SciClone Pharmaceuticals Management Discusses Q3 2012 Results - Earnings Call Transcript

 |  About: SciClone Pharmaceuticals, Inc. (SCLN)
by: SA Transcripts


Welcome to the Q3 2012 SciClone Pharmaceuticals Incorporated Earnings Conference Call. My name is John, and I'll be your operator for today's call. [Operator Instructions] Please note that this conference is being recorded.

I will now turn the call over to Jane Green, Investor Relations. You may begin, Jane.

Jane Green

Good morning. SciClone would like to thank you for joining on the call today. The company would also like to remind you that today's call is being recorded. Speaking on today's call are Dr. Friedhelm Blobel, President and Chief Executive Officer; and Gary Titus, Senior Vice President and Chief Financial Officer.

It is SciClone's intention that forward-looking statements regarding financial guidance and commercial and development activity made during today's call be protected under the Private Securities Litigation Reform Act of 1995. Forward-looking statements are subject to risks and uncertainties. Actual events or results may differ materially from those projected or discussed. All forward-looking statements are based upon current information available and SciClone assumes no obligation to update these statements. To better understand these risk factors, please refer to the documents that SciClone files with the Securities and Exchange Commission, including forms 10-Q and 10-K.

I'll now turn the call over to Friedhelm Blobel.

Friedhelm Blobel

Good afternoon, and welcome to SciClone's third quarter 2012 financial results conference call. Before I ask Gary to discuss our third quarter results and other corporate matters, I would like to provide some perspective on our overall business, including our progress in the last 1.5 years since the acquisition of NovaMed as well as the challenges and opportunities that lie ahead of us. In the third quarter, ZADAXIN sales were essentially flat compared to the second quarter and increased 12% in the quarter and 22% year-to-date compared to the prior year. Combined with revenue from other marketed products, this resulted in our overall company revenue growth of 9% in the quarter and 30% year-to-date.

There are several internal and external factors affecting our performance in the China market, which we are addressing. Externally, the China pharmaceuticals market is predicted to continue to grow at a rate of 15% or more due to increased consumer demand and expanded access to health care services. This is good news for pharmaceutical companies with substantial businesses in China, such as SciClone. At the same time, the China government is putting pressure on this market through price controls and other measures designed to contain health care costs. An example is the periodic price reductions that are imposed across therapeutic classes of drugs. Another example is the strategy of capping expenditures, putting a total prize limit on what can be spent on pharmaceuticals and other health care services by hospitals. Capping is being piloted in a number of leading hospitals throughout the country. Also, it remains unclear if this will become a policy for all hospitals in the future.

Relative to the recently announced 18% national price reduction of ZADAXIN, we were able to negotiate a favorable outcome with our importer that resulted in less than a 5% revenue impact on our company. But we believe that the prolonged uncertainty of the pricing issue had a dampening effect on ZADAXIN sales to the hospital pharmacies. Despite some challenges we face, we believe this limited price reduction is a positive outcome for our future. As we will discuss later in our call, we saw a rise in ZADAXIN channel inventory this year, particularly in the third quarter and have lowered our annual revenue projections in response, but we remain confident in our ZADAXIN business and our continuing efforts to expand sales for greater market penetration.

Internally, while there are important strategic benefits of the NovaMed acquisition, we are disappointed that the overall business has not met our original expectations and has not created the value at the profit and cash flow level that we originally anticipated. We have taken expedient action to identify and address issues across our China organization, some of which may have affected ZADAXIN sales to the hospital pharmacies, and to put strategies in place designed to strengthen our business and to improve our financial performance in subsequent quarters.

Over the next few minutes, I will discuss why we believe that the enhancements and changes we are implementing should have a long-term positive effect in our business and reestablish our company on a sustainable growth trajectory.

