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Executives

Paul Herendeen - EVP and CFO

Roger Boissonneault - President and CEO

Rochelle Fuhrmann - SVP, Finance

Analysts

Gregg Gilbert - Bank of America

Gary Nachman - Susquehanna Financial Group

Shibani Malhotra – RBC Capital

Chris Schott - JP Morgan

Randall Stanicky - Canaccord Genuity

Mark Goodman - UBS

Douglas Tsao - Barclays

Michael Tong - Wells Fargo Securities

David Risinger - Morgan Stanley

Elliot Wilbur - Needham & Company

Tim Chiang - CRT Capital

Warner Chilcott Limited (WCRX) Q3 2012 Earnings Call November 9, 2012 8:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Warner Chilcott announces third quarter 2012 financial results call. [Operator instructions.] I would now like to introduce your host for today’s conference, Paul Herendeen, executive vice president and chief financial officer. Sir, you may begin.

Paul Herendeen

Thank you, operator. I’m joined here this morning by Roger Boissonneault and Rochelle Fuhrmann. This morning, we issued a press release that details our operating results for the third quarter 2012. The press release is available on our website.

Roger will make a few opening comments, and then I’ll provide some additional color around the financial results for the quarter. And as the operator said, we will end with a Q&A period.

Before we get started, let me point out that this call will include forward-looking statements. These statements are subject to a number of risks and uncertainties that could cause the company’s actual results to differ materially from such statements. These risks and uncertainties are discussed in our 2011 Form 10-K and other filings which are available on the SEC’s website.

The forward-looking statements made during this call are made only as of the date of this call and the company undertakes no obligation to update such statements to reflect subsequent events or circumstances.

In addition, we will make reference during the course of the call to non-GAAP financial measures as defined by the SEC. In accordance with SEC regulations, we have provided reconciliations of those measures in our press release issued this morning to what we believe are the most directly comparable GAAP measures.

With that, let me turn things over to Roger Boissonneault, our president and CEO.

Roger Boissonneault

Thanks, Paul. Good morning, and thanks for joining us on the call. Paul will cover some financial results in a moment. Since our last call, we put another solid quarter on the board, the revenue over $600 million and adjusted cash and income of $0.99.

That is an odd number, and Rochelle and I have been trying to convince Paul to come up with another penny, but when he puts his accounting hat on, and that’s that pointy hat, he gets a little glaze over his eyes and pretty set in his ways, and he won’t come up with the next penny, so I guess we’re going to have to live with the $0.99.

That being said, I’d like to recognize the R&D group and their efforts. We are very proud of our R&D team and think that our ability to self-develop products is really unappreciated in the market. The R&D team’s track record is outstanding, and we expect they will continue to deliver value as we look ahead.

Outside of the required disclosures, we do not disclose specifics regarding our product development projects or even speculate on the expected timing of potential approvals. Let me say this, that during the last quarter, we made good progress on our effort to develop improved versions of a number of our key products. We will keep you posted on the material developments and our product pipeline as they arise.

Another item we have focused on is the status of our manufacturing facility in Fajardo. Since our last call, the FDA has reinspected the Fajardo facility and we are optimistic that we will address the concerns expressed in the FDA’s warning letter. While we hope to put the warning letter behind us soon, we will not be able to announce any final resolution of this matter unless and until we receive written correspondence from the FDA. To the extent that there are significant developments on this front, we will certainly pass them on to you.

Also during the third quarter, we implemented three initiatives intended to enhance shareholder value. The first was the payment of a $4 per share special cash dividend, funded through the use of approximately $400 million of cash on hand and $600 million of additional term debt.

Secondly, we adopted a new annual dividend policy, under which we expect to pay a total cash dividend of $0.50 per share each year, payable in equal, semiannual installments of $0.25 subject to board approval. Earlier this week, we announced that the board approved the first of the semiannual cash dividends of $0.25, payable on December 14 to shareholders of record as of November 30.

Third, we renewed our existing share redemption program. This allows us the flexibility to redeem up to $250 million of our shares through the end of 2013 at our discretion. These three corporate initiatives are meant to return value to all of our shareholders.

Let me also say that none of these activities limit our ability to continue to pursue potential strategic business development opportunities. We believe that we will have ready access to capital in the event that an attractive strategic opportunity presents itself in the near term.

With that, let me turn it over to Paul to provide more details around our Q3 financial performance. Paul?

Paul Herendeen

Thanks, Roger. Let me start with a very high level overview. We had a good quarter from a financial perspective as Roger said, posting adjusted cash and net income of $0.99 a share. Revenue from what I call our core business, which is everything other than global ACTONEL revenue, were essentially flat compared with the prior year quarter. That’s pretty good when you consider that we absorbed the launch of a generic competitor for DORYX 150 in Q2.

Within operating expenses, we continued to drive costs down. In the quarter, you can clearly see the benefits of having restructured our Western European operations and selling expenses in the U.S. were reduced as we pared our field sales forces as part of our ongoing efforts to balance our investments in promotional resources with the expected returns on those investments.

Meanwhile, ACTONEL continued to color our overall results. Global ACTONEL revenues declined $47 million compared to the third quarter of last year, constituting the lion’s share of the $49 million period over period decline in our total revenue.

