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Executives

Patricia Eisenhaur - Vice President of Investor Relations & Corporate Communications

R. Joyce - Chief Financial Officer, Principal Accounting Officer, Executive Vice President, Corporate Controller and Treasurer

Paul Bisaro - Chief Executive Officer, President and Director

George Wilkinson - Executive Vice President of Global Brands

David Buchen - Executive Vice President, Secretary and General Counsel

Sigurdur Olafsson - Executive Vice President of Global Generics

Analysts

Ken Cacciatore - Cowen and Company, LLC

David Risinger - Morgan Stanley

Ronny Gal - Sanford C. Bernstein & Co., Inc.

David Maris - Credit Agricole Securities (USA) Inc.

John Boris - Citigroup Inc

Michael Faerm - Crédit Suisse AG

Elliot Wilbur - Needham & Company, LLC

Michael Tong - Wells Fargo Securities, LLC

Shibani Malhotra - RBC Capital Markets, LLC

Timothy Chiang - CRT Capital Group LLC

Gregory Gilbert - BofA Merrill Lynch

Christopher Schott - JP Morgan Chase & Co

David Buck - Buckingham Research Group, Inc.

David Amsellem - Piper Jaffray Companies

Marc Goodman - UBS Investment Bank

Watson Pharmaceuticals (WPI) Q2 2011 Earnings Call July 26, 2011 8:30 AM ET

Operator

Good morning. My name is Brandy, and I will be your conference operator today. At this time, I would like to welcome everyone to the Watson Pharmaceuticals Second Quarter Earnings Call. [Operator Instructions] I would now like to turn the call over to Patty Eisenhaur, Vice President, Investor Relations. Please go ahead.

Patricia Eisenhaur

Thank you, Brandy, and good morning, everyone. I'd like to welcome you to Watson's second quarter 2011 earnings conference call.

Earlier this morning, Watson issued a press release reporting its earnings for the second quarter ended June 30, 2011. The press release, together with additional materials reconciling our GAAP and adjusted financial results and forecast, are available on our website at www.watson.com. 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, our President and CEO, who will provide an overview of the second quarter within our Global Generics, Global Brands and Distribution business segments; Todd Joyce, our Chief Financial Officer, who will then provide additional details on the performance of our business segments as well as our consolidated financial results for the quarter. Paul will conclude our presentation with our updated outlook for 2011. We'll then open the call up for questions and answers.

Also on the call and available during Q&A session are Siggi Olafsson, Executive Vice President of our Global Generics division; Fred Wilkinson, Executive Vice President of Global Brands; Al Paonessa, Executive Vice President and Chief Operating Officer of our ANDA Distribution division; Bob Stewart, Executive Vice President of Global Operations; and David Buchen, our Executive Vice President, General Counsel and Secretary.

Please note that today’s call is copyrighted material of Watson Pharmaceuticals, Inc. and cannot be rebroadcast without the company’s expressed written consent.

I’d 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's 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, the Watson Form 10-K for the period ended December 31, 2010, and Form 10-Q for the period ended March 31, 2011.

With that, I'll turn the call over to Paul.

Paul Bisaro

Thanks, Patty, and good morning, everyone, and thanks for joining us today. Watson reached a new milestone in the second quarter, reporting a record $1.1 billion in net revenues, a 24% increase over last year. While all 3 of our business segments, Global Generics, Global Brands and ANDA distribution performed well in the quarter, Global Generics was particularly strong with revenue increasing 39%. The launch of the generic version of Concerta was the main driver for revenue and earnings in the second quarter, and generic Concerta will become even more significant in the second half of 2011 and into next year.

Non-GAAP net income also increased 24%, resulting in record earnings of $1.01 per share, and adjusted EBITDA came in at $243 million, increasing 17%.

We achieved these results while continuing to invest heavily in R&D sales and marketing. Spending for research and development increased 30% as we continued to invest globally to grow our Global Generics and Global Brand businesses. Spending on sales and marketing was up 26%, and reflects our investment to grow sales internationally and our commitment to grow our U.S. brand presence to our target audiences.

Now I would like to highlight a few of our accomplishments for the quarter. We launched generic Concerta in May and generic substitution was faster than expected in the second quarter. We ended the quarter with a market share of roughly 73%. Since the end of the quarter, market share has continued to increase and is now slightly above 75%. Remember that Concerta does have seasonality associated with it. And therefore, we expect overall prescription trends for the product to decline in the third quarter with a return to second quarter levels in the fourth quarter.

Overall, we're extremely pleased with the launch, and we believe that generic Concerta will be a significant long-term driver of Watson's profitability.

Also we are very pleased that we completed the acquisition of Specifar Pharmaceuticals during the quarter. Specifar is a profitable, successful company with a third-party development business and significant R&D, manufacturing and regulatory expertise. Specifar has a strong portfolio of approved products and dossiers on file in over 36 countries. This will provide Watson with more internally manufactured products for our global markets, resulting in more competitive product offerings and higher profitability for our international businesses over the long term.

The integration of Specifar is already underway. Our teams are making excellent progress, and we have already seen benefits in R&D, portfolio management and regulatory affairs. Specifar has also signed numerous additional business agreements with third parties since the close of the acquisition, demonstrating the ability of this business to continue to thrive as part of Watson.

In the U.S., we launched 6 new generic products and announced 7 new patent challenges during the quarter. Internationally, we launched 14 new products this quarter in Europe and 5 new products in Canada, including Next Choice, our emergency contraceptive product. We have more than 130 ANDAs on file in the U.S., with approximately 34% of them either first to file or shared exclusive opportunities and an additional 600 applications internationally.

