Mallinckrodt's (MNK) CEO Mark Trudeau on Q4 2016 Results - Earnings Call Transcript

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Mallinckrodt PLC (NYSE:MNK)

Q4 2016 Earnings Conference Call

November 29, 2016 8:30 AM ET

Executives

Cole Lannum – Senior Vice President-Investor Relations

Mark Trudeau – Chief Executive Officer

Matt Harbaugh – Chief Financial Officer

Steve Romano – Chief Scientific Officer

Hugh O’Neill – President-ARD

Analysts

Chris Schott – JP Morgan

Gary Nachman – BMO Capital Markets

Louise Chen – Guggenheim

Douglas Tsao – Barclays

Annabel Samimy – Stifel

Marc Goodman – UBS

Irina Koffler – Mizuho

Gregg Gilbert – Deutsche Bank

Sumant Kulkarni – Bank of America Merrill Lynch

Sameer Singh – Piper Jaffray

David Risinger – Morgan Stanley

Jason Gerberry – Leerink Partners

David Maris – Wells Fargo

Stephan Stewart – Goldman Sachs

Operator

Good day, ladies and gentlemen, and welcome to the Mallinckrodt Q4 2016 Earnings Conference Call. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, today’s conference call is being recorded.

I would now like to turn the conference over to Cole Lannum, Senior Vice President, Investor Relations. Please go ahead.

Cole Lannum

Thank you, Candis, and welcome to today’s call. Joining me are Mark Trudeau, CEO; and Matt Harbaugh, our CFO. Dr. Steve Romano, our Chief Scientific Officer; and Hugh O’Neill, President of ARD are also here and will join us for the Q&A session. Mark will start us off with some brief comments and Matt will follow providing details on our financials. We’ll then go into our customary Q&A session.

Before we begin, let me remind you of some important details. On the call, you’ll hear us making some forward-looking statements and it’s possible that actual results could be materially different from our current expectations. Please note that we assume no obligation to update the information contained in these forward-looking statements even if actual results or future expectations change materially. We ask you to please refer to the cautionary statements contained in our SEC filings for a more detailed explanation of the inherent limitations of such forward-looking statements.

We’ll also provide some non-GAAP adjusted financial measures with respect to our performance. A reconciliation of these adjusted measures to GAAP is detailed in our earnings release and its related financial tables, which can be found on our website, mallinckrodt.com. We use our website as a channel to distribute important and time-critical company information and you should look to the Investor Relation pages of our website for such information.

As noted in our press release, unless otherwise specified, all comparisons of quarterly or annual performance are to the third quarter or full year of fiscal 2015. In addition, the revenue growth ranges we’ll be discussing today are on a constant currency basis unless otherwise noted. As a reminder, the last quarter of 2016 included an extra selling week, a phenomenon that occurs once every five or six year with our 52, 53 week fiscal year accounting convention.

While the exact quantification of the impact of the extra week is extremely difficult to determine, we believe it added approximately 6 to 9 percentage points to the quarterly sales growth rate of the Company as a whole and about 1 to 3 percentage points to our annual sales growth. We’re providing this estimated sales impact at the total Mallinckrodt level to give you context but caution that you should not extrapolate it to any particular segment or product line as that may give you an inaccurate picture of our actual performance.

For the September quarter, we reported GAAP diluted earnings per share from continuing operations of $1.01 with full year of fiscal 2016 GAAP earnings of $4.39. After adjusting for specified items, our non-GAAP adjusted diluted earnings for the quarter came in at $2.04 per share and $7.85 per share for the full year fiscal year 2016.

Now, I’ll turn it over to Mark.

Mark Trudeau

Thanks, Cole, and thanks to all of you for joining us on today’s call. I’m pleased to report that Mallinckrodt delivered another strong volume driven quarter to end fiscal year 2016 even before the positive impact of the extra selling week. As has been the case all year, our robust performance across Specialty Brands has more than offset expected declines in Specialty Generics, which continues to face significant challenges.

Perhaps most importantly, we continue to fulfill our strategic vision in the quarter with additional transformation of our portfolio. For example, we: announced the planned divestiture of our nuclear imaging business; achieved wins in INOMAX intellectual property that we believe will further extend the durability of this asset; enhanced our growing organic pipeline with acquisition of an innovative development platform of regenerative medicine skin substitutes that have the potential to transform the standard of treatment for burns and wound healing; advanced our trials for Terlipressin for hepatorenal syndrome type 1 and Synacthen Depot in the treatment of Duchenne muscular dystrophy; and just last week, we announced a new trial for Acthar in treatment of ALS.

These accomplishments mark the beginning of our transition into what we see as the next exciting chapter of our long-term strategic roadmap for sustainable success, driving in-line products fostering innovation with investments in a growing organic pipeline, and providing new patients with access to powerful effective treatments. In our brands business, strong focus on execution drove our achievements and provides a great example of our acquire-to-invest strategy in action. We generate new clinical and health economic evidence and then ensure the data is shared with healthcare providers and payers to help them understand the value our therapies bring to patients and the healthcare system.

Net sales were up 14% and 16% for the September quarter and the year respectively, led by steady volume increases and strong performance across the Specialty Brands segment, which as a whole was up 36% for the quarter and 42% for the year. Adjusted diluted earnings per share growth were notable as well, up 21% for the quarter and 16% for the full year. This pattern of solid predominantly volume based growth in Specialty Brands has been consistent over the past several quarters. And we see that trend continuing as we look ahead.

In Specialty Generics, which now represents less than 30% of our total net sales, the 19% decline in the quarter was consistent with our expectations. We’ve continued to project strong headwinds for this business for some time and expect significant downward pressure on the segment to persist. Having said that, the segment continues to generate cash and we’re focused on supplementing performance through careful cost management and select introduction of new ANDAs.