Through active management of our costs, we were able to overcome the impact of most of the sales decline and posted adjusted EBITDA, using the bank bond definition, of $338 million, down a modest $14 million, or 4%, compared to the prior year quarter. With a favorable tax rate in the quarter as well, our adjusted cash net income rose to $247 million, which was up 8% versus the prior year quarter.

Let me discuss revenue first in a little bit more detail. As I said in the summary, revenue from our core business was essentially flat versus the prior year quarter. So let me start with the growers. Our OCs in the aggregate grew 1% on a 3% lift in LOESTRIN franchise prescriptions compared with Q3 of 2011. LO LOESTRIN continues to be our priority and LO LO prescriptions more than doubled compared with the prior year quarter.

With the focus squarely on LO LO, LOESTRIN 24 declined as would be expected, but overall our OC franchise prescriptions increased compared with the prior year. Our objective is to grow our overall OC franchise. At the current time, that means growing LO LO at the expense of LOESTRIN 24. Our priorities may and likely will change in the future as our OC portfolio continues to evolve through our product development efforts.

Overall, we expect our OC franchise to be a growth driver for us through the balance of 2012 into 2013 and beyond. ASACOL continues to be a large, stable, slow-growing franchise, and that’s the way I’ve described it in the past. And in Q3, net sales were $191 million, up 1% compared with the prior year quarter.

ASACOL is one of our key franchise, and you should expect us to aggressively defend our market-leading position in this attractive market segment. There’s been a bit of activity on the regulatory front with respect to the pathway, or the potential pathway, for potential generic competitors to ASACOL, including the FDA’s issuance of draft guidance and a citizen’s petition that we just filed.

I’ll wait for the Q&A to hear specific questions from you on that front, but I’ll leave you with this. We continue to believe that demonstrating legitimate equivalence to a product such as ASACOL presents a high bar. That said, we would not, and will not, rely solely on that belief, and will pursue all avenues to improve, protect, and grow the ASACOL franchise.

ESTRACE Cream continues to respond to the promotional efforts that we put behind the brand. Prescriptions were up 13% from the prior year quarter while the growth in reported net sales were held to a more modest 7% due to a contraction of pipeline inventories relative to the prior year quarter. We expect ESTRACE Cream to continue to be a growth franchise for us.

ATELVIA continues its steady, albeit slow, growth, reaching net sales of $19 million in the quarter. Rxs were up 51% compared with the prior year quarter. The watchwords here are slow and steady.

ENABLEX net sales were essentially flat compared to the prior year quarter, even though Rxs were down 17%. A little color here. You’ll recall that when we acquired the ENABLEX rights from Novartis, as part of that transaction we essentially stepped into a number of managed care contracts covering ENABLEX. Over the course of the last year, we’ve taken a hard look at some of those contracts and elected to terminate or not renew those that we felt were inconsistent with our view of value. While ENABLEX Rxs are down, our gross to net has improved.

Let me spend a minute on DORYX. Even though net sales decreased $9 million or 31% compared with the prior year quarter, there’s some good news here. In our second quarter facing generic competition, field prescriptions for DORYX 150 remained reasonably strong. Based on the most recent weekly Rx data, branded DORYX 150 retained more than 60% of total Rxs for the product and its generic competitor.

I’d like to give a tip of the hat to our dermatology sales team here as they’ve done a terrific job promoting the benefits of our branded product to dermatologists under challenging circumstances.

It’s important to note that the maintenance of DORYX prescriptions came at a cost in gross to net for the brand. While we’re happy to report DORYX revenue in this quarter that may be higher than many of you were expecting, it would be prudent to expect a continued downward trajectory for DORYX net sales as you think about this into the future.

I want to reemphasize a point that we made on our last call. We continue to promote DORYX using our dermatology sales force because we believe in the future of the brand, and because it’s important to us to maintain relationships that we forged with dermatologists over the last decade. We like the dermatology business, and expect to be a player in that segment as we go forward.

Finally, on the revenue front, ACTONEL. ACTONEL continues to fall away, with global revenues down 28% compared with the prior year quarter. The total U.S. oral bisphosphonate market is down roughly 20% for the first nine months of 2012 compared with the same period in the prior year. We expect global ACTONEL revenues to continue to decline at this same rate, if not a greater rate, from here forward.

Moving to gross profit margin, our gross profit margin as a percentage of total revenue was 87% in the quarter, and we are still on track to meet our guidance for the gross profit margin for the full year 2012, which we have articulated as between 88% and 89%.

SG&A expenses in the quarter were $183 million, down 15% compared with the prior year quarter. Let me give some color on each of the components of SG&A. Advertising and promotion, what we call A&P, those costs were down $12 million, or 38%, due to a number of factors including cost savings resulting from moving to a distributor model in Western Europe.

Selling and distribution costs generally were down $34 million, or 26%, also due to cost savings as a result of the move to the distributor model in Western Europe, lower co-promotion expenses as a result of lower ACTONEL sales outside the U.S., and a reduction in the size of our U.S. field sales forces.

In the third quarter, G&A, our general and administrative expense, were up $13 million, or 24%, primarily due to less FX gains compared with the prior year quarter and higher legal spend compared with the prior year quarter. G&A expense in the quarter also includes a $6 million litigation-related charge, which represents our current estimate of damages that are probable to be paid in connection with our DORYX 150 patent litigation.