In our Global Brands business, we announced that the FDA-accepted Columbia's new drug application for PROCHIEVE for the prevention of preterm birth and women with a short cervix. The PDUFA date is February 26, 2012.

We also launched a new low-estrogen oral contraceptive, Generess Fe. And shortly after the close of the quarter, we expanded our brand pipeline through an exclusive licensing agreement with Antares to commercialize their topical oxybutynin gel product in the U.S. and Canada. This licensing agreement is a great example of the ways we will look to supplement our growing brand business portfolio.

Lastly, we continue to experience strong growth in RAPAFLO, with sales up 15% quarter-over-quarter.

Finally, Watson remains in excellent financial condition with $234 million of cash and marketable securities at the end of the quarter, and our debt-to-adjusted EBITDA ratio remains low at 1.4x.

With that, I'll turn the call over to Todd who will provide some additional color on the financial results.

R. Joyce

Thanks, Paul. I will now review our results on a consolidated and divisional basis. Net revenues for the second quarter were $1.1 billion, an increase of 24% over the prior-year period, reflecting strong growth in product sales in both our Global Generics and Global Brands divisions.

Net revenues for Global Generics were $792 million, up 39% on a year-over-year basis, primarily due to the launch of generic Concerta. Sales of extended-release products, which include generic Concerta, were $380.1 million, up 138% year-over-year. Sales of oral contraceptives were in line with the prior-year quarter at $96.3 million. And sales of new products were offset by erosion in our base OC franchise.

X-U.S., net revenues were $119.2 million, compared to $110.5 million in the second quarter of last year. This increase was due to the acquisition of Specifar. Adjusted gross margin for the Generic division was 45.2%, 3.4 percentage points lower than last year, primarily as a result of the launch of generic Concerta. Under the terms of our agreement with J&J, Watson's share of gross profit on this product will increase each quarter through the rest of 2011 and into early 2012.

Moving to the Global Brands division. Net revenues were $112.9 million, up 9%. This reflects a 20% increase in product sales in the quarter driven by the addition of new products including CRINONE and Generess Fe and higher sales of RAPAFLO. Global Brands' other revenue decreased $5.7 million to $20.9 million as the prior-year period was favorably impacted by the out-licensing of 2 legacy brand products. Global Brands' adjusted gross margin was 77.8%, up 60 basis points year-over-year. We expect brand margins to remain close to this level for the rest of the year.

Finally net revenues from our ANDA Distribution division were $176.4 million, down 12% from the prior-year period as a result of lower sales from third-party product launches. Distribution adjusted gross margin for the quarter was 15.4%, down slightly from last year.

Turning now to operating expenses. Consolidated R&D for the second quarter was $80.5 million, up 30% year-over-year as a result of increased development spending in both our generic and brand businesses. For the full year, we expect R&D spending on a GAAP basis to be in the range of $300 million to $320 million. On a non-GAAP basis, R&D spending in the second half of 2011 will be slightly below first half levels.

SG&A for the second quarter was $187.5 million, an increase of $30.9 million. This includes $6 million in costs associated with the acquisition of Specifar, which has been excluded from our non-GAAP results. This increase also reflects higher brand selling costs in support of the launch of Generess Fe and higher international SG&A in our Global Generics business, which includes the addition of Specifar.

For the full year, we expect SG&A expenses on a GAAP basis to be in the range of $700 million to $725 million. On a non-GAAP basis, we expect SG&A expenses to be slightly higher than second quarter levels due to increased international SG&A spending with the addition of Specifar and higher legal costs associated with our generic product development program.

Amortization for the second quarter was $74.6 million, up from $56.6 million in the first quarter reflecting accelerated amortization of our Nulecit product rights due to unfavorable market conditions, amortization of newly launched products within our international generics business and amortization of intangible assets acquired as part of the acquisition of Specifar. For the full year 2011, we now expect amortization expense to be approximately $320 million.

On a non-GAAP basis, our income tax rate was 35.7% in the second quarter, down from 37.5% in the prior-year period. Our income tax rate on a GAAP basis was 45.2%. Our GAAP tax rate was negatively impacted by amortization of foreign intangibles at a tax rate lower than the U.S. rate and by certain foreign losses for which no tax benefit has been recognized.

On a non-GAAP basis, which excludes amortization and impairment charges and other charges as detailed in Table 4 of our earnings press release, earnings for the second quarter were $1.01 per share, up 22% from $0.83 per share last year. GAAP earnings for the quarter were $0.42 per share. Our adjusted EBITDA for the second quarter was $243 million, a 17% increase.

Cash from operations -- cash flow from operations was $60 million for the quarter, and cash and marketable securities were $234 million at June 30. Cash flow for the second quarter was impacted by $128 million in tax payments, consisting primarily of U.S. federal and state estimated tax payments for the first and second quarter.

Accounts receivable increased $292 million on a sequential quarter basis, due primarily to the May launch of generic Concerta. Payment terms on sales of our U.S. generic products are approximately 65 days. Accounts receivable also increased as a result of the acquisition of Specifar. Our DSO at the end of the second quarter was 69 days. We expect our DSO to return to normal levels in the range of 55 to 60 days during the third quarter.

We remain well positioned financially following the acquisition of Specifar with a debt-to-adjusted EBITDA ratio of 1.4x. Our financial position affords Watson the ability to continue to capitalize on investment opportunities to further grow our businesses.

With that, I'll turn the call back over to Paul for an update on our 2011 forecast and concluding remarks.

