know what is going to happen at K-V and Sandoz. So, until we have clarity, it was hard to put more in.

Elliot Wilbur - Needham & Company

Did you give the INFED contribution in the quarter? If you did, I missed that.

Paul Bisaro

No, we don't. We just gave a franchise for the nephrology group.

Elliot Wilbur - Needham & Company

Okay. Roughly 10% of that, is that…?

Paul Bisaro

I think, it is a little higher than that. I think we have said in the past in the high 20s.

Operator

Your next question comes from Scott Hirsch with Credit Suisse.

Scott Hirsch - Credit Suisse

Two questions quickly on gross margin. You mentioned that it was up from the Micro-K and essentially product mix, but can you also give us a sense of what the opportunity is going forward from integrating additional products into Goa?

Paul Bisaro

Well, what we said in the past on this topic is, we haven't given specific percentage numbers, but what we said last quarter was we did about, I believe, somewhere between $20 million and $30 million and we took out of the supply chain costs last year. We expect to do better than that this year and we expect to do even better than that in 2010.

So, as you sort of think about supply chain and the cost of the supply chain, if you add all that up, you can see there is going to be a pretty significant, what we think is pretty significant increase in margin expansion opportunities.

Holding down your margin expansion opportunities are the fact that your prices sometimes come down. So, it is hard to quantify exactly what the percentage increases will be, but I think we are in pretty good shape going forward.

Scott Hirsch - Credit Suisse

Okay and then can you break out how much SG&A was dedicated to the RAPAFLO and GELNIQUE launches?

Paul Bisaro

I don't think we are going to decline to do that. You can see there has been an increase in quarter-over-quarter. I think it is fair to say that a substantial amount of that was directly related to RAPAFLO and GELNIQUE.

Mark Durand

And that is when you exclude, of course, the one-time legal settlement payment of $18 million to Elan.

Scott Hirsch - Credit Suisse

Okay. Actually one more real quickly; McNeil is sort of asking that generics prove partial PK area under the curve for Concerta. Has that ever been asked for before by anyone else, or have you seen that before in any other product?

Paul Bisaro

David, why don't you go for that?

David Buchen

I think there were some discussions on that in connection with bupropion, but that came up post approval and there may be one or two others that are pending at the time. Ambien CR is another one where it was discussed and I think those are the two that come to mind.

Operator

Your next question comes from Rich Silver with Barclays Capital.

Rich Silver - Barclays Capital

Most of my questions have been answered. Just back on the FERRLECIT arbitration, what form of disclosure will that decision come in? Is it something communicated to you and then you just issue a press release, or could there be some other way that it gets out into the public domain?

Paul Bisaro

Well, we anticipate that it will be communicated to Sanofi and ourselves at the same time and then I suspect, at least we will put out a release in due course. Not sure what they are going to do, but that is what we will do. So, we will let people know what the status is going to be as quickly as we can.

Rich Silver - Barclays Capital

Okay and then just back on the gross margin in the quarter and outlook, is it safe to say that despite some of the supply chain initiatives and product mix that Micro-K still makes up the lion's share of that improvement?

Paul Bisaro

I wouldn't say it is the lion's share. I would say it is a portion of it. I think on the overall mix of generic sales of the substance that we had, it is not that big of a contributor to drive gross margins across that many products that high. So, it is really a function of a lot of different things.

Operator

Your next question comes from Ronny Gal with Bernstein.

Ronny Gal - Bernstein

Couple of quick ones; first, Paul, you have mentioned the problems with the INFED and I was wondering if you can just comment more broadly. Are you seeing the FDA being more active on regulatory issues, particularly API, and you can just give us some color on that. What do they actually do? What are they asking that they did not before, and how will that influence the industry?

Second, around both the Adderall and Concerta Citizen's Petition, so forth, if I recollect on the Andrx launch it does have the capability of matching the release profile of a branded product more accurately than some others and I was just wondering if you guys can ask the FDA for approval before the CPs are resolved because you might have a product that adhere to the requirements no matter if the Citizen's Petition is accepted or rejected.

Paul Bisaro

Well, yes. That is always the way you start. I think we will start from the position that our product doesn't run afoul of the Citizen's Petition issue, but even if the agency does, we don't think the Citizen's Petition has merit. So, I think you are right. We will probably start down both of those paths, and that is what our basic argument will be.

As to your question about FDA, I think the FDA has stepped up its activity, particularly in overseas locations, and that will continue to result in some companies perhaps getting into having some issues they have to deal with and unfortunately for our product, this was one of those situations where everything wasn't quite the way it should be and the agency has made us step back a bit and made our raw material suppliers step back a bit and that has affected our INFED supply.

So, it is unfortunate and we will continue to work through that, but as to your general question, I would expect the agency to continue to push pretty hard on foreign inspections. As you may know, the Congress has made foreign inspection legislation one of the priorities that they have, particularly the House, Dingell's bill and others have made foreign inspections a big issue and I would expect the agency to continue to focus resources on doing those kinds of foreign inspections, which could result in disruptions from time to time.