Overall, SG&A expenses are trending lower than anticipated for the year. As a result, we’ve lowered our guidance for adjusted SG&A expense for the full year 2012 by $50 million to a range of $725 million to $775 million.

R&D expense in the quarter was down 4% compared with the prior year quarter. FDA filing fees incurred in the quarter were more than offset by lower expenses associated with internal R&D projects compared with the prior year quarter. Based on our current assessment of the timing and stages of certain of our R&D projects, we’ve lowered our 2012 guidance for expected R&D spend by $10 million to the range of $90-110 million.

Adjusted cash net income per share for the third quarter, which adds back the after-tax impact of the amortization and impairment of intangibles, the amortization and write-off of deferred financing costs, and the litigation related charge recognized in the quarter, was $0.99 per share, using fully diluted shares of 250.6 million shares for the quarter. Note that our share count reflects our share redemption activity earlier in 2012.

On the liquidity, we generated net cash from operations totaling $184 million in the quarter compared with $251 million in the prior year quarter. Our cash generation this quarter is a bit below what I would describe as our normal run rate. It’s held down by the timing of the settlement of a number of working capital accounts. We expect Q4 to be a stronger cash flow quarter.

As Roger noted in August 2012, we borrowed a total of $600 million of senior secured term loans which, together with approximately $400 million of cash on hand, we used to fund that special dividend to our shareholders of $4 per share, approximately $1 billion in the aggregate. During the third quarter, we did not make any optional prepayments of debt, and we did not make any redemptions of our shares under our share redemption program.

We ended Q3 with $304 million of cash on hand. On a net-net basis, our net leverage was roughly 2.5x trailing 12 month EBITDA. We ended the quarter with approximately $4 billion of gross debt comprised of $2.76 billion of term debt and $1.25 billion in face amount of 7.75% senior unsecured notes.

Turning to our full year guidance, I’ve touched on many of the items that factored into the changes we made to our full year 2012 guidance. Our anticipated revenues for 2012 remain the same as previously communicated, in the range of $2.4 billion to $2.5 billion for the full year.

Please note our year to date revenue is $1.929 billion, and we can all do the math to see that this implies Q4 revenue in the range of $471 million to $571 million. In thinking about Q4, you should take into consideration the fourth quarter has historically been a lower revenue quarter for us, and that we are expecting to continue to feel the impact of a declining ACTONEL franchise.

We also lowered our full year estimates for SG&A and R&D expenses I noted earlier. Based on our actual results through the third quarter, we changed our expectations for our cash tax rate for the full year. We define our cash tax rate as the percentage that you get when dividing our total GAAP tax provision by our adjusted earnings before taxes and book amortization of intangibles. Our revised expectation for our cash tax rate for 2012 is in the range of 11-12% of adjusted EBITDA, 100 basis points lower than the previously communicated range.

As a result of all of these changes, we’ve raised our guidance for adjusted cash net income per share for the full year of 2012 by $0.20 per share to a range of $3.75 to $3.85 from the prior range of $3.55 to $3.65. For all of the details of the guidance, please refer to the table that is included in this morning’s press release.

Before taking your questions, I’d also like to highlight two additional items. Yesterday, we filed a universal shelf registration statement on Form S3, as our existing shelf was set to expire in mid-November. To avoid any confusion, we are doing this in the ordinary course. We make it a point to have an available shelf registration statement in place at all times to enable the company to be in a position to issue registered securities, debt or equity, in accordance with SEC rules and regulations. Again, the S3 we filed yesterday was prepared and filed in the ordinary course of business, ahead of the expiration of our existing shelf.

Second, a personnel note. For those of you that don’t already know, our IR spokesperson, Emily Hill, has left us to take on a far more rewarding challenge as a full-time mom. We wish Emily and her family all the best. We’re in the process of recruiting a new IR professional. Until that person is in place, Rochelle Fuhrmann and I will do our best to be responsive to your inquiries.

With that, I would like to open up the line to Q&A. In the interest of addressing all parties, please try to limit yourself to one question. Operator, could you open for Q&A please?

Question-and-Answer Session

Operator

[Operator instructions.] And our first question comes from the line of Gregg Gilbert with Bank of America. Your line is open.

Gregg Gilbert - Bank of America

Paul, good job for not being bullied into another penny. Glad to hear that. [laughter] Two questions. Maybe on the R&D front, I know you’re not looking to talk specifically a whole lot, but can you confirm what the applications are, what type of applications are on file for next generation? So I’m assuming SNDAs. And can you share any color on timelines for those?

And then Roger, maybe higher level, maybe you can just walk us through what the organization has been through in terms of the strategic review and the distraction and kind of how you’ve gotten the troops to stay focused on the task at hand.

Roger Boissonneault

As far as the R&D, they are indeed NDAs. Not SNDAs, but NDAs. And we have been busy. As far as have they been filed, what’s filed, we don’t like to put that color on it, because a lot of people file NDAs, but the magic moment is when they get approved, and a lot of things can happen in that 10-month review process. But we just want to confirm that there is significant activity. We do intend to see the fruits of our activity in 2013.

As far as the issues, and I think what you’re alluding to is perhaps some of the stuff around DORYX and how well the troops have sustained themselves. I think it’s Marie [Carillo] has taken on Paul and Paul even acknowledges that Marie has won. I mean, we’ve talked about this. What is the asset? The asset is certainly the sales force, and probably to a lesser extent the product. This is a unique category. It is very dominated by specialists. Specialists are very particular about the types of products and they will go to a great extent to make sure that their patient gets the right product. Not so much with the primary care audience.