Paul Bisaro

Thanks, Todd. Now I'd like to provide you with an update of our 2011 forecast, which includes the results from our acquisition of Specifar Pharmaceuticals as of the acquisition date of May 25.

Our estimate for full year net revenue is now approximately $4.5 billion, up from $4.2 billion. We now expect our Global Generics segment revenue to increase to between $3.1 billion and $3.3 billion.

Turning to the assumptions for our U.S. Generics business. We continue to assume we will see some additional competition on our generic Toprol in the fourth quarter and our generic oral contraceptive franchise throughout the remainder of 2011.

Just as a reminder, our forecast does not assume any competition on generic Concerta in 2011. Our U.S. generics forecast includes contribution from new launches, the most significant of which will be generic LIPITOR in the fourth quarter.

On the brands side of the business, we continue to expect net revenue between $445 million and $465 million for the year, and we now have removed any contribution from PROCHIEVE until 2012.

With the ANDA Distribution business, we continue to anticipate revenue to be between $770 million and $800 million. Recall that ANDA has experienced fewer than expected third-party launches this year. And as a reminder, ANDA's reported results do not include the sale of Watson products.

We now expect adjusted EBITDA of between $1.025 billion and $1.075 billion, and we also increased non-GAAP EPS to reflect the acquisition of Specifar and better-than-expected results for the remainder of our businesses. So now we expect non-GAAP earnings per share to be in the range of $4.25 and $4.50 per share. Specifar accounts for approximately half of the increase in the non-GAAP earnings per share forecast.

While we typically do not provide a quarterly forecast, I would like to provide some directional guidance on the second half of 2011. We expect the results in the third quarter to look somewhat similar to the second quarter and the fourth quarter to be higher than the third quarter and be our most profitable quarter for the year.

In summary, today we reported strong financial results in the second quarter, producing record revenue and earnings generation. And I am extremely confident Watson's businesses will continue to grow and evolve to meet or exceed our growth objectives for 2011 and beyond.

As always, I would like to thank our employees for their hard work and the role they play everyday in the future growth of our global businesses. With that, we'll open it up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of John Boris with Citi.

John Boris - Citigroup Inc

First question. I think you disclosed the sustained release sales were about $380 million. Can you potentially let us know what Concerta's contribution was within that overall amount?

Paul Bisaro

Well, John, I would have been disappointed if nobody asked that question. But as you know, we don't separate out our product sales. So we're not going to be doing that here either. It was obviously a very significant contributor for the quarter.

John Boris - Citigroup Inc

Okay. And then on gross margin, at least for the quarter, they were certainly under what we were projecting. Obviously, Concerta had an impact there. Can you maybe just provide some color, either you or Todd, on the progression of the gross margins as we move into the back half?

R. Joyce

Yes, the back half will be stronger in terms of Concerta contribution to the -- or the impact of the Concerta sales in the second half will be less than the Q2 levels because we'll have an escalating gross margin throughout this year and into early next year.

John Boris - Citigroup Inc

Great. Thanks for that. And then just lastly on the Specifar revenue contribution, can you just quantify what that was?

Paul Bisaro

That was in the range of between $60 million and $70 million. I'm sorry, that will be for the year, sorry.

John Boris - Citigroup Inc

For the year. For the quarter?

Paul Bisaro

It was a very small amount.

Operator

Your next question comes from the line of David Risinger with Morgan Stanley.

David Risinger - Morgan Stanley

I have 2 questions. The first is with respect to Concerta inventory stocking, could you frame that for us? On the one hand, it would seem logical that there would be a lot of inventory stocking, but on the other hand, you appear to have a lower incentive to stock because cost of goods declines over time. And in addition, Paul, I think you mentioned that Concerta's sales would remain strong going forward, although there's some seasonality to be aware of. And then second, Siggi, if you could please discuss organic growth at U.S. in the second quarter and prospects for organic growth in the second half of the year?

Sigurdur Olafsson

Yes. So it's Siggi here. On the Concerta stocking, I think you all saw that the market reacted quite well. Our generic penetration was quite strong and much stronger than was experienced with Metroprolol XR [ph]. As we mentioned in the beginning, there is a part of it, the stocking, that happens always when you launch a new product. And we probably experienced in the beginning a little bit more stocking due to the experience that the market has with other ADHD products. But overall, it's not unusual for a product like that. So we saw some stocking in the quarter, but we don't think it will affect our future quarter for Concerta going forward. I think on the growth outside of the U.S., as we mentioned before, the international growth will maybe be through the Specifar acquisition. Both the third-party business is doing well and the Greek business is also doing quite well. We estimated that Europe would be flat this year. They remained on the revenue line. The main reason being that we have been pruning quite a lot of the portfolio to focus on the bottom line in Europe. It's important thing to do once in a while to look at the bottom line and see, so we are aiming for a flat revenue line in Europe. But we have seen some revenue growth in Canada on the other hand. So I think mixed growth due to Specifar, flat due to Europe, but also some growth in Canada this year.

David Risinger - Morgan Stanley

And just to clarify, the European growth you're talking about, you're saying flat. Is that including Specifar, flat, or before Specifar, Europe is flat?

Sigurdur Olafsson

Before Specifar. Specifar will give growth to Europe going forward.

Operator

Your next question comes from the line of Chris Schott with JP Morgan.

Christopher Schott - JP Morgan Chase & Co

Just had 2 questions. The first was on SG&A. Can you just elaborate a little bit more on the SG&A trend for the remainder of the year? Seems like we had a decent step-up in expenses this quarter. I know you're adding Specifar, but can you just begin to talk a little bit about what's driving that ongoing bump in SG&A going forward? And then the second question with regards to Specifar, the integration and just -- can you just comment a little bit more on your priorities for business development in Europe right now? Where are you guys looking? What is kind of your kind of the top of the list in terms of where you'd like to go?

