Cambrex Corporation Q1 2008 Earnings Call Transcript

Executives

Greg Sargen – VP and CFO

Jim Mack – Chairman, President, and CEO

Analysts

Jeff Zekauskas – JPMorgan

Dmitry Silversteyn – Longbow Research

Cambrex Corporation (CBM) Q1 2008 Earnings Call Transcript May 1, 2008 5:00 PM ET

Operator

Good afternoon. My name is Don, and I will be your conference operator today. At this time, I'd like to welcome everyone to the Cambrex First Quarter 2008 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session.

(Operator instructions) Thank you. Mr. Sargen, you may begin your conference.

Greg Sargen

Thank you, Don. Good afternoon, everybody. Welcome to Cambrex's first quarter 2008 conference call. My name is Greg Sargen, and I am the CFO of Cambrex.

Before we begin, I will provide the customary Safe Harbor comments regarding forward-looking statements. Today's discussion will contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, and Rule 3B6 under the Securities and Exchange Act of 1934. These statements may be identified by the fact that words such as expects, anticipates, intends, estimates, believes, or similar expressions are used in connection with any discussion of future financial and operating performance. These statements are based on Cambrex's current plans and expectation, and involve risks and uncertainties that could cause actual outcome and results to materially differ from those included in the forward-looking statements. For further information please refer to our reports and filings with the SEC.

Today's release includes tables reconciling non-GAAP amounts to GAAP amounts. Management believes that the adjusted amounts provide a more meaningful representation of the company's operating results for the periods presented due to the magnitude and nature of certain expenses recorded. This conference call will last approximately 45 minutes.

A replay of the call will be available shortly after we end today through next Thursday, May 8, by calling 1-800-642-1687 domestically, and 706-645-9291 internationally. Please use the conference ID number reference 44524695 to access the replay.

Today's call will begin with a business review of Jim Mack, our Chairman, President and CEO. I will follow Jim with a few comments on our first quarter and guidance, before opening up the call for Q&A.

With that, it is my pleasure to introduce Jim Mack. Jim?

Jim Mack

Thank you, Greg, and good afternoon, ladies and gentlemen. I will begin today's call with an overview of our first quarter 2008 performance followed by commentary on key aspects of our business.

As with recent quarters, this quarter came in pretty close to what we expected heading into the year. Our sales were down 5.1% compared to the first quarter last year, mainly due to the timing of orders, lower sales of the more commoditized fine chemicals and feed additives, and of course a contractual price decline on our largest API. Partially offsetting these declines were strong sales of DEA-controlled substances in the quarter. It should be noted that we are comparing results to an unusually good quarter last year where sales were up 20% over the year before.

Gross margins for the quarter were 35.5% versus 37.5% in the first quarter of 2007. 1.3% of the 2% decline was due to unfavorable impact of foreign currency, with the remainder due to the contractual price decline of our largest product, and additional costs related to the validation of our new facility in Milan, Italy. Favorable mix largely due to the higher sales of DEA-controlled substances partially offset the decline. Adjusted EBITDA was up $2.1 million versus the prior year, due to a significant reduction in corporate costs, resulting from the 2007 restructuring activities.

Corporate spending for the quarter before restructuring and strategic alternative expense was approximately $3.9 million, compared to $8.4 million for the first quarter last year. Adjusted EBITDA before corporate expense was down $2.3 million versus last year, due to the lower sales volumes, and gross margins that I just discussed. Operating expenses were lower at all sites, although foreign currency resulted in reported operating expenses being slightly higher for the quarter.

As Greg mentioned earlier, there is a table at the end of today's release that reconciles non-GAAP amounts back to reported results.

While much of what I will discuss next I have mentioned in prior calls, we believe it is important that our current and prospective investors understand how we view the markets in which we compete. We are seeing major changes at pharma companies as they shut down plants and consolidate manufacturing operations. In order to cut costs and direct more resources to the development of multiple NCEs, or New Chemical Entities, they will continue to outsource the manufacture of APIs and advanced intermediates for clinical trials. To take advantage of that trend, we have succeeded in expanding our key account relationships with mid-sized to large pharma companies. These relationships typically begin with a stream of new custom development projects, and progress to securing longer-term custom manufacturing contracts. Just last year, we completed over 85 custom development projects, up from the mid-20 range a few years ago.