Paul Herendeen

Before we move to the next question, I think part of your question was around we went through earlier this year that strategic review, and that surely had an impact on our organization. I think when we did terminate that in the summertime, it has been helpful to us to get back. Because it has an impact on your ability to recruit. It has an impact on your ability to retain good people when there’s uncertainty about the future ownership of the company.

So in a positive way, that is behind us, and we’ve been able to move forward and continue to strengthen our organization. So I know some people thought we were hoping that the strategic review might have gone a different direction, but we are very excited about our prospects as a standalone company and now have removed that uncertainty and can just continue forward.

Operator

Our next question comes from the line of Gary Nachman with Susquehanna Financial Group. Your line is open.

Gary Nachman - Susquehanna Financial Group

Roger, we’re seeing the generic OC market in general heating up a little bit. Is that something that you think could impact share for the LOESTRIN franchise overall? Can you talk a little bit about how you plan to grab more share in that market?

Roger Boissonneault

You say it heated up. When we look at that market, it’s kind of an interesting market in that there is a significant brand element of it. There are some generic OCs that are being provided at low cost. Or at no cost. But the issue here is that they tend to be the 30-35 mcg products, and the older generic OCs.

And it is sort of amazing to me that you still have products out there like ORTHO TRI-CYCLEN LO, which still has market exclusivity, which generates a lot of our access, despite the fact that it’s not really actively promoted.

So I do think there are opportunities in the marketplace. I do think that the fact that we only have the 10 mcg product truly distinguishes us from any generic oral contraceptive. And then as Paul said, we went into this game with the idea that we were going to push both LO LO and LOESTRIN 24, and you’ve really got to concentrate on a product. And it’s relatively within I would say the last four to six months that we’re really concentrating on the LO LO product.

Unfortunately, it causes cannibalization of 24, because that’s where sales tend to go, as the low-hanging fruit. But I think that promoting a 10 mcg product, which has no generic, truly distinguishes us as a brand, and that’s what we’re going to be executing on.

And Paul also alluded to the fact that we’ve made investments in this brand to introduce new OCs, which will maybe even test the limits of the 10 mcg.

Gary Nachman - Susquehanna Financial Group

And just a quick follow up. How many women’s health reps do you have promoting LO LO after the restructuring?

Roger Boissonneault

I would say 199 to be consistent with Paul, but as I look to Rochelle, I think we’ll go with 200. We have about 200 reps.

Gary Nachman - Susquehanna Financial Group

Did that number come down as part of the restructuring?

Roger Boissonneault

No.

Paul Herendeen

That’s an area where we continue, and would expect to continue to invest. As you think about where we may have adjusted our expectations, it’s primarily in the bisphosphonate area.

Operator

Our next question comes from the line of Shibani Malhotra with RBC Capital. Your line is open.

Shibani Malhotra – RBC Capital

Just one for Paul actually. On the share buybacks, you didn’t buy any shares this quarter. Is it because you only had two weeks? And how are you thinking about that this year and over the next few months? And then following on from that, have you considered using your share buybacks to actually buy out some of the shares that private equity owns at the moment? That’s a question we get quite a bit from investors.

Paul Herendeen

During the quarter we elected not to utilize the share redemption program. That’s a function of we look at, every quarter, the calls for our capital. And I will tell you that in terms of deploying capital on an ongoing basis, share redemption is quite low on the list. It’s a tool that we have in our kit, which we would expect to use as appropriate, whether that’s in the balance of this year, whether that’s the first quarter of next year, and all the way through the expiry of the current version of that program at the end of 2013.

So we elected not to because we felt that there were other calls on our capital during Q3, and we’re not going to opine as to whether or not we’re going to utilize the program. It’s in there to take advantage of situations when we have lots of excess cash sitting around that we might like to use, but it’s not something that’s high on our list.

With respect to the PE folks, I know you get the question all the time, and people have all sorts of ideas about what we should do. Never say never, but that’s probably not something on our radar screen.

Shibani Malhotra – RBC Capital

If I may just follow up, you said it’s not high on your list. Can you just talk about what is high on your list?

Paul Herendeen

[laughter] Of course. And you know what it is. It’s a wonderful leading question. I think first and foremost, we’ve talked about a little bit here in our prepared remarks, is to invest back in our business. Second would be to maintain dry powder in order to be able to execute business strategic business development transactions, which we think would be highly value generative.

And then beyond that, that’s where we start thinking about, well, gee, we have excess capacity here, we’ll go ahead and pay. I want to point out, we’re initiating a dividend here. We haven’t even paid our first one yet. As an ongoing obligation to pay that to our shareholders, that’s a call on our capital too, which happens to fall in the fourth quarter. And then again two quarters out.

Operator

And our next question comes from the line of Chris Schott with JP Morgan. Your line is open.

Chris Schott - JP Morgan

Just two quick questions here. Maybe first as we look out to 2013 and thinking about some of the SG&A reductions announced today. Can you talk about your core product growth, and do you still see the business as a mid single digit grower, I think as you talked about with your initial 2012 guidance?