Paul Bisaro

Okay. Well, let me start on the SG&A and then I'll turn it over to Todd. One of the things that -- ways to grow your business, 3 ways to really grow our business as we look at it. We can do mergers and acquisitions, do outside growth and drive growth that way. We can drive growth organically through higher R&D spending, which we have done in the quarter and which we will continue to do throughout the remainder of the year. And the third thing we can do is invest in sales and marketing. And we have chosen to do that, not just in the U.S. side by putting more sales reps on the ground and continuing to drive the value of our brand franchise in the U.S., but we've also spent more money in our international businesses to help drive sales in those markets. So that's the general reason for the increase in SG&A, is that investment in the sales and marketing line across our company.

R. Joyce

So in terms of the guidance for the year, we've taken up our guidance, $50 million for SG&A for 2011. About 1/2 of that increase relates to Specifar and that includes the $6 million of costs that we incurred in -- the acquisition costs that we incurred in the second quarter. We'll probably -- we'll have some modest amounts of additional integration costs as we go into Q3 and Q4. The remaining $25 million increase in SG&A is the expansion of our brand business in Canada. As Paul mentioned, higher international generic spending. We've also got some slight increases in distribution spending as well. So that accounts for the remaining $25 million increase in guidance.

Paul Bisaro

And then Chris, I think, you asked about sort of business development opportunities that we're looking at. We continue to be very aggressive in what we're looking at. We're looking at things around the globe. The challenge is finding the right kind of opportunity. I mean, Specifar is a great example of finding the right opportunity and then being in a position to act on it quickly. Thankfully, we're in a great position to be able to do that. But finding the right opportunity always takes time. And we continue to look in Europe. We'll continue to look in South America. We've looked in Canada, Australia, all of our markets to see if there's a way to increase our presence in those markets. Probably the one exception is the U.S. generics business. Our business is very strong here. Short of looking for something, maybe a different delivery platform, there really isn't a lot of incentive for us to go out and acquire generic companies in the U.S. But other than that, everything else is on the table, including brand opportunities.

Christopher Schott - JP Morgan Chase & Co

And can I just add a quick follow-up to that? Does your Specifar acquisition and the capabilities and the manufacturing you acquired with that company, does that change any of your priorities of what you would look at in Europe? Things that maybe were not as attractive before, with Specifar now are a bit more attractive? Or does that really not change anything?

Paul Bisaro

I don't think it changes it very much. Specifar was a tactical acquisition to increase our internally developed manufactured products. Clearly, the value in all of the -- in-licensing is a big part of the opportunity in Europe and everybody has every product. And the more products they manufacture, the more profitable they are. And so Specifar really went a long way in helping us achieve higher profitability within the countries that we're operating. We'll continue to be very aggressive on the in-licensing front and that's a business development function. But Specifar gives us that base. It also opens up the opportunity to be more commercial, moving maybe into other markets because they have existing applications that would complement the applications that we have from the Arrow acquisition in some markets that we're currently not commercializing. So it does help us, but it doesn't change our overall focus all that much.

Operator

Your next question comes from the line of Marc Goodman with UBS.

Marc Goodman - UBS Investment Bank

Could you give us an update on the couple of cases like the Nexium patent case in Europe? What's happening there and when are you guys going to start to monetize that? And then what are your thoughts on Lidoderm? Obviously, there was a ruling there. And then on Mucinex, what's happening with that?

Paul Bisaro

Well, I'll start and let David jump in and help me out here. On the generic Nexium in Europe, we're just moving forward with the application. We hope to have Specifar get its approval by the end of the year or late this year. In which case, assuming everything continues to go forward -- and by the way, that would be in France, I believe, is the first market that we expect the approval, we will launch. David, is there any other update on the patent piece?

David Buchen

No. I think everybody's aware that the [indiscernible] patent was invalidated by the EPO and the latest on the trihydrate patent is just that there was hearing on an injunction -- a request for injunction by us was denied. That's really [ph] the latest on the Esomeprazole front. With respect to Lidoderm, we've got a favorable market hearing. We'd like to claim interpretation and so we will continue to press that going forward. And then on Mucinex, the Court of Appeal ruled as everybody, I think, saw. The judgment was affirmed and so we're just now waiting for the FDA to take action on our application. It's been pending for about 30 months.

Marc Goodman - UBS Investment Bank

So Paul, does that mean you're expecting Mucinex pretty soon? I mean, pending 30 months, that's even longer than the 25 or 26 months that's average these days?

Paul Bisaro

I'm not sure what the average is anymore, but it may be more than 30 months on the average. Unfortunately, Marc, the hardest thing we do now is try to predict when approvals are going to come and we're working diligently to get that application approved.

Marc Goodman - UBS Investment Bank

And then just back on Nexium for a sec, just to try to understand, so it's approved in France first and then you launched in France? Or is that for all of Europe?

Sigurdur Olafsson

Let me take it. It's Siggi here. So we are doing it through a decentralized procedure and also through a national procedure. Our strategy was first to launch in France, but then all over Europe in all the European market, following the French launch.

Operator

Your next question comes from the line of Greg Gilbert with Merrill Lynch.

Gregory Gilbert - BofA Merrill Lynch

I'm just trying to straighten up some concern on modeling stuff first. Paul, you commented on prescriptions and seasonality of those where Siggi, I think, talked about de-stocking not effecting sales. So can you just kind of straighten us out on what you expect for sales of Concerta directionally over the next few quarters? We're going to go ahead and assume that all the growth from 1Q to 2Q in ER was Concerta.