Regarding our methylphenidate ER product and the FDA’s recent actions, we continue to disagree with the agency’s position based on scientific grounds and we believe it’s not consistent with the best interest of patients. We’re moving forward with the hearing process and we’re pleased the agency granted our request for a 90-day extension, allowing us to submit more robust documentation. The evidence we’re compiling demonstrates why we believe our therapy should remain to ADHD patients, who can benefit from this cost effective alternative. As the process moves forward, we’ll provide updates as appropriate and we will continue to vigorously defend the safety and effectiveness of our drug.

Now let me give you some additional perspective on the key products in our Specialty Brands business. Acthar contributed another strong quarter with net sales up 19% in the period driven predominantly by volume. Obviously, we’re very pleased but note that absent the extra week, these results would have been more in line with our expected mid single to low double-digit range. We saw continued growth particularly in rheumatology, pulmonology and nephrology. This strong volume growth continues in this quarter, consistent with what we’ve seen since acquisition, propelled by our investments as well as commercial and medical affairs execution.

In rheumatology, we saw steady prescription growth in both rheumatoid arthritis and in lupus, where we believe the published data on Acthar use continues to help physicians better understand the value it can provide to certain patients with these diseases. We’re also seeing steady increases in pulmonology prescribing as physicians absorb recently published data detailing Acthar’s use in sarcoidosis. And we’ve redoubled our efforts in nephrology helping us to continue to grow in that space. Early feedback from our launch into ophthalmology is also promising and we’re dedicating resources to expand our efforts in this therapeutic area.

In infantile spasms, intensified efforts to ensure that infants afflicted with this condition have access to Acthar brought consistent market share gains across the past several quarters. We’re committed to further broadening and improving our reach to this fragile patient population. We continue to advance our Acthar market access strategy and engage with key payers. Acthar now has nearly 60% of commercial lives under contract and we see potential for more. We’re continuing to find ways to partner with payers to improve appropriate patient access. Overall contract performance has aligned with our expectations, in forming our current efforts as we seek to further expand the percentage of covered lives under contract. As we expand patient access in pulmonology and rheumatology, our patient mix has shifted more toward older patients, many of whom are covered by Medicare. Based on our commercial and contracting momentum and data results, we remain confident in our long-term normalized growth rate expectations for this product in the mid-single to low double-digit range.

In the hospital business INOMAX, our second largest product, delivered another stellar quarter with net sales up 22%, reflecting both demand growth, favorable contracting and the extra week. We believe the recommendations for earlier and prolonged use of nitric oxide in joint guidelines recently published by the American Heart Association and the American Thoracic Society are having a positive impact on use. Though unlikely to reach fiscal 2016 levels, we expect INOMAX will continue to see growth rates that are higher than historical norms for the next several quarters, with a return to more traditional mid single-digits growth rates long term.

As I mentioned, in the quarter, the US patent trial and appeal board affirmed the validity of multiple INOMAX drug and device patents, enhancing our confidence in the intellectual property estate surrounding INOMAX to at least 2031. But let me put INOMAX performance into very human terms. This past year saw the highest annual consumption ever recorded for INOMAX. In fiscal 2016, we estimate more than 10,000 critically ill neonates received INOMAX treatments. When you consider these infants and the children with infantile spasms who are treated with Acthar, it's no exaggeration to say that Mallinckrodt medicines are making a significant difference in the lives of families every day.

I'm pleased to report, we achieved 23% growth in revenue for OFIRMEV in the quarter, results wholly driven by volume. Our strong performance is the result once again of commercial execution bolstered by recently published health economic data showing the potential for multimodal analgesia to shorten hospital stays for certain patients. Going forward, we expect these factors to continue to drive OFIRMEV growth.

We're encouraged by the continued performance of Therakos as we completed our first full-year post acquisition, with net sales growth of 24% on a pro forma basis. We're continuing to refine our commercial model for Therakos to present the best value proposition for customers and further expand patient access. We're separately working urgently to resolve temporary production issues we've recently experienced with our third-party manufacturer for kits supporting the older XTS product. Though the XTS device is being discontinued over time, it still makes up a meaningful portion of our installed base.

We expect to report negative revenue for the product in the December quarter. While it's possible the situation could continue into the second quarter of 2017, we believe our efforts to mitigate this kit’s shortage will successfully resolve the issue sooner. Overall, revenue impact from the shortage is expected to be somewhere between $5 million and $10 million in the December and March quarters. Importantly, we believe we will be able to offset most of the earnings impact in the December quarter from strength in the rest of our businesses.

Closing out Specialty Brands, our hemostasis portfolio has continued to perform in line with our expectations. We're pleased to be launching Preveleak and RAPLIXA and like most hospital launches, we expect a slow but steady uptake. The longer term double-digit growth we expect over this portfolio's 2016 net sales figure will be driven by the launches of these new products.

Now let me share the latest developments in Science and Technology. A core tenant of our acquire to invest strategy is not only to focus Science and Technology resources on supporting key inline products but to also build out a robust organic pipeline in Specialty Brands, developing new indications and new products in areas where patients currently have few alternatives and need better options.

Last week, we shared the exciting news that we will launch a Phase 2 proof of concept clinical trial to assess the efficacy of Acthar in nearly 200 patients with ALS, also known as Lou Gehrig's disease, a condition with extremely limited treatment options today. Built on observations in the initial pilot safety trial, we worked closely with the FDA on the design of new program. And we're very pleased that our Investigational New Drug Application or INDA was awarded the agency's fast track designation.

The ALS study will assess the effects of Acthar and establish measures of disease symptoms and progression, enabling us to evaluate the potential benefit it may bring to patients with this devastating disease. We expect the trial to begin enrolling in 2017 and it will take several years to complete.

Also for Acthar, we recently noted the first patients treated in Company-sponsored trials for both rheumatoid arthritis and lupus. With these three and the recently announced FSGS study, Mallinckrodt's initiation of Company-sponsored randomized controlled Acthar clinical trials will result in the study of the drug in more than 800 patients, a significant advancement for this product.