And then the second quarter was just to elaborate a little bit more on generic ASACOL and the draft guidance from the FDA, are you generally comfortable this guidance provides you the protection you need for the franchise. And if the FDA does not agree with some of these CP requests that you put in, are you still comfortable that you have enough protection with this guidance to get really comfortable that there’s not a risk here as we kind of look out over the next year or so?

Roger Boissonneault

I’ll start with the second question, which is the comfort. I’m never comfortable. So we do believe we have a solid argument. We believe we are on the side of good science and reason. That being said, I wouldn’t say I was comfortable. So I think you have to employ multiple strategies along these lines, one certainly being the citizen’s petition route. And there’s other strategies that we can employ to make sure that we can defend the ASACOL franchise because indeed it’s an important franchise to us, but I really don’t think that a generic can mimic the efficacy of the current product. So we believe the CP is a good instrument, but it’s not our only instrument.

Paul Herendeen

And I’ll take the first question, which was related to thinking ahead to 2013. You talked about the cost levels, and I think the thrust of that is gee, are you cutting out so much cost that it will keep you from being able to do good things in 2013. The answer to that is no. Any of you who’ve followed us for an extended period of time know that we’re not shy about adding resources when it’s appropriate to add resources, and we’re surely not shy about cutting resources when we don’t see appropriate returns on those investments. So as we’re sitting here right now, we believe that the aggregate size of our field sales forces in the U.S. is adequate to enable us to take advantage of the opportunities presented by our existing portfolio of brands.

Then there’s a second part of your question. Yeah, as I look out to 2013, I, for a number of quarters encourage people to break apart our business into the core and ACTONEL. ACTONEL, not much we can do about it, so push that off to the side. It helps generate some cash and some earnings, but it’s going in the direction that nobody likes.

Then there’s the core, and as I said that core business is one that we feel like we can grow at a modest rate into ’13 and beyond. But we’re not providing our guidance for 2013 today. But within that portfolio, I think I went through and when I talked about the components of our portfolio, our OCs, our ASACOL, our ESTRACE Cream, ATELVIA, and those are assets that we think we can go ahead and grow.

Operator

Our next question comes from the line of Randall Stanicky with Canaccord Genuity. Your line is open.

Randall Stanicky - Canaccord Genuity

Paul, we’ve seen several companies find success relative to the stock at least by engineering other mergers or deals with other companies and kind of taking advantage of a broader tax advantage. Is this something, notwithstanding the strategic review, that you guys are still looking at? And then specifically, how hard would it be for a [unintelligible] to do something like that?

Paul Herendeen

Before I answer the question, how do you think about doing that, what are you getting at there, because I’ll start with the foundation. Our tax structure is an advantage. We absolutely look for ways that we can lever that structure with optimizing acquisition of, particularly product assets, product rights, transactions and companies that might have assets that can be dropped into our structure, so it absolutely plays into the way we think about strategic opportunities out there. I’m not sure about the nature of your question. Are you talking about us looking at merging with other companies?

Randall Stanicky - Canaccord Genuity

Yeah, Paul. I mean look, we’ve all been following the company for a long time. We’ve seen the opportunity for product acquisitions, the [PCP] deal, etc., but I’m thinking something more of bigger, broader scale. Your tax structure, I understand it comes from two sources, but does that allow you the flexibility to do something on a bigger scale?

Paul Herendeen

Well, I’ve said this in many of our investor conferences as well as in one on ones, our structure is unique. Our structure would be a great value to a number of parties who might like to have a structure like us. That doesn’t mean we’re necessarily going to transact. But our structure would be a great asset to a third party.

Randall Stanicky - Canaccord Genuity

Let me just shift then. Quick question for Roger. As you think about ASACOL, there’s been a lot of focus here. Obviously some things have gone your way positively. How would you view a 505(b)(2) or a noninterchangable threat to that asset?

Roger Boissonneault

A 505(b)(2) means that it would be nonsubstitutable, and someone would have to go out there and promote the product. It is a tricky market. You do have the specialists, where you get a lot of the new starts. But probably over 50% of the market is actually in primary care. And so that means that if you indeed were to do a 505(b)(2) and start to promote the brand, it would be a tricky launch, because you couldn’t say you were any better than ASACOL.

We have an excellent franchise with the gastroenterologists. And you’d have to do a FP/GP type of promotion to even gain access to the chronic piece of this therapy. So if someone wanted to take that on, then I wish them the best of luck, but it would be a tough road.

Operator

And our next question comes from the line of Mark Goodman with UBS. Your line is open.

Mark Goodman - UBS

Roger, can you talk about the OC market just a little more from a branded competition? Are you seeing any competition out there when your field force is out there detailing against other people, or is it just you? Obviously prescriptions don’t really grow much as far as the broader category. And are you seeing any price increases stick? I know you take price increases, but how much discounting do you have to give back? So are we actually seeing year over year price increases? And just second, can you give us an update on the disclosed pipeline stuff?

Roger Boissonneault

Some of the price increases stick. And the other issue around that is for the branded segments, it’s not an area of deep discounting. We have pretty good gross to net with the LOESTRIN franchise. As for the branded segment, GENERESS is out there, and Watson is aggressively promoting the GENERESS brand. They’re doing a pretty good job with that. I was in Puerto Rico the other day. We actually make GENERESS, which disturbs me, but we do a good job with that.