Paul Bisaro

Well, let's see if I can help you. I mean, on the seasonality, of course, in the summertime, kids take a drug holiday in this category. So there is a general decline in total prescriptions. We probably will not be -- our Concerta contribution won't be affected for 2 reasons: One, we'll continue to grow our market share. And two, our royalty, our percentage of the gross profit increases. So our contribution from Concerta will be flat roughly the same quarter-over-quarter, okay? But total revenue from Concerta should be down second quarter -- sorry, third quarter as the second quarter and then back up in the fourth quarter.

Gregory Gilbert - BofA Merrill Lynch

Okay, fair enough, and then my other question, Paul, I was going to ask you to comment on any specific impact to Watson on the Medco expressed field that's at least proposed at a higher level, what you think it means for the generic industry, if anything?

Paul Bisaro

Yes. Well, first of all, both Express Scripts and Medco are good customers of ours and we certainly appreciate their business and we never like to see a customer go away. But the combination of the 2 account for about 3% of our revenue, 3% to 4% of our revenue. So they're not a big contributor to our total revenue. But we'll look forward to working with the combined company going forward. As to concerns, I think I'm sure I'm not the only person to say this, I think we're all a little concerned as companies get bigger and bigger, that market power and the leverage that they have is somewhat concerning. But on the other hand they can be even a better customer for us. So I guess we'll just have to wait and see what ultimately comes of this. It'll be interesting to see what the FTC's position is on this merger.

Operator

Your next question comes from the line of Tim Chiang with CRT Capital.

Timothy Chiang - CRT Capital Group LLC

Maybe you could comment a little bit about the base business x Concerta? How are things holding up in Toprol XL, Micro K? What sort of assumptions are you guys making for pricing in the U.S. in our business? Is it actually holding up better than you thought early this year?

Paul Bisaro

Yes, well on the base business, I mean, it continues to be strong. We continue to benefit from some of the missteps of some of our competitors and that has meant that our base business continues to perform quite well. Regarding sort of the big products, Metoprolol and Micro K and the like, we have seen a reduction in Micro K, as you would expect, as additional competition is on the horizon. And people are reacting, we're reacting to the price in the marketplace. But Metoprolol has been strong and remains strong in the basic, on a quarter-over-quarter basis -- I'm sorry on a year-over-year basis, I think, Metoprolol was even up again. And then I think you asked about pricing. I guess, pricing on the base business again you got to separate out some of their outliers like Micro K and the like, but if you separate those out, the base business pricing continues to be stronger than expected. Our erosion is not in the high single digits anymore. It's more on the mid-to low single digits. In fact, in some cases, we've actually even taken price on products where we were underwater on the margins, we were able to take price up and those prices have stuck. So a little bit of a new pricing environment out there. Some of that is due to again the missteps of some of our competitors. But in the most part, I think people are being pretty careful about what they do with price.

Timothy Chiang - CRT Capital Group LLC

Well, just want to follow up. I think there's an FDA advisory tunnel meeting today on neurotherapeutic and strokes and bioequivalents. I mean how close are you paying attention to this? It seems like the FDA is thinking about it, maybe even what the panel is going to discuss potentially even tighter standards for some of these products?

Paul Bisaro

Well, this is an ongoing debate and has been an ongoing debate since [indiscernible] launched back in the mid-90s. We continue, as a company and as a generic trade association, to argue against additional standards, additional tighter scrutiny for neurotherapeutic index drugs. All the clinical studies that have ever been performed on generic drugs show that there is no clinical difference between these kinds of drugs, notwithstanding the anecdotal evidence that people keep coming up with. So yes, Tim, we're engaged in this process and we'll continue to be very active in voicing that issue. Again it's -- anecdotally, everybody talks about this stuff, but when you really look at the data, there is no difference. So we'll continue to fight it.

Operator

Your next question comes from the line of Elliot Wilbur with Needham & Company.

Elliot Wilbur - Needham & Company, LLC

Just one follow-up question on Methylin ER sales. Paul, I think the expectation is that eventually the margins will converge to something close to Watson's segment, generic segment margins overall. Can you just remind us if that's a timeline-specific step up in margin or there's some other thresholds that trigger that? And then is there any -- is it sort of a gradual step quarter-to-quarter-to-quarter or is there any kind of large onetime? And then a follow-up question, I guess, for Todd, and just kind of working through some of the changes in overall guidance parameters and thinking about the $75 million upward adjustment in EBITDA, I come up with an EPS impact associated with that of about $0.40, kind of using a 35.5% tax rate or so. So I'm wondering is that just maybe you guys being a little bit conservative, keeping a few extra pennies in the pockets for just in case? Or is there something in the tax or kind of below pretax line that I might not just be thinking of?

Paul Bisaro

Elliot, I think it just shows we need a lower tax rate. But regarding the Concerta, it's time based, the step-up is time based and it's gradual. So hopefully that covers it. And Todd, I'll let you...

Paul Bisaro

I think we've provided the details and the reconciliation table to show the difference between earnings and adjusted EBITDA. I think the best we can provide you is that reconciliation.

Operator

Your next question comes from the line of Michael Faerm with Crédit Suisse.

Michael Faerm - Crédit Suisse AG

I have 2 questions, first is on R&D. Your R&D expense was up about 35%, non-GAAP this quarter and that compares, I think, your comments in the past of expecting around 10% to 12%, I'm just wondering what were sort of the primary drivers of that? Are they sort of temporary factors or what extent are they more durable? And secondly on the new launches of Generess and Ella, Could you comment on how those launches are going and to the extent you could quantify that, that would be helpful. And also to what extent are the IMS volumes indicative of the real progress of those launches?