Since acquisition, committed investments in HEOR, medical affairs and research efforts for Acthar as well as the modernization of our manufacturing process equate to more than $1.25 billion. And we expect continued robust investment into the drug to continue in the years ahead. More broadly, over the course of fiscal 2016, we initiated five Company-sponsored trials for other Specialty Brands products. Our strong science focus is also evident in the nearly 100 publications and data presentations generated this year, almost half of which related to Acthar.

In other areas of our pipeline, we continue to advance the Phase 3 Terlipressin registration trial. Enrollment in the trial is progressing as planned. We received FDA fast track designation for our INDA for the study of Synacthen Depot in patients with Duchenne muscular dystrophy and are pleased to report the Phase 1 trial in healthy volunteers is ongoing and will provide the necessary data to inform dose selection for patients entering Phase 2.

In the quarter, as I mentioned, we also announced and closed our acquisition of a regenerative medicine company focused on proprietary human skin substitute products. The lead developmental product is StrataGraft regenerative skin tissue, which has received orphan designation from the FDA. We're preparing to start both the Phase 3 trial for the treatment of severe deep partial thickness burns and the Phase 2 trial for treatment of severe full thickness burns. If approved, this product could transform the standard of burn treatment. The broader platform has potential to provide wound healing for other types of skin injury as well.

Now let me touch briefly on business development. We continue to be very focused on optimizing our commercial and development portfolio in three ways: building and diversifying our Specialty Brands platforms with additional commercialized assets consistent with our acquire to invest strategy; executing on transactions that will expand our pipeline; and opportunistically identifying and adding ANDAs to support our specialty generics portfolio, such as the recently announced Intellipharmaceutics license agreement.

We're assessing a growing list of attractive opportunities both commercial stage and development and expect to further add to our portfolio in coming quarters. Now, I'll turn the call over to Matt.

Matt Harbaugh

Thanks, Mark. Let me take a few moments to go a little deeper into our financials. First, as a reminder, our Nuclear Imaging businesses has been reflected as a discontinued operation beginning in the September quarter with each prior period recast to reflect this change. You've seen that the September quarterly results were strong, fueled largely by our higher margin Specialty Brands segment, coming in ahead of expectations.

Net sales were $887 million representing growth of 14%. September quarter net sales for the Specialty Brands segment were $633 million, representing growth of 36%, reflecting especially strong performance from key brands and ongoing focus on driving volume.

Acthar performed at the high-end of our expectations in the quarter, with growth of 19% or $327 million in net sales, an all-time high, even after adjusting for the additional selling week. We’re also pleased to report that INOMAX generated $127 million in net sales, a 22% increase. As Mark noted, we believe many of the factors contributing to this growth will continue to be drivers in the near term.

Turning to OFIRMEV. We were pleased to see another increase in volume demand for the quarter, resulting in $76 million in net sales, a 23% increase. The Therakos business also performed well, with net sales of $55 million, a 24% increase on a pro forma basis.

Now, let’s turn to Specialty Generics, which continues to be challenged by overall market conditions and increased competition across a number of categories. We saw net sales of $240 million, representing a 19% decline over the prior-year quarter and an 18% decline for the fiscal year. We expect this downward trend to continue for the foreseeable future. Turning to methylphenidate ER specifically, we are pursuing the FDA’s hearing process and will submit necessary documentation by the recently extended due date of March 19, 2017.

However, remember this is a product with high gross margins above our corporate average and if withdrawn, it would have significant near-term impact to our earnings. Regardless of the outcome of the FDA process, we anticipate newly announced, AB rated, competitive entrants to further reduce our market share upon the launch of those products. As it relates to 2017 for our Specialty Generics business, we continue to expect double-digit declines in revenues, even taking into account the impact of the extra week comparison. Fortunately, and as we have seen this past year, we anticipate our Specialty Brands businesses will help to mitigate the declines we foresee for Specialty Generics.

Total Company adjusted gross profit as a percentage of net sales increased slightly in the quarter to 75.3%. Due primarily to continued expected weakness in our Specialty Generics business, gross profit as a percentage of sales should be down sequentially over the next several quarters.

R&D expense as a percentage of net sales for the quarter was nearly 8%, with absolute spend increased over prior year. And a higher concentration of total spend was devoted to further investment in Specialty Brands. Our adjusted effective tax rate in the September quarter was 15.7%, compared to 16.2% affected primarily by business mix.

Turning to the balance sheet and liquidity. We generated free cash flow of $141 million in the September quarter bringing the total for the fiscal year to slightly over $1 billion. We have and will continue to focus on three capital allocation priorities: acquisitions, share repurchases, and debt reduction.

Notably, in fiscal 2016, we achieved the following: acquired the hemostasis portfolio in StrataGraft for a combined $245 million; repurchased a total of $651 million in shares; and reduced debt by $470 million. Even with these actions, we ended the fiscal year with a cash balance of $281 million and very manageable leverage, a net debt leverage ratio of a modest 3.6 as you can see posted on our website this morning.

Note that the leverage ratio marginally increased from the prior quarter as it was unfavorably impacted by the move of nuclear imaging to discontinued operations with no offsetting credit for the expected $574 million in upfront cash proceeds to be received when the transaction closes.

Looking ahead to 2017, you should expect to see continued strong cash generation though the planned nuclear divestiture and weakness in Specialty Generics will put downward pressure on our free cash flow as compared to 2016.

At this point, I’ll turn it back over to Cole, who will take us into Q&A.

Cole Lannum

Thanks Matt. Before we start the Q&A session, I want to remind you to please limit yourself to a single question with a brief follow-up if and only if needed. We have a lot of people on the line today, so I want to get through as many as possible. Feel free to put yourself back in queue afterwards and I promise, we’ll get through as many questions as we can.

With that, operator may we please have the first question.

Question-and-Answer Session

Operator

Absolutely. Our first question comes from the Chris Schott of JP Morgan. Your line is now open.

Chris Schott

Great, thanks very much for the question. So I had a question on product concentration. Acthar is doing great but it continues to be a very controversial asset for the Street. I think you talked about a goal of reducing singled product exposure to less than a third of the Company’s EBITDA over time. So my question here is can you maybe update us one where you stand on your concentration given the strong Acthar performance as well as some of the generic market pressures and imaging divestiture.