Ronny Gal - Bernstein

Just going back quickly to the Adderall and Concerta Citizen's Petition, you kind of mentioned that you will be making this argument before the FDA that you matched the profile more accurately. Can you tell us a little bit more about the process? Is there, like, an additional documents you guys have to file? Do you know because of added Concerta, is it a little ahead of Adderall XR in terms of resolution and so forth?

Paul Bisaro

No, what you would do is, we sort of send in our arguments to the agency and make them part of our application with respect to in addressing the concerns and the Citizen's Petitions and you would do that for any Citizen's Petition, not just Concerta or Adderall. We have had a considerable amount of experience at Watson dealing with Citizen's Petitions and that is the way we traditionally do it. This is not generally public submissions we generally submit it to our application which keeps them private.

Ronny Gal - Bernstein

Right, but you commented that you have got something to do, this is what you would be arguing. I thought this kind of everything has been with the FDA now for…?

Paul Bisaro

I didn't mean to be that precise. Those arguments are being made and have been made.

Operator

Your next question comes from Caius Christoe with Morgan Stanley.

Caius Christoe - Morgan Stanley

Good morning, guys. Three quick questions for you; firstly, on FERRLECIT; does guidance assume a full year contribution from FERRLECIT, and if you were to lose arbitration, would you have to payback lost sales or profits.

Then secondly, on your OAB franchise, how much pressure did you expect Pfizer's recent launch of Toviaz to have on market share of OXYTROL and future launch of GELNIQUE? Then on RAPAFLO, I am assuming generic Flomax in March 2010. However, we still haven't seen pediatric approval. Is there a chance we could see generics in sort of second half '09?

Paul Bisaro

Okay. Well, let me start with FERRLECIT for the full year. Yes, we have FERRLECIT in our model for the year and if we were unsuccessful in the arbitration, we don't know exactly. It would be up to the arbiters what we would have to pay, if anything, to Sanofi. So, we don't know exactly how that will play out. We hope not to find out frankly.

Caius Christoe - Morgan Stanley

Would it be more likely to be sales post February or just inventory post February?

Paul Bisaro

If you are thinking would there be damages in excess of profits generated from sales, I think that is very, very unlikely. So, it would probably be something along the lines of profit generated by sales from the time that the agreement expired or whatever time they decide it expired to current time.

So, there would be some payback, but, again, it would be up to the arbiters. It could be zero. They could decide that under the terms of the agreement or just under the equity that we don't owe them anything, but I don't expect to see any damage issue.

Caius Christoe - Morgan Stanley

So, there might be sort of up to three and a half months worth of sales or profits you would have to pay back?

Mark Durand

We are not expecting any decision to have an impact on our Q1 financials.

Paul Bisaro

So, no is the answer. Not three and a half months. As to the Toviaz product, it is a new entrant in the OAB category, but we think GELNIQUE is going to be the premier product in the category. It is a once a day gel. It doesn't have the first pass effects that that product does have, so we think we have a better side effect profile, proven substantially better side effect profile.

So, we actually think that we are in a very good position to compete with that beginning in mid-May. There is quite a buzz at the AUA about our GELNIQUE product as well. There were a number of presentations on the product and we were very, very pleased to see the excitement from the urologists.

As to OXYTROL, we do expect OXYTROL to be, I don't know what the right word is, cannibalized maybe is a better word by GELNIQUE. OXYTROL is a patch product that has to be worn for three days and, three to four days actually, and we think that GELNIQUE, we think patients that prefer the patch will probably be very likely to switchover to the GELNIQUE product. So, I guess that, hopefully that answers your question on that front.

Then your question about Flomax, I think Ranbaxy has said that they anticipate a launch of the product in March 2010, and I think that was out of their press release. I don't know what the current status is of the pediatric extension. I think people are assuming they will get it. I guess that would be the most I know about that particular topic. Of course, if it goes generic earlier, that would be good for RAPAFLO.

Operator

Your next question comes from Greg Gilbert with Banc of America.

Greg Gilbert - Banc of America

Paul, could a generic and/or store brand version of Plan B be in the cards for this year?

Paul Bisaro

Greg, as you know, we don't comment on the products that we have in our pipeline. I will say that we are an oral contraceptive provider and that is an oral contraceptive.

Greg Gilbert - Banc of America

Okay. Is there any update to provide on the Lotrel situation, given that that's dragging out slowly and I think you were bound by Teva's future decision on that?

Paul Bisaro

No, I don't think there is any updates on that.

Greg Gilbert - Banc of America

Lastly for Mark, in the other revenue under generics, it ticked up a bit from 4Q levels, not a ton, but can you help us what drove that and should that tick back down going forward? Thanks.

Mark Durand

Yes, we had an adjustment in Q4, so I wouldn't look at that Q4 to Q1 trend as being predictive going forward.

Patty Eisenhaur

Great. Well, Kerry, we will have to conclude the call now. Thank you everyone for participating on today's call and we will be happy to follow-up with you later today if you have additional questions. Thanks again.

Operator

Thank you. That concludes today's teleconference. You may now disconnect.

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Source: Watson Pharmaceuticals, Inc. Q1 2009 Earnings Call Transcript
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