So I think they’re out there. They’re certainly out there very active. Merck and the NuvaRing does have active promotion. The Byer people, they’re still out there. You know, the Yaz and Beyaz. It’s kind of confusing to figure out what they’re promoting, because they have a number of products. And the interesting one is the Ortho Tri Lo, which I said before is still… You talk about brand loyalty, and the halo of that Ortho franchise, you still have physicians starting patients on Tri Lo by simply sending them samples.

So in short, there is competition out there. I think the generic competition basically happens certainly in the pharmacy level. But like I said, we’re basically growing the 10 mcg, the LO LO segment of this marketplace, and there are no generics at the 10 mcg level.

And you wanted a little bit about the pipeline, but I think I’ve showed you our cards. That’s one of the areas that I think we’ve done a lot of research. We’ve been the innovator. We’re the first people with the low dose. We’ve talked about 24. And within oral contraceptives, we continue to innovate and we have a pipeline that will support that innovation, that you’ll start seeing revealed in perhaps ‘13/14.

Mark Goodman - UBS

Can you also comment on the broader pipeline? The ED drug, where is that?

Roger Boissonneault

Yeah, we’re moving along. We’re in conversations with FDA with udenafil. We think we have a clear path. We are scheduling a pre-NDA meeting. I think that will happen sometime next year. Probably first quarter. So we think that things are moving nicely. We’re also dealing with the new tetracycline we talked about. We think we might have some news for you as to the results of the Phase II perhaps first quarter next year. And then consistent with positive Phase II results, we’ll be moving into Phase III studies.

And so far I’m cautiously optimistic. So those projects are going. I don’t have everything in front of me, but we’ve got an excellent R&D group. And I think we just don’t get that credit until we actually get the product into the marketplace. But we do certainly have some strategic assets that we’re working on.

Operator

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

Douglas Tsao - Barclays

Paul, I’m just wondering if you could talk a little bit about profitability of the ACTONEL franchise right now relative to the core business. Obviously you’ve seen a decline in the scripts and the volume, but you’ve also restructured the business and you guys as a company have always been very good about generating economic profits from your assets.

Paul Herendeen

Sure. If you think about that business, it continues to be a profitable business. And from a cost perspective, and this is just global ACTONEL, since we moved to a distributed model in Western Europe, really the sum total of the cost against the ACTONEL franchise really is in the cold promotion payments that we make to Sanofi.

And we have previously disclosed in the United States that accounts for, on a fixed basis, $175 million this year. And I’m looking at Rochelle, because I have not done the revised calculation of how much the o-U.S. piece is as a percentage of the o-U.S. ACTONEL revenue, but that’s the sole cost against it.

It’s a relatively high gross profit margin product, so you take the revenue times 90%-plus gross profit margin, and subtract out those co-pro, and you can still see, it’s a pretty profitable business. It’s also a profitable business that is in our tax structure. So in other words the marginal tax rate on that is like 10%. So, profitable.

Douglas Tsao - Barclays

And then just in terms of the ASACOL franchise, I know you guys have indicated in the past that you did not think IMS scripts necessarily captured exactly what was going on with the business and in terms of your volumes. I was just curious if there was any better accuracy or precision between new scripts versus total scripts, and also if IMS perhaps didn’t give an accurate reflection of where the conversion from the 400 to the 800 was.

Paul Herendeen

It’s not something with respect to the split between 400 and [8D]. What you’re referring to is we’ve owned this asset now since 2009. And we know exactly what we shipped out into the trade. And we know exactly what’s still out there in the trade, because we have inventory management agreements in place. So we have this perfect visibility into what’s out there with distributors.

And if you went through an analysis and said, gee, I’m going to strongly correlate the IMS Rx data and say that strongly correlates with the relief from wholesalers and ultimately through retailers, then you would conclude that there’s an enormous amount of pipeline inventory out there. I know that to be false.

So in that war we just keep looking at it and saying, not only is there not a direct correlation, the relationship continues to change. So, as I think I might have said on the last call, perhaps it was two calls ago, all I want to say on this is people look at IMS data and they say it’s infallible. It’s exact. It’s perfect. In some cases it’s not. And I think this is one of those cases.

Douglas Tsao - Barclays

So just to clarify, Paul, from what you’re saying we should not look at this and say… Because what I was just wondering is if in that lack of precision, and infallibility of IMS data, which I think we all recognize, or should recognize. Were we missing something systematic in terms of the volumes of HD versus the 400, just so we can consider where you are with that process and the status of the overall franchise?

Paul Herendeen

One thing you do have to take into account - that’s a good point - is to the extent that someone has an HD Rx versus a 400 Rx, they tend to use more mg per day. It’s around 15% more per day. So there is that element, to the extent that you look at the franchise, and you look at HD, an HD Rx is kind of worth 1.15 of an ASACOL 400 Rx. So sure, you need to take that into account.

I think what I’m trying to say is if that was the only factor, and it was constant, then you say, okay, I’m okay. There’s a consistent error term. The error term, when you combine the franchises here, is not consistent. And so it makes it a little bit more challenging to model. I’ve said in the past, I’ll say it again, I think of ASACOL as kind of a stable to low-growing franchise. We’re the market leader, and the market turns over relatively slowly. In fact, not relatively, it turns over very slowly.