And a second part of this is how much of a priority or sense of urgency is there at the Company to reduce this exposure at this point relative to other uses capital such as share repo, given where the stock is trading. Thanks.

Mark Trudeau

Yes thanks Chirs. This is Mark. So your question around product concentration is very appropriate. Obviously Acthar has done better than we expected. Frankly, across our Specialty Brands portfolio we’ve done very well really all of our brands have done quite well. But Acthar has done a little bit better than we expected. And as you mentioned, we now have our nuclear business in discontinued operations.

So while our long-term objective is to have no single product account for more than a third of our operating income, currently our concentration has increased a bit and certainly Acthar now represents a significantly greater proportion of our operating income than a third. Our objective, again long-term, is to continue to diversify our portfolio. And so looking for opportunities that would enable us to do that relatively rapidly is obviously high on our objective. We will continue to update the marketplace going forward as we identify additional opportunities to expand our commercial portfolio as well as add to our development portfolio.

So with regards to capital allocation, I think certainly business development, all else being equal, is a high priority for us but you’ve seen with the amount of cash flow that we have that we’ve been able to do a number of different things with our capital, including business development, buy back shares and reduce debt and we would look to continue to do opportunities – look to continue to manage our capital effectively based on what is most economically attractive but certainly diversifying our portfolio is very, very high on our list.

Cole Lannum

Thanks Chris. Next question please.

Operator

And our next question comes from Gary Nachman of BMO Capital Markets. Your line is now open.

Gary Nachman

Hi, good morning. On generic Concerta, with the three extra months to prepare the data, do you now think you have a better shot of keeping that product on the market? Any insight into what you’ll be providing the FDA?

And you mentioned in your prepared remarks you’re filings some new ANDAs. Give us a sense of how many new ANDAs you might be filing over the next year and are you aggressively looking at ways to enhance the pipeline with M&A?

Mark Trudeau

Right, couple questions there. Let me start with meth ER. Certainly the additional 90 days as we mentioned in the prepared remarks enables us to build what we believe is a very robust and compelling set of information to present to the FDA to support a hearing and we’re very pleased that the FDA has given us that time to do that. With regards to how long the product would continue to stay on the market, certainly our objective would be to have data to support our position that the product should remain on the market. But that will be determined based on what the FDA decides once they see our data package when we present it in March of next year.

With regards to ANDA filings, again, we will continue to look to enhance our generics portfolio with additional ANDAs. We were pleased with the IntelliPharmaCeutics deal that we just recently signed. We'll continue to look for opportunities like those as well as building out ANDAs from our own pipeline. But again, typically since we're focused primarily in controlled substances, a relative number of ANDAs is going to be relatively smaller in any given amount of time. But over time we would look to build out a much more robust pipeline, either through M&A or our own developmental efforts.

Matt Harbaugh

And Gary, I want to remind you too, we mentioned this in the prepared remarks, even if we keep meth ER on the market indefinitely, we do expect the competitive environment there to change and maybe change pretty dramatically over the next year. So even if it stays on the market, you should expect the business to come under pressure if additional entrants come into that market. Next question, please.

Operator

And our next question comes from Louise Chen of Guggenheim. Your line is now open.

Louise Chen

Hi, thanks for taking my question. So I was wondering if you could quantify the magnitude of the headwinds seen in gross margin for Specialty Generics and how much of the year-over-year sales erosion was price versus volume?

Mark Trudeau

Yes, I’ll take that. Good morning, Louise. Clearly, you see that we have had some downward pressure on our gross profit as a percent of sales or gross margin. We expect that to continue in future quarters because of the pressure we see in Specialty Generics. I would say the downward pressure over the last year has principally been price, some volume, but it's principally been price that's been dropping as ANDAs get approved by the agency combined with the customer consolidation downstream. So as we said in the prepared remarks, we do expect to see this pressure to continue.

Cole Lannum

Next question, please.

Operator

And our next question comes from Douglas Tsao of Barclays. Your line is now open.

Douglas Tsao

Hi, good morning, thanks for taking the questions. Matt, you sort of touched on it quickly just then but if could you maybe talk a little bit about your visibility in the controlled substances or Spec Generics business next year especially as we head into the sort of consortium bidding cycle, so how confident do you feel. I am seeing that you are giving specific numbers now that your sense of how that business will perform next year?

Matt Harbaugh

Yes. One thing I would go back to, Doug, is keep in mind that the Specialty Generics business in the fourth quarter was 27% of the revenue of total Mallinckrodt. So I'd hate for us to spend the whole call talking about the situation in generics because we've got a lot of exciting things going on across the portfolio. I would say that we do see the downward trend continuing, the pressure continues on the business. So from a longer term outlook I would Specialty Generics to continue to be a smaller component of our total revenue. Especially if we're able to add and supplement with business development to the portfolio, so as I said on the third quarter earnings call, we are not out of the woods yet and I would say that theme continues through to today.

Cole Lannum

Thanks, Doug. Next question, please.

Operator

And our next question comes from Annabel Samimy of Stifel. Your line is now open.

Annabel Samimy

Hi, thanks for taking my question. I wanted to talk a little about M&A for a moment. It seems that you had a pretty clear strategy of buying durable assets with specific focus on rare autoimmune diseases or hospital products clearly we’ve all heard rumors about supplement which seems to have a very different class of characters. And I'm just wondering with the desire to diversify is the urgency to look at a broader set of assets increasing. And also on the level of generics, given the continued pressure and I guess limited number of controlled substances in a declining part of generic contribution to your overall revenues, what's the overall thought of staying in generics given the structural pressures that we're seeing continue? Thanks.

Mark Trudeau

So let me take the overall M&A question and then I’ll ask Matt also to comment a little bit more on the generic piece as well. So with regards to M&A, we're very pleased with the assets that we've been able to accumulate over time. We focused on, again, as you said, Annabel, highly durable assets, typically those that are under-resourced, typically those that have relatively low patient penetration where the opportunity for long-term growth is driven predominantly by volume, particularly if we make some very focused investments as we've done with virtually all the companies and products that we’ve acquired over time.