First, I'll provide some background. The acquisition of NovaMed was a major strategic event that transformed our company and established SciClone as a substantial specialty pharmaceutical company in the China market with broad market presence and significant growth prospects. Almost overnight, SciClone grew from a small, essentially one-product company to midsize market competitor. We expanded our commercial, regulatory and reimbursement capabilities. We acquired a larger and therapeutically diverse portfolio of branded marketed products that span high-growth areas including infectious disease, cardiovascular disease, CNS disorders and oncology and added it to our flagship brand, ZADAXIN. We acquired a portfolio of potentially market-leading products still early in their life cycle, such as Aggrastat, and the development portfolio to drive long-term future growth. And we gained licensing and promotion collaboration with companies seeking to leverage our capabilities in the China market.

Post acquisition, we moved quickly and efficiently to put together management and commercial teams, align our regulatory strategies and support our business development and alliance management efforts. We reorganized and structured the existing sales teams and the commercial function. We upgraded our analytics, customer targeting and market intelligence tools. We executed on the marketing and regulatory strategies that were already in place and working at both companies, focusing on accelerating the forward momentum of the combined company so that we could achieve aggressive growth targets.

At the same time, we launched an extensive company-wide compliance effort and worked diligently to put stronger, more comprehensive legal and compliance practices in place and promulgate those for intensive education and training throughout the organization. We believe that these efforts were appropriate and necessary. We delivered an impressive full year 2011 performance, including growing our flagship product, ZADAXIN, into $100 million plus brand. In 2012, our performance has been limited by the underperformance of NovaMed assets and the slow growth of the ZADAXIN brand. Nevertheless, we do believe that the NovaMed's acquisition succeeded in putting SciClone on the map uniquely positioned as a U.S.-based, China-focused specialty pharmaceutical company with the ability to partner and compete effectively with more established market players.

Today, we believe SciClone ranks in the top echelon of multinational companies operating in China and occupies a respected niche as a top performer in this complex and growing pharmaceutical market. Reflecting that status, during the last 12 months, we have been able to hire about a half dozen senior-level Chinese employees of a caliber and expertise which we couldn't access before. At the same time, we are transitioning out some of our senior management, notably the China CEO and the China COO. Overall, these changes are having a fundamental positive effect and are positioning us today to participate in the future opportunities of the China market.

We are now in the next phase of managing our growth and maturation for the long term. We have more to do to ensure that we continue to deliver strong financial results with profit contributions from all revenue growth drivers. We also have more to do to ensure that everyone who is part of or associated with the SciClone organization continues to operate according to the highest regulatory and compliance standards.

In the third quarter, there were some developments that affected our performance. We are responding to these developments by taking actions to strengthen our business and improve our financial performance in subsequent quarters, so that we can continue to meet new challenges and to take advantage of new growth opportunities.

We are making some important changes to our strategies, operations and personnel that we believe will strengthen the foundation for our continued success. These changes are already underway and we are seeing positive benefits from them.

Today, ZADAXIN has approximately 13% of the volume share in the thymalfasin market and more than 40% of the renminbi value share. We continue to focus on building demand for ZADAXIN based on its excellent reputation as a high-quality premium brand. The inclusion of thymalfasin in the treatment guidelines for hepatocellular carcinoma issued by the China Ministry of Health, also in its latest edition, should help to drive utilization even higher. In addition, the China government's concern about, and imposed limitations on, overuse of antibiotics provides opportunities to increase usage for this proven immunostimulatory agent, not only for the treatment of sepsis, but also in general surgery.

The long awaited price reduction for ZADAXIN which we announced in September finally removes what we believe has been an overhang on our company on this product. We are pleased to announce that based on agreements with SciClone's primary ZADAXIN importer and distributors to absorb the majority of the 18% reduction in the retailer's price, the actual impact on SciClone's revenue and margin is less than a 5% decrease in our future sales price. Their actions reflect how highly ZADAXIN is valued by our industry partners and by patients with serious medical conditions, who may now have greater access to this important and more affordable therapy. Over the long term, we believe that the price revision can positively affect ZADAXIN sales to increase volume and broader penetration into Tier 3 as well as Tier 2 cities in target geographies, and that it can strengthen our provincial tendering strategies.