Our pipeline of custom development project remains robust, and currently includes 12 projects for APIs in Phase III clinical trials. The largest and most competitive sector of the market for custom development projects is in the early stages, Preclinical and Phase I, where the work is labor-intensive, and the early chemistry requires more optimization work at bench scale. While this business is less profitable than later-stage custom development work, it is important to expand our practice of partnering with our clients early in a project life cycle. To that end, during January of this year we acquired ProSyntest, now called Cambrex Tallinn, a contract research and development company located in Estonia, with whom our team in Sweden had a long-standing relationship. This acquisition will enable us to more effectively compete in the early stage markets, and provides us with a strong pool of talented chemists to advance numerous proprietary products. Cambrex Tallinn has been fully integrated and is already engaged in 10 active R&D projects.

Building on our custom development pipeline, and successfully completing numerous projects over the past years has led to the development of capabilities and competencies that we are utilizing in the development of our portfolio of proprietary products. We are continually identifying and pursuing the development and acquisition of new proprietary technologies to build on our existing platforms in the areas of high potency DEA-controlled substances, enzymes, continuous process manufacturing, polymeric drug delivery, and taste masking. Our approach to the generic API market continues to be one focused on niche products, to take advantage of our multi-purpose, rapid turnover, flexible manufacturing capabilities. We are experiencing success growing our supplements business, where we gained approval as a second supplier with nearly $12 million of sales of 2007, versus just $6 million of sales of 2006. We expect continued strong growth in supplements during 2008. We also have a strong and growing franchise within the DEA-controlled substances where there are significant barriers to entry, and we are pursuing opportunities to expand this business.

We are aggressively pursuing Lean Six Sigma programs throughout our business. We have approximately 20 self-directed Lean Six Sigma teams at our operating sites with multiple programs to boost productivity, reduce costs, and improve quality. During 2007, these teams drove significant cash and machine time savings, decreasing cycle times, increasing throughput, and decreasing the need for future capital investment. We expect similar benefits from these initiatives in 2008. We continue to add new projects to expand the revenue generation from our proprietary Polymeric Drug Delivery technology, which encompasses taste masking. The drug delivery market, as we discussed in the past, is large, fragmented, and growing at higher rates than the overall pharmaceutical API market. We currently sell five products utilizing our patented technologies within smoking cessation, cough and cold medicines, driving sales of just over $20 million in 2007, up from low-single-digit millions a few years ago.

We expect that our sixth product will be launched by our customer in late 2008 or 2009. We continue to add personnel and other resources to this effort, and expect to incur just under $1 million of incremental operating expenses for these initiatives in 2008 compared to 2007. We are in the early stages of executing on this plan, and have over a dozen new products in development. We are optimistic that we will be able to introduce at least three additional new products in the next 18 months, giving us new revenue, and significant geographic expansion.

I'd like to now comment briefly on our key capital projects. We do remain on-schedule to commission a new medium-scale cGMP production unit at our Karlskoga, Sweden site in early 2009. This facility addresses our need for greater capacity to produce APIs for late-stage clinical materials, and commercial product. This project will drive nearly half of our projected capital spending in 2008.

In Charles City, Iowa, we will complete five new high-containment suites and associated laboratories for high-potency compounds during this second quarter. This expansion will allow Cambrex to enhance its leadership position and secure more custom development projects in the oncology market, one of the fastest growing segments of the pharmaceutical industry. Lastly, we will complete and validate our new state-of-the-art finishing facility in Milan, Italy during 2008. This facility along with recently added laboratories and automated warehouses, will provide increased capacity and flexibility to handle the growth that will come from the work our R&D personnel are completing on multiple APIs that come off-patent starting in 2009.

Taken together, these capital investments will allow us to compete effectively for new branded and generic APIs at critical flexibility and capacity as we convert our large pipeline of custom development projects into long term commercial manufacturing arrangements, and support our growing proprietary products business.