We like specifically the hospital marketplace. We like the autoimmune and rare disease space because we believe these areas of the pharmaceutical industry typically are going to offer those types of assets. And we think that's the appropriate strategy to continue to focus on going forward. Both of those areas are of course quite broad which enables us to look for assets across a number of different therapeutic areas and we think that focus is the right one going forward.

With regards to generics, again, our long-term view here is that this is a very solid cash generation business for us, one that certainly helps diversify our portfolio as well as fund some of the additional M&A that we are doing. But we want to continue to enhance that business over time, both by operational efficiencies as well as looking to build out a portfolio of ANDAs which could provide growth and offset for the long-term.

So Matt, I don't know if there's else you want to add to that.

Matt Harbaugh

Yes. The only thing I would add is we're not limited to controlled substances. We're looking at more if you will Specialty Generics or products that have higher barriers to make or low competition. And so while our legacy is controlled substances, we're thinking more expansively about that. The other thing I would add is you can see on the website today we posted our net debt leverage ratio, 3.6. If you actually take the math related to the nuclear business and calculate that in, you'd find that our net debt leverage would be around 3.3. And so we are well positioned to continue to pursue business development. We've been able as Mark said earlier to not only buyback shares and do some acquisitions but we’ve also paydown our debt in a significant way. And so from a balance sheet perspective, we're in great shape to pursue business development.

Annabel Samimy

Okay. Thank you.

Mark Trudeau

Thanks. Annabel. Next question, please?

Operator

Thank you. And our next question comes from Marc Goodman of UBS. Your line is now open.

Marc Goodman

Good morning. For Acthar, just helps us understand better how much of the contracting has already kicked in and is impacting the business so far. I'm just trying to understand – you keep increasing commercial contracting, you get the Medicare piece of the business is goings up. I heard you comment about older patients with these indications it seem to be growing. So I understand that part but I just don't understand why that piece of the business is increasing so fast and yet the commercial business is increasing so fast. So helps us understand when the contracting if it's kicked in at all, I mean, and when it's going to kick in and how the price has kind of been impacted by it so far. Thanks.

Mark Trudeau

Yes. So let me start with this and then I'll ask Hugh O'Neill, who heads up our autoimmune and rare diseases business which includes Acthar to comment further on this because Hugh's actually been leading a lot of the activity in the market access arena. So again, we're very pleased with the results that we've seen with our contracting approach, the fact that we have now nearly 60% of covered lives under some form of contract, given that two years ago there were almost zero lives under contract is a really impressive performance.

Let's just recognize, though, that signing contracts really doesn't guarantee you any business. What it does do is provide a vehicle so that you can promoted broadly across your indication set and gives you greater charity longer term around market access in the commercial part of the business. It should be expected that the proportion of our business that is paid for by Medicare would increase, given the fact that we are changing the mix of our business, much more towards things like rheumatoid arthritis and pulmonary sarcoidosis, which typically affect older people. But overall we're very pleased with the contracting approach and here you may want to just add a couple of comments on how you see it going forward?

Hugh O’Neill

Yes. Thanks, Mark. I want to add a few points on this. I think it's important to keep in mind where we started. When we began with this product, we re-engaged payers. We engaged payers for the first time and that took some period of time. To Mark's point, we are pleased with what we've done, but we put in place a strategy that allows us to capture the majority of our commercial lives under some form of contact, with the first and foremost goal of trying to stabilize the reimbursement process and stabilize the marketplace, we're pleased with what we've seen there.

As it relates to the shift in the payer mix, you guys know the story which is really about the growth of where the business is coming from. Some of that growth is being driven by – most of that growth is driven by new patients and those new patients are predominantly coming from areas of more elderly patients in areas of rheumatology, nephrology and pulmonology. When that shift occurs we would expect Medicare specifically to grow as an overall proportion of our payer mix versus what it's been done historically when the majority of our business was in more acute indications like neurology and MS flares.

So there is nothing here that’s happening I think that we were surprised by. I think we are optimistic that our payer engagement strategy starting with the clinical story and the rational behind the appropriate use of the product is taking hold by both dealing with our commercial payers as well as stabilizing the reimbursement landscape as our patients begin to evolve a little bit more towards the Medicare patients. So hopefully that helps.

Cole Lannum

Thanks. Next question please.

Operator

Thank you. Our next question comes from Irina Koffler of Mizuho. Your line is now open.

Irina Koffler

Hi. Thanks for taking my question. Just to pivot off of the last question, could you provide us some context about historical penetration of these indications in the elderly, like sarcoidosis and rheumatoid arthritis and where the growth has been to the current levels. And also do you view the Medicare book of business as a bit more stable than your commercial book in the sense that reimbursement is a little bit more predictable here and maybe little more consistent? Thanks.

Mark Trudeau

Again, let me just start with that. Irina, thanks for the question. And then I'll turn it to Hugh to give you some more detail. So overall our patient penetration rate is in the mid single digits, it’s continuing to grow. So we're very pleased about that. If we think about some of the newer indications like RA, lupus, pulmonary, sarcoidosis, these are areas two years ago where the patient penetration rates were less than 1% and we're clearly seeing gains in penetration in those areas, predominantly on the basis of new data generation. I mean, you heard us talk about in the prepared comment just this year alone we've literally put out dozens of data sets for Acthar, clinical data and health economic data, and it's that data that's been really driving a lot of the penetration in the business.

With regards to the mix of payer, being in Medicare is just a natural result of the fact that the product mix is changing. You heard Hugh mention the fact that this business when we took it on a couple of years ago was predominantly a neurology business and now it's starting to evolve much more into a pulmonology and rheumatology business.