So it’s hard for us to grow units in a meaningful way, but I think of this as something where we might be flattish to up a little bit in units. And certainly have the ability to increase price and have that flock through into our net sales. So we haven’t changed that view. That’s the way we think about ASACOL as we go forward.

Operator

Our next question comes from the line of Michael Tong with Wells Fargo Securities. Your line is open.

Michael Tong - Wells Fargo Securities

Roger, I think I detected an increased level of enthusiasm in your R&D pipeline, maybe just verbally more so. So the question is, as you think about the pipeline reaching the inflection point and getting a lot of new product approvals, how do you think about your existing SG&A structure? Do you allocate current expenses into what might be new product launches over the next couple of years? Or do you need to then add to your SG&A expenses going forward as you prep for launch?

Roger Boissonneault

That’s a good question. I remain enthusiastic. I’m sorry if I didn’t seem enthusiastic before, but Paul’s been enthusiastic. I’ve always been enthusiastic about the pipeline, and the issue is, despite my enthusiasm, there probably is a lack of trust. Not because of my enthusiasm. It’s a fact. We have delivered.

And I think sometimes you look at financial relationships and you say, well, but your R&D budget isn’t large enough. And even Paul complains about our R&D budget. And the fact that maybe we should be spending more. And to me, it’s more like what comes out of R&D, not what goes into it, you know? I came out of Parke-Davis and Lipitor came out of a very modest budget. So the thing is, it’s not really how much you spend. It’s that level of execution, and we’re very proud of our group.

When we go into the year, and this is to your how do we plan for SG&A, new products are not in the financial plan. So when we get something approved, we take that time to say, let’s relook at this financial plan. So we have the ability to adjust our A&P during the year. So when we’re looking at 2013, I’m sure Paul looks at it and says nothing happens.

If we get a big approval, then what we’ll probably do is adjust, and we’ll move more SG&A behind the new product, because it’s going to require that type of investment. But then again, everybody is, oh, we’re all happy. Oh, we’ll spend some new money against the new product. But until a new product comes, we don’t make that type of investment. When it comes we will make that type of investment.

Operator

And our next question comes from the line of David Risinger with Morgan Stanley. Your line is open.

David Risinger - Morgan Stanley

[unintelligible] has done a great job of cutting costs and driving efficiencies over the last couple of years, and Roger and Paul, I was hoping that you could just talk about where the cost structure stands today, with respect to SG&A and R&D, and whether the current run rate is likely to be the run rate in the near term or whether we should expect further stepdowns in SG&A or R&D.

And then separately, Paul, I think in the past you’ve provided a little bit of color on your anticipation of stepdowns in co-promotion payments to Sanofi over the next couple of years. So if you could update us on that so that we better understand the Sanofi copromotion payment reductions to come, that would be great.

Paul Herendeen

I’ll take both of those questions. Let me start with your question around our cost structure. I think where you’re going there is how much more could we squeeze out of our cost structure. As we’re sitting here right now, and with the portfolio we have, I think that I would describe our current run rate on the selling expense side, aside from co-pro, but the actual selling expense side, as being good for what we see ahead in 2013, even potentially into 2014.

Now, Roger just said, that could change. If we had an approval of something and we felt that it was appropriate to put additional resources behind that, we would not be shy about adding 100 territories or increasing our advertising and promotion budget by $20 million or something if we felt like we had an opportunity to generate kind of above average growth from an asset that’s not presently part of our portfolio.

So you said the great MBA answer, it depends. Selling expense, where it is right now, I think we’ve done a very good job of matching the investment that we are making in our field sales resources against the opportunities presented by our existing portfolio. To the extent that we add to that portfolio in ’13, we might tweak that upward.

With respect to G&A, G&A is our wildcard. I think on the ongoing G&A, like the stuff that is relatively straightforward to forecast, we have always been very stingy with our G&A dollars, and I expect we will continue to be like that. And so I think we’ve got the ongoing part of G&A down and squeezed down pretty well, and probably could do a little bit more, but we’re pretty well down there in G&A.

The wildcard in G&A is legal expenses. As you know, that’s part of our business model. Any branded prescription pharma company is challenged on all sorts of stuff all the time. And so that’s a little bit difficult to predict, not only in the magnitude of the dollars that you’ll be spending in those actions, but also the timing. So that’s a bit of a wildcard, but with respect to the ongoing part, I think we’re pretty squeezed down.

On R&D, Roger just referenced this a moment ago, I am the guy that said, if we, this year, are going to spend $90-100 million in R&D, I really do wish that was $150 million. But I really only want it to be $150 million if at the margin that $40-60 million of incremental investment is in projects that we’re really excited about.

So right now, I think the R&D spend, it’s in the neighborhood of $100 million, is a reasonable expectation for us, unless we come across one or more things that we want to drop into that pipeline. And just to be clear, I wish we could spend more, because the way we approach R&D is not to spend to an amount or a percent or whatever. It’s to spend on projects that we think will be successful for us.

I’ll give you the co-pro. It’s relatively straightforward. This year, as I said, the fixed amount on the co-pro that we’ll pay is $175 million, in the U.S. In 2013, it’s $175 million in the U.S. In ’14, it’s $125 million. And in ’15 it’s zero. So that would be helpful in ’15.