I'll make 2 additional points on the pricing issue. First, while the China government revises pharmaceutical prices on an ongoing basis, we believe that the ZADAXIN price is not likely to change again for quite some time to come. That should enable us to enjoy price stability and allow for continued volume growth, as well as remove some uncertainty concerning ZADAXIN sales potential. Second, it is particularly noteworthy that ZADAXIN, Aggrastat and several of our oncology product continued to be independently listed from their generic competitors. This represents a substantial benefit in the tendering process which allows for preferential pricing for these high-quality branded products compared to generics. We are confident that ZADAXIN can continue to be a major growth driver for SciClone. It is clear, however, that we have to do more to penetrate the China markets on the national, provincial, city and institutional levels.

While we believe that the overall market for thymalfasin continues to grow and despite the expansion of our ZADAXIN-focused sales force, we have not been as successful as we would like in driving ZADAXIN sales. We believe that recent management turnover in the sales organization may have affected our efforts. In addition, during the third quarter, and particularly in September, we believe there was a significant increase in ZADAXIN channel inventory levels at our customers in China, which affected sales. We don't have absolute visibility into channel inventory, but our information indicates that it increased by approximately $14 million. We also can't be certain about the cause of this increase but we believe that several factors may have contributed, including that hospital pharmacies may have slowed their purchases awaiting the NDRC price reduction and the advantage of buying product at a lower price. In addition, we believe our recently announced management changes, as well as disruptions that related to our material weakness in our internal controls, which I will address in a moment and that we will include in our Form 10-Q to be filed later today, adversely affected the effectiveness of our sales organization.

We have taken steps to address these issues, directly recruiting experienced, new senior-level executives in China who have broad experience in multinational pharmaceutical companies to strengthen our organization. We are also working with our importers to address the channel buildup. We believe these strategies will be effective but that the effect on ZADAXIN sales may continue for some period of time.

To enhance our sales and marketing strategy, designed to expand market penetration and growth for ZADAXIN and other products, we are widening our market strategies by targeting numerous smaller hospitals, as well as hospitals that are in more rural areas. We are also piloting a program for cross-selling ZADAXIN with our oncology sales force to further leverage their market reach. The implementation of these strategies has already commenced in the fourth quarter. We anticipate that these additional strategies will begin to positively affect sales growth over the next several quarters.

Let's now discuss SciClone's entire marketed product portfolio. We have emphasized before that having a large and diversified product portfolio that includes multiple entrants in the major therapeutic areas, such as oncology, cardiovascular and CNS disease, is a market advantage in China. We have also emphasized that having such a large marketed portfolio means that SciClone is not dependent on its development portfolio to drive growth. This is important because it takes a long time even once the product is approved by the SFDA to get to the full commercialization stage and then to build traction in the market. In our marketed portfolio, we have some market winners such as ZADAXIN and Depakine, and potential stars such as Aggrastat and Stilnox. We also have legacy products in our portfolio that have been weak financial performers. We are in the process of reallocating our sales and marketing resources to focus on our high potential products and reemphasize our -- or phase out entirely those underperforming products that do not merit further support.

Among the potential stars in our portfolio is Aggrastat, an intervention cardiology product. When we announced the price reduction for ZADAXIN, we also noted that the new NDRC price of Aggrastat is quite favorable. Importantly, with a review behind us, most experts expect that major provinces will issue new tenders next year after the Chinese new year. This will eliminate the biggest obstacle so far for a more aggressive growth path for this product.

