Cambrex Corporation Q2 2008 Earnings Call Transcript

Executives

Greg Sargen – VP and CFO

Steve Klosk – President and CEO

Analysts

Dan Leonard – First Analysis

Mike Sison – KeyBanc

Jeff Zekauskas – JP Morgan

Eugene [ph] – Longbow Research

Cambrex Corporation (CBM) Q2 2008 Earnings Call Transcript August 6, 2008 8:30 AM ET

Operator

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

I would now like to turn the call over to Mr. Greg Sargen, Chief Financial Officer. Sir, you may begin.

Greg Sargen

Thank you, Sylvia. Good morning, everybody. Welcome to Cambrex's second quarter 2008 earnings conference call. My name is Greg Sargen and I am the CFO of Cambrex.

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

These statements may be identified by the fact that words such as “expects,” “anticipates,” “intends,” “estimates,” “believes,” or similar expressions are used in connection with any discussion of future, financial and operating performance.

These statements are based on Cambrex's current plans and expectations and involve risks and uncertainties that could involve actual outcomes and results to materially differ from those included in the forward-looking statements.

For further information please refer to our reports and filings with the SEC. Yesterday's release includes reconciling – includes tables reconciling non-GAAP amounts to GAAP amounts. Management believes the adjusted amounts provide a more meaningful representation of the Company's operating results for the periods presented 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 Wednesday, August 13th by calling 1-800-642-1687 domestically, and 706-645-9291 internationally. Please use the conference ID number reference 56338629 to access the replay. A webcast will also be available on the Investor Relation section of the Cambrex Web site located at www.Cambrex.com, and can be accessed for approximately a month following the call.

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

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

Steve Klosk

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

Our reported sales were up 5% compared to the second quarter last year and down 2.6% after adjusting to the effects of foreign currency. The currency adjusted decrease was mainly due to lower volumes of generic APIs and a contractual price decline on our largest API. Partially offsetting these declines were continued strong sales of DEA controlled substances in the quarter, one of our key focus areas.

Gross margins for the quarter were approximately 30% versus 38% in the second quarter of 2007. 1.2% of the decline was due to the unfavorable impact of foreign currency. The remainder of the decrease was due to lower pricing on our largest API, negatives mix and higher production costs. Increased sales of higher margin controlled substances in the U.S. partially offset the decline in margins and the other parts of the business.

The cost increases for the quarter were primarily due to additional expenses to validate the new finishing facility in Milan and increases in the cost of utilities and raw material input. The increased validation costs in Milan will continue throughout the rest of the year but will taper off as the year comes to a close. The new finishing facility had six production lines and since we regularly manufacture approximately 60 APIs in any given year at that facility, the combination of production line and product validations results in a time-consuming regulatory process.

Adjusted EBITDA was $12.4 million versus $15.2 million in the same quarter last year. With the decline largely driven by the lower margins that I just discussed, offset by reductions in Corporate spending resulting from the 2007 restructuring activities and lower legal costs. Corporate spending for the quarter, before restructuring and strategic alternatives expense and the impact of accelerated vesting on prior equity awards to our outgoing CEO, was approximately $3.3 million compared to $3.7 million for the second quarter last year.

As Greg will discuss later, we expect significant full-year savings within our Corporate cost center, above and beyond previous expectations. Adjusted EBITDA before Corporate expenses was $15.6 million compared to $18.9 million last year, due to the lower sales volumes and gross margins that I just discussed.

SG&A expenses and R&D expenses were lower at the operating sites after eliminating the effects of foreign currency. As Greg mentioned earlier there is a table at the end of yesterday's release that reconciles non-GAAP amounts back to reported results.

Now I would like to talk about some key aspects of our business and what we are doing operationally to position ourselves for improved performance going forward. One of my first endeavors as CEO of Cambrex was to gather the global leadership team to define our key strategic initiatives, ensure alignment throughout the organization and make sure that we have the right people with the right resources to achieve our growth goals.

While we are still formulating some of these initiatives and assembling the teams that will drive them, I want to share some of the takeaways about which I will talk more in the future as these initiatives take shape. We identified several key focus areas for the business where we believe we can achieve superior and sustainable financial results.

I'd first like to discuss two key initiatives related to products and services that we have been involved with for some time. The first is the continued build-out of our custom development pipeline which we define as clinical or preclinical phase projects. And the second is the addition of new products, technologies, and geographies to grow our generic API business.