Hugh O’Neill

Yes. I think a just couple of point on that. When we look at – it’s always important to keep in context the patient populations that we're thinking about when we think about the use of Acthar and proper use of Acthar. So this is usually a third or fourth line treatment, these are sicker patients who have failed on multiple therapeutic options. So we think about appropriate patient penetration we are talking about relatively small numbers of patients that are appropriate for the use of the product, and even at that, there's still significant opportunity for us to be able to penetrate those markets greater than where we've been to Mark's point earlier.

When we think about Medicare, I want to make a comment about that. I think it's – we don't view one payer channel easier than any other payer channel. I think the entire way we're thinking about this business is by generating the appropriate health economic outcome research data, the approximate clinical data that the compelling story for Acthar will be such that those appropriate patients will be agreed upon between the payer and us and the clinician and how we actually promote the product.

So we don’t expect and we don't take for granted the Medicare channel. We actually work very hard in order to continue to position the product appropriately clinically, as well as from an ETOR perspective and the value associated with that. And as the mix continues to shift, as we launch more data and more indications our expectations, this is a moving target. Payer mix does not stay static. It is dynamic. And as the portfolio shifts a little bit, we expect that will change of time as well.

Cole Lannum

Thanks. Next question please.

Operator

Thank you. Our next question comes from Elliot Wilbur of Raymond James. Your line is now open.

Unidentified Analyst

Hi. This is David on for Elliott. Good morning. Thanks for taking the question. Just a quick question on the cash flow numbers. Are they inclusive of the nuclear imaging business this quarter and do you know how much that business generated? Thanks.

Mark Trudeau

Yes. So the nuclear business is included in the cash flow statement. And it will be included in the cash flow statement until the divestiture occurs. And on an annualized basis, which I think is the easiest way to look at this, it's between $100 million to $150 million annually from a cash perspective.

Cole Lannum

Thanks, Dan. Next question please.

Operator

Our next question comes from Gregg Gilbert of Deutsche Bank. Your line is now open.

Gregg Gilbert

Thank you. Follow-up question for Hugh on the amount of Acthar business that's paid for by the government. Do you see any risks associated with the amounts or the growth in that channel that would trigger a process or extra scrutiny by the government? I think there's obviously been some controversy in the market not only about your potential mischaracterization of the channel mix which I assume you disagree with, but I’m curious whether there is any unique risk with having that much business and potential additional growth in Medicare versus other channels?

And my follow-up is on INOMAX. Can you talk a little more about – you sounded a little more bullish than last quarter in terms of the duration of the higher than trend sort of growth you are expecting. Can you talk about perhaps penetration or metrics that would let us come up with our own conclusions about how much you can grow and for how long before settling back to the mid single that you expect at some point. Thanks.

Mark Trudeau

Yes. So I think Hugh you can take the Acthar question and I'll go with the INOMAX piece of it.

Hugh O'Neill

Yes. So let’s talk about a little bit about the question regarding risk. I go back to the initial discussion we just had about how we see the evolution of the business. We are always constantly trying to ensure that the evidence that we have for the appropriate use of the product holds true regardless of who the payer is. Now, I think the Medicare component is one where – as you guys know there are third-party insurers that interact for Part D that negotiate specifically with manufacturers. We continue to have those engagements about the appropriate clinical rational for the product and about the value equation for the product.

We do like to see obviously continued evidence generation and growth for the brand, whether it's commercial payers or Medicare payers. There's always risk inherent in action that payers could potentially take a bit against the product whether it’s Medicare or Medicaid or the commercial channel, but what's really important for us, and what we feel optimistic about, and you’ve heard Mark mention it earlier in the work and the partnership we’re doing with our science colleagues is that more date we can generate, the evidence we can generate, the more appropriate use of the product that we agree with the payers and how to position it appropriately, the more we can mitigate that risk. And that’s appropriate for whether it’s Medicare or commercial payers and that's been our strategy all along.

Mark Trudeau

So with regards to INOMAX, we're very pleased with the performance of this product, obviously. The growth rate all year has been significantly higher than historical growth rates. And we do see that growth rate likely to continue albeit not necessarily at the rates that we’ve seen in 2016, but certainly higher than the mid single digit range that has been the historical situation driven by a couple of factors.

One is certainly our contracting approach to the marketplace has been quite positive, but also the fact that consumption has increased, consumption meaning utilization has increased. We think part of that is just the fact that the guidelines that support prolonged and earlier use of nitric oxide for the benefit of patients and the combined factors of those guidelines plus our contracting strategy, we think is really driving this increased utilization – this increased volume utilization, we would expect to see that continue over time. Albeit as we’ve said longer-term we would expect this business to revert back to more of a single-digit – mid-single digit type growth business, but we think there will be tail in between what we’ve generated in 2016 and that kind of longer-term normalized growth rate.

Steve Romano

Gregg, remember two, the comps just start to get tougher over the next several quarters. And yet, we’re still saying even with those tougher comps that we’re going to be ahead of the long-term normalized number and this is probably good opportunity to remind people too and of course because of the extra week this quarter, the comps would be very tough in the September quarter of next year across the Board not just for INOMAX. That's something to keep in mind whenever you are modeling. Next question please.

Operator

And the next question comes from Sumant Kulkarni of Bank of America Merrill Lynch. Your line is now open.

Sumant Kulkarni

Good morning. Thanks for taking the questions. First, could you update us on two conceptual goals, R&D as a percentage of sales I think you said 6% to 8% in the past and free cash flow should be just take out $100 million to $150 million annually that the nuclear cash – a Nuclear Imaging was contributing. And second for Matt, specifically could you quantify any kind of financial capacity that you have on M&A in terms of absolute dollars or maybe in terms of a target leverage ratio.

Hugh O’Neill

That sounds like more than one question there Sumant, but we try to see if we can get it through, so Matt?

Matt Harbaugh

Sure. I’ll start and then maybe Dr. Romano would like to talk about how he sees R&D spending as a percent of sales. Sumant as you saw in the quarter, we were at 8% and obviously with all of the great activity we have going on in the science and technology group that Mark outlined in the prepared remarks earlier. Our spend is going to increase in R&D over time all of the ALS work, Duchenne muscular dystrophy, Terlipressin, StrataGraft, all these activities are going to put further pressure on our R&D spend and we’re more than happy to reinvest in R&D to realize the future of the company.