I will now turn the call over to Greg.

Greg Sargen

Thanks, Jim. Like to add a few comments on the first quarter financial performance, I will then briefly comment on 2008 guidance, and we will conclude with some questions. First a few comments on discontinued operations.

Discontinued operations in the first quarter last year include the results of operations through the date of sale and the corresponding gain on the sale of the Bio Businesses during that quarter. There is no activity recorded within discontinued operations in the first quarter of 2008. All results I am about to discuss, both actual and forward-looking, pertain to continuing operations, unless otherwise noted.

I'd first like to briefly describe the restructuring expenses and strategic alternative cost lines in our income statement. Restructuring expenses in the first quarter of 2008 consisted of a charge for the lease and other costs associated with the consolidation of our New Jersey technical center activities into our Charles City, Iowa facility, and the resulting shutdown of the New Jersey facility. We are attempting to sublease the New Jersey facility for which we have a little less than three years remaining on the lease at an expense of approximately $1.4 million per year. Depending on the success of our subleasing efforts, additional lease expense may be recognized as restructuring expense in future periods. Strategic alternative cost in the first quarter this year consist of external advisor expenses related to a project to restructure our European legal entities, severance, and minor adjustments to change in control benefits for certain executives, all pursuant to the sale of the Bio Businesses.

We are working towards completion of our legal entity restructuring later this year, and expect the structure we are working towards will be more cost and tax efficient. We will update our progress and expected impact of that initiative when it is substantially complete later this year. Cambrex had net interest expense of $700,000 for the quarter versus income of 1.5 million in the same quarter last year. The company earned significant interest income during the first and second quarters last year on the proceeds from the sale of the Bio Business. The company capitalized $600,000 of interest into long term capital projects during the first quarter of 2008.

The company ended the quarter with debt net of cash of $79.7 million, an increase of $16.5 million from the last quarter. The increase in net debt during the quarter was partially driven by increases in inventory, which net of the impact of currency increased about $11 million since year end. The increase was primarily due to the timing of expected shipments in future quarters for certain key products, build-up of inventories for validation purposes related to our capital expansion at our Italian facility, and build-up of our largest product due to a contractual requirement to increase safety stock. We perceive much of the build-up to be temporary in nature, but we do expect inventory levels to remain higher than usual during the middle part of the year. The remaining increase in net debt was driven by payments for various items for which reserves have been previously established, including our Rutherford legal settlement, and a contractual payment related to a change in control agreement, among other items.

Income tax expense for the first quarter of 2008 was $2.7 million, resulting in an effective rate of 39% for the quarter. As we do not recognize tax benefits for losses in certain jurisdictions, including the U.S., our effective tax rate has been and will continue to be volatile due to shifts in the geographic mix of income, or losses from one period to the next.

Finally, I'd like to discuss guidance for 2008. As stated in today's release, we continue to expect sales growth of between 5% and 10%, and EBITDA before restructuring and strategic alternative costs, which we refer to as adjusted EBITDA, of $53 million to $57 million. We do advise readers to refer to the ‘Other Matter' section in the release earlier today for brief commentary on our recent customer product recall that may have a material impact on our ability to achieve our 2008 guidance. The tables in today's release provide a reconciliation of adjusted EBITDA to reported GAAP numbers.

Restructuring and strategic alternative expenses are expected to be approximately $1.5 million, primarily related to the closure of our New Jersey R&D facility that we announced in the fourth quarter of 2007, cost to complete the project to improve our legal entity structure, and certain expenses related to the exit of feed additive business towards the end of 2008.

For 2008, capital expenditures are still expected to be $32 million to $34 million, with strong foreign currencies pointing us at the high end of this range. The majority of the spending in 2008 will be directed towards the key projects that Jim described earlier. As I have said in prior calls, we believe that the three-year period from 2006 through 2008, during which we will have averaged nearly $32 million of capital expenditures per year, represent the heavier-than-usual period of capital expenditures for Cambrex, but was necessary to position the company to take advantage of the key trends in our business. We expect to revert to capital spending levels in 2009, and immediately beyond, in the low- to mid-$20 million range, on average. Depreciation in 2008 is expected to be approximately $21 million to $23 million.