Paul Bisaro

Well, let me handle the R&D and then I'll turn it over to Fred for the brand questions. Michael, I think you're going to see us continue to spend heavily in R&D on the generic front. Some of that spending is now the result of products that are probably -- that cost more, basically, to develop. Things that require clinical endpoint studies, products like respiratory products. These are more expensive to develop by states and are more costly than say the more traditional generic product. So you're going to see us spend more on the generic R&D front because of that. On the brand side, remember we included in our brand business not just the small molecule development efforts, but also our biologic development efforts. And as our FSH product continues to advance through the clinic, you're going to see more and more spending there. So we're in a good position to be able to invest and reinvest some of the profits that we're generating from across all of our business segments. And as I mentioned earlier, there's 3 ways to grow your business, and we're going to do -- use all means necessary to grow our business going forward and R&D spending is going to be one of them.

George Wilkinson

So regarding the Generess launch, we're 5 weeks into the launch, so you've seen 5 weeks worth of data and the reminder is in the marketplace for generally the physicians to give significant samples to start the process. So we're pleased with the growth that's going on in the prescription segment that we can see, but I think we're even more pleased with the response that we've had on the pull-out of examples, the cards that are being used and just the general reaction of products. It's nice to position as the 25 mcg OC, right in between the 20 mcg and 30 mcg. I think we can see some nice uptick. Prescriptions, probably start paying attention to them in September when we're through with the real slug of samples that have been distributed.

Michael Faerm - Crédit Suisse AG

And could you comment on ella?

George Wilkinson

Yes, so ella, prescription trends are not a terrific indicator because we're participating in 2 other segments with Planned Parenthood and also through the mail order or the online pharmacy segment. Both of those businesses are going okay. Planned Parenthood has been a bit distracted with some other things and they've not adopted some of the programs as aggressively as we had hoped. But we're still looking [ph] at the product reasonably high.

Operator

Your next question comes from the line of David Amsellem with Piper Jaffray.

David Amsellem - Piper Jaffray Companies

Just a couple, longer-term question on Concerta. I know your 2013 EPS growth targets reflect another generic entrance, but given that we haven't seen any FDA movement on any of the generic at/or all XR filings and how realistic is it to expect the agency to act on any of the Concerta ANDAs by then?

Paul Bisaro

David, I don't know is the answer. The agency has -- is a bit overwhelmed with all the stuff they've got to do. They're woefully underfunded as we know and as a generic trade association, we've been working hard to work on a basically a PDUFA-like program to get them more funding. That funding probably won't kick in until -- we won't see the benefit of that funding probably until 2013. 2012 would be maybe the first year that they would see any money. But it's almost impossible to predict how long it's going to take the agency to get through complicated issues now with the staff that they have and the level of funding they have. And frankly, it's not encouraging to see the government and the federal budget talks where they are and because more funding cuts of the FDA means slower and slower decisions. So I can't predict when they're going to get to these questions around partially you see and the like. But you got to assume that they'll eventually get to them. I just don't know when.

David Amsellem - Piper Jaffray Companies

All right. And then a question on business development. Bearing in mind that your debt to EBITDA is a good bit lower than your peers, how high would you theoretically want to take the debt to EBITDA up to in order to get an acquisition done?

Paul Bisaro

Well, we've talked a lot about this, we've been asked this question a number of times and what we've told the investors and what we've told our rating agencies is that our target number is somewhere around 3.5x and that would include, of course, any EBITDA contribution from the target, so we have a lot of headroom. It's not as much the willingness to spend because we are willing to go out and invest in acquisitions. It's finding the right acquisition. That is really what takes the longest time. So we're careful about how we spend money, but we do have a lot of headroom and we continue to look.

Operator

Your next question comes from the line of Ken Cacciatore with Cowen & Company.

Ken Cacciatore - Cowen and Company, LLC

Questions for Fred first. Fred, can you talk a little bit about what's going on in the physician community for OB GYNE, so maybe ACOG, in terms of guidelines around PROCHIEVE and the data that you had? Could you give us any thoughts of what they're thinking and maybe if they're -- if maybe ACOG is looking to change the guidelines? And then a follow-up question for Paul.

George Wilkinson

Yes, so there's been an enormous amount of work in this area. Obviously, this is a critical issue for us since successfully marketing PROCHIEVE. There has been a lot of meetings between both the national and the local ACOG chapters. It appears that ACOG and the Maternal-Fetal Medicine group will probably come together and create a guideline. We're hearing guidelines established somewhere between mid-fourth quarter and as late as February. But they seem to be coming to a general consensus that there's enough evidence that routine cervical screening should be a standard of care. And then they go into a series of different directions as to what to do after you do screening. And in our minds, that's exactly where we want them to go. We'll go fight it out in the marketplace as to what to do afterwards, but cervical screening is a critical issue. There seems to be a lot of noise. I mean, there's 2 editorials that we're in -- recent publications outlining the economic advantages and the benefit of doing cervical screen and then using some form of progesterone. So we're in the right spot and progressing the ball nicely.

Ken Cacciatore - Cowen and Company, LLC

Paul, on Lidoderm, did you guys share any terms with each other? Understanding you said you're going to push maybe the next legal step, but has anyone kind of swapped ideas here in terms of settlement?