In the 2002 to 2003 time frame we developed an initiative to build out our custom development pipeline. And have since ramped that pipeline up from a small number of projects to having completed over 80 distinct projects in 2007. We expect to complete a similar number of projects in 2008. So far in 2008 we have received a record number of requests for proposals in the United States, and while we have seen some softening in our key accounts in Europe, we continue to see a strong pipeline of projects to bid on in that market also.

We currently are working on 15 projects involving Phase III compounds. And, in general, the mix of our pipeline has moved over the past two years towards a heavier mix of Phase II and Phase III clinical projects. Part of our strategic positioning going forward will be to drive towards a higher mix of projects in our pipeline to which we can apply specific know-how or intellectual property, to develop superior synthetic chemical routes and processes that are not easily replicated by our competitors. This will improve our success rate and minimize time spent on less profitable projects where the chemistry is widely practiced.

As we look at new projects, we are evaluating all three of our key manufacturing sites, along with our new Estonian facility, Cambrex Tallinn, to determine where the project can best be executed. The ultimate goal is to follow the molecule through the regulatory process and sign a long-term commercial supply agreement upon regulatory approval. These steps along with the acquisition of Cambrex Tallinn, should help to increase the profitability of our custom development revenues, and put us in a strong position to either the sole source provider or at a minimum one of the key suppliers upon regulatory approval.

Just as importantly, building out our custom development pipeline and successfully completing numerous projects over the past few 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 of new proprietary technologies to build on our existing platforms in the areas of high potency compounds, controlled substances, enzymes and biocatalysis, continuous process manufacturing, polymeric drug delivery, and face masking. I will speak shortly about a couple of these areas in more detail.

Our approach to the generic API market continues to be one focused on niche products that take advantage of our multi-purpose, rapid turnover, flexible manufacturing capabilities. Due to the inability to develop new products prior to patent expiration in our Italian facility until about two and a half years ago, we have aggressively grown our supplement business, where we gain approval as the second supplier of the generic API. With nearly $12 million of sales in 2007, versus just $6 million in 2006, we expect continued growth in supplements in 2008.

We also continue to sell more of our generic APIs into emerging geographic markets. Our new product development pipeline is significant with over a dozen products planned for launch. The first in 2009 and ramping up in 2010, 2011 and beyond.

Now I'd like to talk a little more about a couple of exciting initiatives that we have discussed to some degree in the recent past. Closely tied to our generic API business, but a separate focus in and of itself due to what we believe are compelling market dynamics, is our strong and growing franchise within DEA-controlled substances.

The control substances market in the U.S. is far and away the most significant controlled substance market in the world. It is dominated by a small handful of domestic players that have been qualified by the DEA to produce or sell these substances and whom have little or no competition from foreign manufacturers due to DEA requirements.

Cambrex is one of the few companies situated to produce a wide range of APIs for sales to end markets. Last year, we sold approximately $15 million worth of controlled substances and have already sold a little over $10 million through June of this year. Our current products are focused on the attention deficit and hyperactivity disorder market and pain management.

Pain management is the key therapeutic growth area and we intend to develop more products to this segment of the market. We have hired an experienced business champion to support our growth initiatives and he will have full access to acquired resources to identify and develop new targeted compounds, and will work closely with our drug delivery and generic API team to leverage all expertise within Cambrex to significantly expand this business. As we gain more insight into the time lines by which we think we can generate more significant growth in this area, we will keep you apprised of our progress.

As has been discussed in the last few quarters we continue to pursue new products and opportunities in the over-the-counter generic and prescription drug market segment, utilizing our proprietary polymeric drug delivery technology, which encompasses face masking, modification of drug-release profiles and improved drug stability. The drug delivery market is large, fragmented and growing at higher rates than the overall pharmaceutical API market. Some of the benefits of enhanced drug delivery are ease of use. For example, Oral Thin Film, better efficacy, patient compliance, think about the pediatric and geriatric markets, and life cycle extension.

Our technology is suitable for oral dissolving tablets, oral thin film and liquid suspension. It is compatible with a large number of APIs, it demonstrates drug stability and enhancement, it is colorless, tasteless and sugar-free. It can have rapid or modified dissolution or delivery and is IP protected.