As it relates to free cash flow, couple things you need to thinking about there. The first is, the fourth quarter you’ll see this in the 10-K, when we file it, some people may think that the cash flow was a little bit low in the fourth quarter. But in the 10-K, you’ll see that we paid cash taxes of $165 million in the quarter that impacted the number that we posted. I was very happy though on balance for the full year because a year ago when we said, that we thought we generate about $1 billion in free cash flow coming in at $1.2 billion is pretty remarkable. No one could have pegged it that closely against that target. But obviously we’ve been able to put that back to use in multiple different ways.

As it relates to capacity, we certainly have a lot of room as I mentioned earlier, we are still in a very good position as it relates to our net debt leverage. Sumant, I’d encourage you to look at our website and see the calculation of the 3.6, with slight uptick from the third quarter, but really its driven by the nuclear business going out. So we have plenty of capacity, the highest we've taken our net debt leverage was in the low 5s. But we still are generating a lot of cash, we still have roughly $600 million coming in from the nuclear divestiture in the first half of the year. So I would say we really don’t feel constrained as it relates to doing business development. The big key is really finding something that fits all of our criteria.

Mark Trudeau

And Steve as you comment about R&D priorities I think some comment around the evolution of the Acthar business, the fact that we’re now initiating so many controlled clinical trials. But I think in particular the recent announcement around the ALS trial would be interesting from your perspective.

Steve Romano

Sure, Mark. Sure. So first around just the targeting of our spend its roughly about 7% of our revenue, our projected revenues. But I don’t think we’re constrained by that. So what we’re looking to do strategically obviously is to invest in the products that we acquire. So for instance Acthar is a great example. Acthar is an older medicine. It had a lot of clinical experience, but it was actually rather short on more contemporary control trial data. So we’re investing fairly heavily in Phase 4 work across the major clinical conditions in which we promote RA, lupus for incidence and MS.

We also where we see opportunities to progress development opportunities and expand our pipeline activities for both Acthar and other inline brands as well as newer products, we’re investing in those as well. So a good example with Acthar is the previous owners of the company and the product. Questcor had initiated a study in ALS, it was a safely study. We looked at those safety results and we also did some post hoc analysis to get a better understanding of the potential value of the medicine to this particular condition. And remember this is a relentlessly progressive neurodegenerative condition that leads 70% to 80% of those afflicted dead within five years. So it's an area where there really as a tremendous amount of medical need.

And we see, what we believe is a signal of potential efficacy we have to demonstrate that. So we’re now moving forward in investing in a viable proof of concept trial that will allow us to definitively clarify whether there is value to Acthar in that particular population. So that just an example, now clearly as we move forward, we want to build our organic pipeline and you’ll see greater investments, perhaps you’ll see a shift in investments that include more pipeline products for instance the StrataGraft and ExpressGraft platform that we recently acquired.

The initiation of a trial for DMD, Duchenne muscular dystrophy for Synacthen and of course, the completion of our current registration trial on Terlipressin for Hepatorenal Syndrome. So we’re not constrained by that 7% or 8%. I’ll certainly feel very happy going to both Mark and Matt asking for more money, but we have to do it in a prioritize fashion and a strategic fashion and they have to be valued investments.

Matt Harbaugh

Yes. The only other thing that I would add is from an R&D spend, keep in mind we also spend more in specialty brands than we do in specialty generic. So the percent for the blended average for the corporation is one data point, but we do overweight our reinvestment to spec brands and that would be both in 2017 and beyond.

Hugh O’Neill

Thanks, Sumant. Next question please.

Operator

Thank you. And our next question comes from David Amsellem of Piper Jaffray. Your line is now open.

Sameer Singh

Hi, guys this is Sameer on for David, just a few ones here.

Hugh O’Neill

You mean one, go ahead.

Sameer Singh

Portion of the sales may have came from rheumatology and pulmonology for Acthar and how should we think about the gross to next for 2017 and then maybe a follow-up.

Hugh O’Neill

So you want to take the rheumatology.

Steve Romano

I’m not sure that I heard the question…

Hugh O’Neill

Could you repeat the – that you want to know the percentage of sales for what – could you repeat that please.

Sameer Singh

Can you hear me better now?

Hugh O’Neill

Very faintly, could you speak up?

Sameer Singh

Yes, so what percentage of sales mix came from rheumatology and pulmonology for Acthar?

Steve Romano

Yes. So I think I heard the question is the growth came from rheumatology and pulmonology in the quarter for Acthar, that to clarify that percentage.

Sameer Singh

No, what portion of the sales mix, yes.

Steve Romano

Right. So I mean historically the growth – historically the business has been partition roughly 30% in neurology, 30% rheumatology, 30% nephrology and then the balance everything else predominantly pulmonology. What we can clearly see is the percentages are growing for rheumatology, so now its higher than 30%. The percentage of neurology is actually declining a bit and nephrology is roughly holding static and we’re seeing growth also occurring in the pulmonology business. So that kind of gives you some perspective on the mix of business.

With regards to gross to net for 2017, Cole, you may want to make just some comments on how we will be thinking about giving direction for 2017.

Cole Lannum

Yes, so it will continue to be a pressure on us, but we’ve taken into account with all the commentary that we’ve made going on. It is clearly something as we do more contracting on the Acthar side of things. It becomes more of a quantitative number, but we’re not going to specifically call it out for comparative reasons. Suffice it to say that, again with the growth that we’ve seen year-to-date in this quarter, we’ve had more gross net pressure there. But we’ve taken into account in our long-term mid-single to low double-digit growth rate.

With that I’m going to ask you to go back in the queue and go to next question please.

Sameer Singh

All right, thank you.

Operator

Thank you. And our next question comes from David Risinger of Morgan Stanley. Your line is now open.