I'd now like to open up the call for questions. Don?

Question-and-Answer Session

Operator

(Operator instructions) And your first question comes from the line of Jeff Zekauskas.

Greg Sargen

Hey, Jeff.

Jeff Zekauskas – JPMorgan

Hi, good afternoon. A few questions. Can you give me the tax effect on the restructuring charges?

Greg Sargen

The tax effect on the restructuring charges?

Jeff Zekauskas – JPMorgan

You have restructuring expenses of 634, and strategic alternative costs of 177. Is there a tax effect?

Greg Sargen

No, it's all domestic. So, there is no tax expense recorded. I mean, it technically creates a tax benefit for us because it is an expense, but because I am in the mode where I am not recognizing the benefits on expenses in the U.S. right now, it has a zero tax effect for GAAP purposes.

Jeff Zekauskas – JPMorgan

Why was your tax lower this quarter than in some of the previous quarters?

Greg Sargen

Mix of income.

Jeff Zekauskas – JPMorgan

So what was it about FX that gave you a lower rate? Some more income–

Greg Sargen

As Jim said, we had a higher, our mix and partially offsetting the decline in sales was an increase in controlled substances which are all U.S. So when we have a good quarter relative to the international entities in the U.S. for a particular period, our tax rate will be lower, because I am not recording any tax expense on any income that my Iowa facility will generate.

Jeff Zekauskas – JPMorgan

How is your fentanyl business doing?

Greg Sargen

We don't comment specifically on that – at that level of business. So we continue to be engaged with that product in some capacity, but we don't comment specifically on that.

Jeff Zekauskas – JPMorgan

Is that – you don't comment specifically. What's the order of magnitude of the difficulty with the API that one of your customer had a recall, you supplied the API. Can you kind of frame what the earnings risk, or EBITDA risk is, or quantitate that?

Greg Sargen

Yes. I mean we haven't gotten into it because it's variable in nature depending on how the contracts work out. So what we have said publicly to-date is that it is zero to several million, and we think there is a viable pathway to where it can be zero, but there is risk depending on how the timing plays out through the rest of the year that the longer we go and the less – the longer it takes to get certainty on that production plan, it goes up. So I am not going to be more specific than that at this point.

Jeff Zekauskas – JPMorgan

So zero to several million, is that in operating income, or in revenues?

Greg Sargen

That will be in operating income.

Jeff Zekauskas – JPMorgan

Operating income. And did that business perform well in the quarter? Or did it perform poorly?

Greg Sargen

In the first quarter?

Jeff Zekauskas – JPMorgan

Yes.

Greg Sargen

Yes. That business, well the timing of shipments was such that there was negligible shipment of that product in the first quarter. But that was just timing. That had nothing to do with the issue.

Jeff Zekauskas – JPMorgan

Okay. Your guidance, how does your guidance take into account this possible event?

Greg Sargen

It assumes that we achieve the initial production plan that we assumed we would for the year, which is still possible, and some might argue likely, but we have enough – there is enough uncertainty into the timeline for resolution that we felt compelled to tell the market that.

Jeff Zekauskas – JPMorgan

Okay. Will this be an event that possibly could take place in the second quarter, or is this an event that would possibly take place later in the year?

Greg Sargen

Yes, we just don't know. We are working with our customer to clarify the production plan, and we'll accommodate whatever procedures they think are necessary, and whatever delivery schedule they conclude with us.

Jeff Zekauskas – JPMorgan

Okay. Lastly, it looks like same-store sales, excluding currency, were 11.3% lower ex-currency. Can you break up that 11.3% into price and volume?

Greg Sargen

It was about 2% price, and 9% volume.

Jeff Zekauskas – JPMorgan

Okay. Thanks very much.

Greg Sargen

Sure.

Operator

(Operator instructions) And your next question comes from the line of Dmitry Silversteyn.

Greg Sargen

Hey, Dmitry. You are still on mute, Dmitry.