With respect to the rest of the world piece, it’s a percentage, and I apologize, I don’t have that sitting in front of me. My recollection was it’s about 20%-ish of the o-U.S. ACTONEL revenues is the co-pro payment. With those sales declining as well, you would expect that the co-pro would go down as well. I think year to date the rest of the world co-pro is down 40% from the prior year. So that will continue to decline.

Operator

And our next question comes from the line of Eliot Wilbur with Needham & Company. Your line is open.

Elliot Wilbur - Needham & Company

Paul, your color commentary on implied revenue guidance for the fourth quarter aside, even I guess one or two standard deviations away from the current rate of decline, and some of the core products wouldn’t suggest you’d be anywhere close to the low end of the range. And consensus number right now is at the high end. So I guess the question is, is there anything else that we should be thinking about there that may negatively impact top line trends in the quarter such as anticipated reduction in pipeline inventories or some major change in contracting that might result in substantial change in gross to net?

Paul Herendeen

It’s a good question, and I did highlight that, because I know that after we get off this call, and we start the series of calls with folks that just want to catch up on the quarter, people are going to do that exact analysis and they’re going to say exactly what you just said. So thank you for saying it here on the call. If people think we’ll be at the high end, that would be your conclusion. There is certainly nothing within our core portfolio nor even what we’ve foreshadowed with respect to ACTONEL that would lead you to believe that Q4 would fall off.

Other than the fact that I pointed out Q4 tends to be a low revenue quarter for us. It tends to be a low revenue quarter in part because the holidays are in the latter part of December and a lot of folks kind of shut down. And January kind of picks up, and they reprime the pump. Other than that, no, there’s nothing that I would want to point you to to say, gee, there’s something negative out there.

Operator

And our final question comes from the line of Tim Chiang with CRT Capital. Your line is open.

Tim Chiang - CRT Capital

I just wanted to ask sort of a big picture question. Heading into 2013, what do you think the biggest priority will be for you both? Is it to rejuvenate the growth of the company, find an offset to ACTONEL sales declines? Is there something you could sort of finish the call with in terms of giving investors more confidence about your business going forward?

Paul Herendeen

We’d love to have an offset to ACTONEL, but it has been quite a challenge. When we acquired it, it was over a billion franchise, and it’s done nothing but shrink at a very aggressive rate since we acquired it in 2009. It would have been awesome to have an offset, but even if you had an offset, it would just help offset. When I think about our core business, and to give you the confidence, I think that we think about 2013, we think about beyond.

Again, I’ll tick off the drugs that are in our portfolio that we’re very excited about. It’s our OCs. We’re a player in the OC space, the market leader among branded OCs. And we expect to continue to be a player there. And we expect to continue to have the opportunity to grow that overall franchise. ASACOL, which I talked about earlier, is a solid, albeit low-grower, but it’s a big asset. A big asset. ESTRACE Cream continues to click along. ATELVIA, slow but steady. ENABLEX we’re kind of resetting the bar by the actions that I spoke about with respect to managed care contracts, etc. DORYX has been a bit of a revenue drag for us, as we did face the generic competition starting in Q2, but the results in Q3, I think, were better than many people might have anticipated.

As we look forward, that core portfolio has the opportunity to grow. And that’s why I continually try to break ACTONEL apart and it was a good question when you said what’s the profitability of that. You can break it apart. And the way to think about us might be a company that instead of having guidance out there for $3.75 per share is really made up of two things. It’s that stub of what you’re going to get for ACTONEL, and there’s a growth company that’s buried in there that is currently trading at a very low multiple. We’re very excited about the prospects for our core business as we look forward.

Paul Herendeen

Let me give you my simple answer. What could we do? I mean, if you look at history, we’ve made acquisitions. We’ve bought the Pfizer women’s healthcare business, we’ve bought the Bristol Myers women’s healthcare business, we bought P&G’s pharmaceutical business. And it’s all worked out. The only issue with that is it’s very difficult to plan for those acquisitions. But we’re ready to do that type of acquisition or we’re ready to do that type of strategic transformation if the opportunity arises.

As for the business, basically next year it’s going to be a busy year, because we hit these supposed cliffs. So the issue may not be how much did you grow, but did you not hit a cliff? So I think those are the things that investors sort of look at and wonder about when we get the ASACOL question, how long can you sustain that? What’s going to happen with the OCs? You might have a tail there.

And actually, it’s kind of interesting, people aren’t so worried about the ACTONEL cliff, because it’s being mitigated by the fact that the osteoporosis market is declining. So we’re self-mitigating that risk.

But the issue there also is can you extend it, and what’s left there to extend? And we’re working on that front also. But I think now we’re going to have greater visibility on these assets, certainly in 2013 and 2014, so we see that as an opportunity. And we stand ready. If we see another business proposition like the P&G business or another women’s healthcare business, or a dermatology business, we’re there. We’re looking at those types of assets, because it can be folded in quite neatly.

Operator

Thank you. That does conclude today’s question and answer session. I’d like to turn the call back over to management for closing remarks.

Paul Herendeen

Thank you all for joining our call this morning. We’ve had a very active first nine months of 2012, and I think we posted solid earnings despite the challenges that we faced. During that period, we returned another $4 per share to you, our shareholders, and we’ve now initiated a regular dividend on our shares. We will continue to work hard through the balance of this year, and to set the stage for what we view as a productive 2013. Thank you for your interest in Warner Chilcott.

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