Paul Bisaro

Ken, we don't, obviously, disclose discussions. We continue to move forward with our case aggressively. As you know, we're expanding our manufacturing operation out in Salt Lake City to be ready to manufacture the drug as early as possible. In fact, as early as late next year, which is when our 30-months day expires -- I'm sorry, mid next year. So we are moving at all fronts and we're always prepared to sit down and chat about stuff, but we'll keep that to ourselves.

Operator

Your next question comes from the line of Shibani Malhotra with RBC Capital Markets.

Shibani Malhotra - RBC Capital Markets, LLC

First one on PROCHIEVE. Paul, are you expecting a panel for the product? And if so, what do you think that the FDA would be looking to discuss at a panel? And then my second question on Lidoderm, could the Markman decision went in your favor, but can you talk about the regulatory standpoint? Why are you still confident -- why are you so confident that you will be able to get the product approved on time? And how does your opinion get influenced by the FDA comments on water and gel and the fact that we haven't seen a generic on that to date?

George Wilkinson

Yes, this is Fred Wilkinson. Let me address that panel issue for PROCHIEVE. It's unclear whether there will be a panel. I think by moving the PDUFA date to February 26th, they've left room to be able to conduct the panel. They have now published the panel dates for the rest of the year so there's a panel date that is set for the 8th and 9th of December that would be an appropriate time if they wanted to do it. We've gotten no communication that a panel is going to be requested. We are preparing for it. And I think generally with indications as high profile as this, they're probably just going to have to see evidence in front of the panel and ask for a vote on the results of the trial. Not unexpected, and we're prepared for it.

Paul Bisaro

And then Shibani, I think you asked about Lidoderm. Well, first of all, remember patent cases are inherently unpredictable. Notwithstanding a good hearing result, you have to remember that it's up to the judge and things can always change. So it's an argument we've had with the FTC on this matter a lot. It's that you can't guarantee anything. But we are preparing for success and as that process goes forward, the preparations go forward. We look at things like the citizen's petition that's been issued, and I think you've heard me say this before that we believe the citizen's petition in this case has already been answered by the FDA. The arguments that were made in the first citizen's petition that was filed by Endo are basically the same arguments they made in the second petition. The FDA modified Lidoderm guidance, and we follow the new guidance. So I think that issue is resolved. That's our position, and that's why we're so confident about it. We also know what the status of our FDA application is and how it's moving through the process. And we're preparing for approval and we're building significant capacity.

Shibani Malhotra - RBC Capital Markets, LLC

Can I ask a quick follow-up, just on guidance for '12. I mean one of the things you did earlier this year is give '12 as a percentage of '11, a percentage increase. Now that you've increased '11 as much as you have, does that spill through to '12?

Paul Bisaro

I think we're going to hold on giving guidance for '12 until we get through the year and stick with our convention of giving guidance at the beginning of '12 for '12. Things change. We did tell you that, that percentage growth at the time did not include any acquisitions. So you guys will have to kind of do your own math on that.

Operator

Your next question comes from the line of David Buck with Buckingham Research.

David Buck - Buckingham Research Group, Inc.

Just wanted to ask you a quick follow-up on Lidoderm, I guess, for David, have you filed this quarter, you're about to file the motion for summary judgment in that case. And for Siggi, on international generics, can you talk a little bit about the environment there in terms of pricing versus expectations? You also mentioned you're pruning some products, was that a normal planned process? Or was that in response to what the pricing environment was? And then just a follow-up I have for Todd on cash flow.

David Buchen

So on Lidoderm, we have not file for summary judgment at this point. We're still in discovery. Typically, of course, don't want you to file those motions before discovery period ends. We're just wrapping up that discovery and then we'll have expert reports into the fall. So we'll evaluate the right timing once we get through the discovery process.

Sigurdur Olafsson

I think on the European environment, obviously, pricing is a big issue. Overall, it's our expectation, I think, we announced on our last call that we estimate a low or high single-digit, low double-digit to around 10% price erosion in the market. It's a little bit higher in the U.K., around that in France. It's probably in line with what we expected. I think that pruning is something that we do regularly, but we looked more carefully into it this time around because we acquired the business 2 years ago with a portfolio, and with the new pricing environment, there has been a significant pricing erosion over the last 3 to 5 years. You have to look carefully into it. But also at the same time, as Paul mentioned in his introductory talk, we have a significant number of products on file and we have launched 14 new products in Europe as of this year. So it's the renewal of the portfolio that allows us to do more significant pruning than we would otherwise do. So I think the R&D spending we are working on, the international R&D is coming up, allows us to take these actions to look at the bottom line in each of the markets.

David Buck - Buckingham Research Group, Inc.

And just for Todd, a quick question on cash flow. You mentioned Concerta were one of the reasons why cash from operations was only $16 million and the rise in receivables. Should we be expecting something similar to be happening for LIPITOR? And can you remind us what the cash flow impact of that launch will be say in fourth quarter and into 2012?

R. Joyce

Sure, we'll have the same impact of LIPITOR in the fourth quarter, although we only have roughly 1 month as opposed to almost 2 months with generic Concerta, but it'll be a similar situation in that we will not collect any of the receivables for generic LIPITOR in the fourth quarter.

Operator

Your next question comes from the line of David Maris with CLSA.

David Maris - Credit Agricole Securities (USA) Inc.

A couple of questions. First, what's the difference between $4.25 and $4.50 and the $0.25. In other words, what has to happen for you to get to the $4.50? And then I have a follow-up.

Paul Bisaro

Well, I think as you can imagine, it depends on the big products and the competition that we see and the pricing we see for those big products. In short, things like Metoprolol. I think you've all heard me say this before, if Metoprolol remains kind of where it's at, we should be very good. If not, we'll have to adjust our expectations downward. So it's really a question of what happens to the pricing of some of the major products.