We currently sell five products utilizing our patented technologies in the smoking cessation in cough, cold and allergy markets, with sales of just over $20 million in 2007, from low single-digit millions a few years ago. We continue to expect that our sixth product will be launched by our customer by late 2008 or early 2009. We are investing in additional personnel in R&D resources and will 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 this plan and have over a dozen new technology enhanced APIs in our development pipeline that are designed to accelerate our customers product development initiatives in various drug formulation. We are optimist that we will be able to introduce at least three of these new products in the next 18 months, giving us new revenue and making a significant contribution to the geographic expansion of this strategic initiative. Finally, we believe our drug delivery technology will enable us to expand sales of our existing generic API by introducing new enhanced delivery systems for these active ingredients.

I have so far commented on four key strategic initiative areas. Our custom development to custom manufacturing pipeline, generic APIs, controlled substances, and our polymeric drug delivery technology platform. We will also be seeking to leverage R&D we are conducting in continuous processing, the manufacture of high potency compounds and our proprietary biocatalysis technology, which enables the scaled up commercial manufacturing process for what we expect to be our biggest product.

Before wrapping up with a few comments on the status of key capital projects, I would like to briefly convey my thoughts on M&A. We do have limits on the amount of capital at our disposal for making acquisitions. And as such we will be very selective in our approach. We continually investigate the potential acquisition of smaller companies with niche technologies, or intellectual property where we believe we can develop significant barriers to entry or leverage our existing capability, whether it is the ability to scale up complex chemistry, or expand the application of technology, or intellectual property that we already have.

While we continue to explore the possibility of partnerships with or outright acquisitions of service providers in low-cost countries, we remain in no hurry to establish a permanent cost structure in any low-cost country, until we identify the right partner or opportunity.

Now I'd like to comment briefly on our key capital project. I have already discussed the ongoing validation process related to our new state-of-the-art finishing facility in Milan. We also 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 projects and commercial products. This project will drive nearly half of our projected capital spending in 2008.

In Charles City, Iowa, we have completed five new high containment suites and associated laboratories for developing and producing high potency compounds. This expansion allows Cambrex to enhance its leadership position and secure more high potency custom development projects for the oncology market, one of the fastest growing segments within the pharmaceutical industry.

In conclusion, I am very optimistic about our ability to grow our business in each of our key strategic initiatives. I look forward to discussing our progress in future calls.

I will now turn the call over to, Greg.

Greg Sargen

Thanks, Steve. I would like to add a few comments on the second quarter financial performance. I will then comment briefly on 2008 guidance and then we'll open it up to questions.

I would first like to briefly describe the restructuring expenses and strategic alternative cost lines in our income statement. Restructuring expenses in the second 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 shut down of the New Jersey facility and some remaining charges related to the Corporate restructuring that was substantially completed in 2007.

We are attempting to sublease the New Jersey facility for which we have two and a half 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 and future periods.

Strategic alternative costs in the second quarter this year consisted primarily of external advisory expenses related to a project to restructure our European legal entities pursuant to the sale of the Bio businesses a little over a year ago. We are working towards completion of our legal entity restructuring later this year.

While the structure we are working towards will be more cost efficient, the Swedish tax authorities recently proposed a measure that would eliminate most of the future tax savings previously anticipated by the restructure. This measure has not been approved by the Swedish government, and as such, we will continue to monitor the situation.

The Company ended the quarter with debt net of cash of $91.5 million, an increase of $11.8 million from the last quarter. The increase in the last quarter was largely driven by payments related to change and control and severance payments and a small increase of inventory. If we don't make any acquisitions during the second half of 2008, we continue to expect that net of cash to be between $95 million and $100 million at the end of the year.

Cambrex had net interest expense of $600,000 for the quarter, versus income of $900,000 in the same quarter last year. The Company earned significant interest income during the second quarter last year on the proceeds from the sale of the Bio businesses. The Company capitalized $700,000 of interest into long-term capital projects during the second quarter of 2008 and $1.3 million year-to-date.

Income tax expense for the second quarter of 2008 was $3 million resulting in an effective rate of 62% for the quarter. The year-to-date rate is just over 48%. As we do not recognize tax benefits for losses in certain jurisdictions, including the U.S., our effective tax rate has been, and will continue to be volatile, due to shifts in the geographic mix of income from one period to the next.