Unidentified Analyst

Good morning. This is [indiscernible] filling in for Dave. Could you please discuss whether there were any anomalies beside the extra week that help year-on-year grow for Acthar in this September quarter and what should we expect year-on-year organic Acthar growth to be in the neat-term. Thank you.

Mark Trudeau

So regarding Acthar, we were very clear I think in the prepared comments to say that the 19% growth that we saw in the quarter certainly benefited from the extra week. Absent that we would have been in the typical mid-single to low double-digit range. We’ve been very consistent, I think now from multiple quarters to say longer term we would expect the normalized growth rate for this product to be in that range. Again, if you look historically at the number of quarters that we’ve owned Acthar, we’ve typically been in that range very consistently and we would expect that to continue.

Cole Lannum

Next question please.

Operator

Thank you. And our next question comes from Jason Gerberry of Leerink Partners. Your line is now open.

Jason Gerberry

Hey, good morning. Thanks for taking my question. I guess the first one concern of – if you look at the focus at the agency is our – the generic product efficacy. So I was curious if you can comment a little more specifically on how you plan to support your case we’re seeing on the market. And then my follow-up is that, I’d expect in the next three to six months and IP to provide some update on their development pathways for their Acthar alternative. And so could you just provide your latest thoughts in terms of how you’re thinking about type of development pathway, timeline for a reactivated NDA type product like they have? Thank you.

Mark Trudeau

So just very briefly on meth ER our position has been from the beginning that in the FDA confirmed that there is no safety issue with the products that are currently rated as BX. We have contested from the very beginning the basis for – the scientific basis for the rerating. And that will be the primary angle or focus that we will have when we go back to the agency to provide information regarding the efficacy of our product. We continue to believe that this is a very effective cost effective alternative for ADHD patients and that based on the science it’s an effective and safe product and that’s that will continue to be our position with the agency going forward.

With regards to potential corticotropin products that may get introduced to the marketplace long-term get our position and this really hasn’t changed. We would expect that again if and when the FDA creates any kind of a pathway to revive dormant and NDAs, which is the case here, we believe that the process is likely to be long and complex in our position that hasn’t changed.

Cole Lannum

Thanks. Next question please. And operator I think we have time for two more questions and we need wrap it up.

Operator

Thank you. Next question comes from David Maris of Wells Fargo. Your line is now open.

David Maris

Good morning. I was wondering if you could give us a little more perspective around the Therakos situation and what happens here. Your commentary makes it sound like your hope and expectations that it’s going to be resolved sooner or rather than later. But what’s the risk that it gets worse. And what’s – what gives you that hope that’s going to be resolved sooner. Thank you.

Mark Trudeau

Yes. So thanks for the question. So the Therakos situation is one where it’s a production issue, not a quality issue. Our first and most important consideration here is to make sure that patients continue to get access to therapy and this is a situation where we believe we can manage that short-term through inventory management and taking patients who normally might have gone through the XTS system, which is the older system and give them access to the newer system the SELEX system. It’s also important to understand the predominance of the patients and the predominance of the business that’s in the XTS category is in Europe.

And so we are actively managing this production issue to come back on line. I think we appropriately characterize the risk while it’s possible – it could bill into the second calendar quarter of 2017. We believe that the most likely scenario is that we’ll be able to resolve that much sooner be back up in production. And we’ll give you an update as we have further information as the time is appropriate.

Matt Harbaugh

Yes. And David I’d just want to highlight that we do believe that the $5 million to $10 million impact in the December quarter, we think we’ve gotten, we’ve been able to offset that with strength in our broader businesses. As we move into the first quarter of 2017, if it is in the $5 million to $10 million range the blended average gross profit on that business is about where our gross profit as a percent of sales is for the total corporation. So that kinds of give you a sense of the numbers.

Cole Lannum

Thanks. And Operator one last question and we need to wrap.

Operator

Thank you. And our final question comes from line of Stephan Stewart of Goldman Sachs. Your line is now open.

Stephan Stewart

Good morning and thanks for squeezing me in. Just one quickly on Acthar, beyond the absolute price for the drug, the patient out of pockets on the Medicare sites seem relatively high. Can you just speak to your recent affordability there from that perspective as you think about an indication mix the shifting away from the more acute treatments?

Mark Trudeau

You want to take that.

Matt Harbaugh

Yes, I will. Thank you for the question. So we think about affordability of the product specifically related to other therapeutic options that the patients would actually have failed on before they get access to the product. I go back to what we talked about earlier this is a product for usually third or fourth line treatment, especially in these longer care patients like the rheumatology, pulmonology, nephrology patients. And we work very diligently with not only Medicare, but across all the paramedics in order to ensure that patients can have access to the product and it’s affordable appropriately for those patients.

That pressure will continue, I think regardless of whether it’s Acthar across all specialty brands as far as begin to look at how to best manage those large seek all spends. But by generating the appropriate data and generating the right partnership in the right type of contractual agreements we can hopefully mitigate some of that pressure and make sure patients can get access to the product that an affordable rate.

Mark Trudeau

And the other important consideration here is to think about how Acthar is typically used for most patients. Majority of use for Achar is usually in a kind of an episodic type for all situation rather than electronic, we do have some patient that are electronically with that terms we’re relatively small proportion. Most patients are episodic, meaning they might have an episode in a given year might be another year two before they have another episode. So again this is not necessarily something where the expense to the patients is the same every year impacted, it’s predominantly in this episodic category.

Cole Lannum

Thanks, Stephan. We’re going to call it. Thanks for joining us this morning. As a remainder a replay will be available later on today. As far as follow-up question as reminder to everyone, Dan and I are going to be here this morning and early afternoon but we’re traveling to New York to meet with some you at the Healthcare conferences going on right now. So if you send us email as part of the best way for us get back to you. Have a great morning. We’ll take to you soon. Bye-bye.

Operator

Ladies and gentlemen, thank you for your participating in today’s conference. This does conclude the program. You may all disconnect. Have a great day, everyone.

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