David Maris - Credit Agricole Securities (USA) Inc.

When you say you have to adjust it downwards, you mean it would still be inclusive in that range, it just would fall in the lower end? Or no -- 1 or 2 of these go the wrong way and you'd have to revisit the entire guidance?

R. Joyce

Well, I mean, we feel pretty comfortable at the lower end of our range that we're not going to have to move that. But like anything else, bad things could happen, but we're not expecting that to occur. So we're pretty confident with the low end of our range, and I will continue to try to exceed expectations.

David Maris - Credit Agricole Securities (USA) Inc.

And then just as a follow-up. When you talk about the inorganic growth opportunities, are you looking to develop further in Europe, a bigger footprint or an add-on technologies here in the U.S.? Or is it start in Latin America? What are you thinking?

Paul Bisaro

Well, all of the above. One of the things that we're spending a lot of time on is looking at our brand franchise and how do we expand our brand presence throughout the Americas. And over the next few quarters, we'll be launching our Canadian brand business, and we're expecting some big things from that. And if we found the right opportunity to jump start a brand opportunity in the Americas, we would certainly be on that. But we'll continue. But at the same time, we'll continue to look for ways to grow our international, our international generics business by again the right kinds of acquisitions. But again it's not a question of cash. We have the cash available. It's finding the right opportunity that is to some extent holding us back.

Operator

Your next question comes from the line of Ronny Gal with Bernstein.

Ronny Gal - Sanford C. Bernstein & Co., Inc.

First question I have is about the Medco-Express Script merger again. This one is actually to Fred. We know the impact on the generics is going to be moderate as those 2 companies have a moderate impact on generic volume, but they seem to have bigger share of national formulas, can you comment, do you expect more pressure on general pricing in the U.S. market for specialty pharma companies or is that something that is less likely?

George Wilkinson

I think there's already been significant pressures on the brand companies in most of these environments. Anyway, most of them have been fairly aggressive at implementing not only a 3-tier system, but a lot of [indiscernible] and other things that make a Tier 3 position not as favorable as it used to be. I think we've created a good relationship actually with our core products with both books of business. We're very comfortable with the contracts that are there. We think that from a brand perspective, we're not going to be impacted very much with the line that we have.

Ronny Gal - Sanford C. Bernstein & Co., Inc.

And Paul, regarding LIPITOR, I'm guessing some of the market already committed to you that you are to supply this product, but as time progresses and we're not seeing action from Ranbaxy, in your mind, at what point is the remainder of the market essentially goes out and committed to you that you or Pfizer for a product after November? Or is there something that just people are going to wait off until the last day?

Paul Bisaro

Well, I think, frankly, some people will wait till the last day because pricing is going to be a big issue here with LIPITOR and pricing dynamics will vary significantly depending on whether Ranbaxy's in or not in. So I think there will be a number of companies that wait till the last minute. I think everybody knows and all our customers know we'll have enough product available to supply the whole market in November. So I don't think anybody's really too worried about getting the product from us.

Ronny Gal - Sanford C. Bernstein & Co., Inc.

And is there like a point in the next couple of months that we kind of look at the book of orders saying, you know, if they don't have something by then, I probably would have a step-up in expectations?

Paul Bisaro

Well, I suppose there's probably a point in time when it would become clear and that time is probably around beginning of November. If there isn't sufficient -- I mean if Ranbaxy doesn't have sufficient inventory, I mean, customers -- they would probably be in a bad position to not tell customers they wouldn't be able to supply it right away. Again for them, I think it's probably better for them to be in a position where they can fully supply and that's probably what they're going to do. But if they're ready in November they'll tell customers. If they're not ready, I'm certain that -- I know we would tell customers that we weren't ready because we wouldn't want to make people angry about that.

Operator

Your final question comes from the line of Michael Tong with Wells Fargo Securities.

Michael Tong - Wells Fargo Securities, LLC

Quick question. If we just kind of forget about -- if we assume that generic Concerta never launched in the second quarter, how would the generic gross margin in the U.S. look like relative to the first quarter? And then secondly, as far as international goes, as you prune the portfolio, should I expect the margins to trend up? Or is it just enough to offset the price decline? And then lastly, has Canada been stable from a pricing perspective or has it continued to be stable on that front?

Paul Bisaro

Michael, on the general gross margin question, I think it would probably about the same quarter-over-quarter. Maybe slightly down a little bit. And then, Siggi, if you want to...

Sigurdur Olafsson

Yes. So on the international business, the pruning will stabilize the market. Also remember that Europe is such a small portion of the overall business of Watson that even a pruning won't affect the overall gross margin so much. But it's definitely stabilizing the margin and hopefully in the coming years, the new launches will improve the market going forward. I think in Canada we have had a better year this year than last year. Clearly, we see a growth with new launches, but also quite a volume growth. So we are launching. We have already launched 5 new products into Canada, and we have some significant launches in the last half of the year. So that's the market to be. We are spending a lot of time on to -- has to grow to be the second biggest market of Watson.

Patricia Eisenhaur

And Brandy, I'll turn the call over to you to repeat the replay instructions. And thank you, everyone, for joining us on this morning's call.

Operator

Thank you for participating in Watson Pharmaceuticals Second Quarter Earnings Conference Call. This call will be available for replay beginning at 11:30 a.m. Eastern standard time today through 11:59 p.m. Eastern Standard Time on Tuesday, August 9, 2011. The conference ID number for the replay is 79602222. The number to dial for the replay is (800) 642-1687 or 1 (706) 645 9291. This concludes today's call. You may now disconnect.

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