Now I would like to discuss guidance for 2008. As stated in today's release – yesterday's release, we continue to expect sales growth of between 5% and 10%, and adjusted EBITDA of $53 million to $57 million. Due to the expected reduction in full-year shipments of the API to our customer whose product was recalled and slightly lower than expected revenues from generic APIs, we expect currency adjusted revenues to be approximately flat for the year.

Due to the impact of adjusted EBITDA of the lower currency adjusted revenues, partially offset by lower corporate spending, the Company also believes it will finish the year at the low end of its earnings guidance.

I would like to advise readers to refer to the guidance and other matter sections in yesterday's release for commentary on the potential impact of a key customer's product recall and related regulatory processes on our full-year sales and earnings guidance.

Restructuring strategic alternative expenses are expected to be approximately $2.5 million for the full year primarily related to the closure of our New Jersey R&D facility that we announced on the fourth quarter of 2007 and costs to complete the project to improve our legal entity structure.

The $1 million increase from prior guidance is related to the current assumption that we will be unable to sublease the closed facility before the end of 2008 and slightly higher than expected spending on the restructuring project.

For 2008 capital expenditures are still expected to be $33 million to $35 million. Our biggest projects are outside the U.S. in 2008 so the continued strong foreign currencies are driving us to the high end of this range. The majority of the spending in 2008 will be directed towards the three key projects that Steve discussed earlier.

I'll wrap up with a few comments on Corporate headquarter spending. Coming into the year we expected to spend a little over $16 million in 2008 at our corporate offices and with half the year behind us, we are now expecting to spend a little over $14 million for the year. We have aggressively cut expenses at our Corporate headquarters over the past 18 months, and while we believe we have made most of the reductions that we can make at this point, we continue to evaluate opportunities to reduce spending wherever we can.

I would now open up the call for questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Dan Leonard from First Analysis.

Dan Leonard – First Analysis

Hi. Good morning.

Steve Klosk

Hi, Dan.

Dan Leonard – First Analysis

Greg, I'm having a little trouble seeing how you get to the EBITDA guidance for the full-year given the performance year-to-date, and also given your outlook that a million or less revenue on that key product?

Greg Sargen

Right. We – I guess one key point that probably need to be aware of is – we expected to ship a fair amount of that product in Q2 of 2008. So had we shipped what we expected to ship, we would have had a pretty nice quarter. I won't get into the specific quantities. So we do expect that to be relatively back-end loaded for the part of the year as we discussed in the release yesterday. So our second half of 2008 we expect to be stronger than our second half of 2007 – both on a – compared to the first half of 2008 basis and – as a percentage of the overall revenues compared to last year. It's not like we have a lot of margin for error, given that we are at the low end of the range. So we do want to highlight that any significant timing delays, especially on the regulatory aspects of the recalled product, would push us below the range.

Dan Leonard – First Analysis

Well that brings me to my second question. What should we consider timely approval for your customer?

Greg Sargen

Well, we think, I mean – - the way the manufacturing process for this API works – - it's a five-step process. We can manufacture the product for the first four steps. Those first four steps take three months, give or take. So that's the long portion of the process. And then we can store it in a stable form without shelf life issues coming into play. So we will be manufacturing through the first four steps over the next few months and have been. We can then manufacture the fifth step in fairly short order for a fair – a large amount of product, such that we can meet all of the orders to be shipped if we get regulatory approval by, say, the end of October. We can still meet the demand. So we have some time there. A customer has indicated that they will – they expect to have heard from the regulators within that time period. And if their confidence in the outcome comes to fruition, then we should be able to meet the expected orders for the year.

Dan Leonard – First Analysis

If we haven't heard anything by the end of October, then we should assume that that number might be at risk?

Greg Sargen

Yes, it's not a firm date of October 31st, it's kind of there about. As we get closer to that date, we'll continually discuss this matter with our customer and see what we need to do to our production schedule to do anything we can to make that happen. So if it spills over into the first few days of November might we still make it sure. But give or take that's roughly the time frame.

Dan Leonard – First Analysis

Okay. Thank you. That is helpful.

Steve Klosk

You bet.

Operator

Your next question comes from Mike Sison from KeyBanc.

Greg Sargen

Hey, Mike.

Mike Sison – KeyBanc

Hey, guys. Steve, congrats for the new post.

Steve Klosk

Thank you, Mike.

Mike Sison – KeyBanc

In terms of the outlook, just let me revisit – the typical seasonality into the third quarter is expected to continue – the third quarter is typically a very weak quarter due to European shutdowns.

Greg Sargen

It will be weak. But not as weak as it's been in the past, partially because of the currently anticipated shipping schedule for this key product. So some of the second quarter material has moved into the third quarter. Again assuming we hold to a steady progress on resolving those issues, we should have a better third quarter than we typically had.

Mike Sison – KeyBanc

Then when you think about – obviously the fourth quarter is going to be the bigger quarter, and when you think about the second half in total – how much of that is sort of, I don't know if it is a good word – certain to a degree? You've got this order that's in place. How much of the second half forecast do you still have to fight for?

Greg Sargen

Let me comment on a couple of pieces and then I'll let Steve chime in also. If you take the generics piece it tends to be purchase order based. We tend to have kind of an order trends and backlog that give us decent visibility into kind of 60 days, 90 days, maybe 120 days. So there is a little risk in the fourth quarter. But based on their kind of deep dive over the past month or so as to what they expect in the back half of the year, they are pretty comfortable that they can hold to what we expect to happen. On the – what we will call the innovator side, the moving pieces of those business, there are a couple of key orders that we expect to get, but are anything but slam dunks, so they are not guaranteed. I would say the overwhelming majority of our business on the back half of the year is, I won't say, guaranteed, but is relatively secure. And then there is that kind of typical – 5%, to maybe 7%, that will depend on the timing from our customers. And then we have this kind of traditional – well this nontraditional overlay of this recalled product issue which we are trying to be as frank as we can about.

Mike Sison – KeyBanc

Okay.

Steve Klosk

That help?

Mike Sison – KeyBanc

Yes. Steve, when you think about – your gross margin in total for the Company has sort of weakened here over the last couple of quarters. When you think of longer term, what do you think the potential is? I know you might not have the specifics down already. But – what's the potential for gross margins – it used to be somewhere in the 40's. How do you think you need to get there?

Steve Klosk

Well, I think the key, Mike, is we have talked about is driving the mix toward products that are influenced by our IP. So the two key strategic initiatives in terms of growing the controlled substance business and growing the drug delivery business are frankly going to be the biggest key towards driving the margins back toward the mid-30s. And hopefully higher than that as we go out in the later years. But initially we certainly want to reverse what has been the trend of declining margins through that mix. And if we achieve the business plans for growth that we have in controlled substances and drug delivery, and graduate more of those 15 Phase III clinical products into long-term commercial supply agreements, then our margins are going to reverse and they're going to go up and the mix of the business is going to be better. That's what we've got to execute on. And that's very doable.

Mike Sison – KeyBanc

Then it seems to me like most of the margin deterioration is coming in generics. Is there anything in that business specifically that – you need to watch out for heading into 2009? You had the pricing issue, you had some older products come off guard. Is there a good pipeline of new products coming in there? And how do you see the profitability in that business over the next couple quarters heading into 2009?

Steve Klosk

Yes. You are right. Most of the margin pressure has been on that business and on the one – our largest API, where we signed a new five-year agreement. The good news on that product that most of the concession on price will be behind us in '08. So we don't have to dig out of that hole going into '09. I think the strategy on the base generic API business has to be to sort of stabilize it as we begin to introduce new products. And – we are really talking about the majority of those new products starting to come online really beginning in 2010 and then 2011 and beyond. So in the meantime, one of the things that I would like to see us do that I mentioned in my commentary at the beginning of the call, is to take that portfolio of older APIs that we have and use our drug delivery technology and deliver them in more effective and new formulations and delivery forms. If we do that, then I think we're going to be able to hold and potentially even reverse what we are seeing on those APIs. Because now they are going to be unique, differentiated APIs. So the strategy there is stabilize, new products, new drug delivery, and bring, slowly bring that segment of the business back and stop the erosion. At the same time – improve the mix as we discussed on controlled substances on drug delivery, both of which those businesses and those products are significantly higher than the average gross margin for Cambrex.

Mike Sison – KeyBanc

Okay. Great. Thank you.

Operator

Your next question comes from Jeff Zekauskas from JP Morgan.