I'm especially pleased that we have recruited a highly-experienced new head of our primary care business unit, which is responsible for Aggrastat sales. Under her skilled and energetic leadership, we are implementing strategies that will essentially relaunch this promising product, which has significant therapeutic potential in the fast growing coronary stent market. Aggrastat is the only imported glycoprotein IIb/IIIa drug competing in the acute coronary syndrome market and we believe it has tremendous potential. As we have mentioned before, neither ReoPro nor Integrilin, Aggrastat's competitors in the U.S. and Europe, has, to our knowledge, begun the SFDA approval process in China, which means they are at least 5 to 7 years behind Aggrastat, enabling SciClone to have a clear shot at establishing market leadership.

We are working closely with Iroko, our licensing partner, on an Aggrastat market uptake plan providing our sales force with professional training and knowledge to effectively educate physicians about the product's benefits. The second half of 2012, we have also held key physician symposiums which have been well attended.

Let's now discuss our licensing and our product service agreements. While both of these strategies are important to drive SciClone's growth, they are valuable to us only if they are structured to deliver solid profitability to SciClone. We have been disappointed that some of our current product promotion agreements have not met the expectations we set at the time of the NovaMed acquisition relative to revenue growth and profitability. Our collaborations with Sanofi, Pfizer and Baxter are facing expiration dates in the near term. We are taking advantage of these pending expirations to renegotiate contracts with a goal of achieving more favorable terms and conditions.

I'll spend a moment discussing the SciClone-Sanofi agreement. This is an important relationship and we are confident that it will continue to benefit both companies. There are 3 key products that we exclusively promote for Sanofi in China: the anticonvulsant, Depakine; the fast acting hypnotic, Stilnox; and the ace inhibitor, Tritace, a great synergy with our cardiovascular product, Aggrastat. Sanofi has reason to be extremely pleased with our results. For example, Depakine's top line sales are growing well. Depakine is SciClone's second-largest selling product after ZADAXIN. During the last 3 years of SciClone marketing Depakine for Sanofi, sales have increased approximately 28% on an annual compounded basis, indicating that SciClone is well positioned to develop this product's market potential.

It is our understanding that Sanofi, with new management in place in China, is reevaluating its overall China strategy and this process is continuing. While this internal review process is underway, Sanofi and SciClone are discussing various proposals to further expand the partnership, which has been successful for us both. This could include an option to extend our promotion agreement for a shorter period than the current 5 year term to allow for a full discussion of collaboration models. We believe that such an extension would be a positive outcome for SciClone and we expect these extension negotiations will be concluded soon.

At the same time, we continue to seek to establish profitable in-licensing arrangements for approved or late-stage branded, well differentiated products that, if not yet approved, have a clear regulatory approval pathway in China based on existing regulatory approval outside of China. Our objective is to in-license products with high margins that can augment our product sales revenue. We are also continuing to explore opportunities to optimize our promotion services revenues. We are working on the final stage of the regulatory approval in China for our in-license candidate, DC Bead, and on the approval process for our other product candidates, all of which are in clinical trials or in other stages of the regulatory approval process in China.

I'll now discuss some organizational challenges and steps we are taking to strengthen our China operations. Over the last 2 years, we have implemented an aggressive set of programs and practices to ensure that everyone in our company, or who is associated with our company, behaves in accordance with the highest legal, regulatory and compliance standards. As I mentioned a moment ago, we have been successful in hiring experienced new local senior executives who we believe have positively affected our China organization. Our first addition late last year was a new head of compliance. We have successfully hired a new Vice President and CFO of our China operations who is a U.S. CPA and has extensive experience in both U.S. and China companies. We have, as I mentioned before, brought in an experienced new general manager for our primary care business unit, which should energize our sales efforts.

We've also successfully recruited new heads of our Regulatory, Human Resources and Business Development groups, all of whom are high-quality, accomplished, respected professionals, who are absolutely committed to excellence in execution, as well as in compliance. Through these efforts, we believe we have put a stronger team in place and enhance the cooperation and communication between our U.S. and China organizations.

We have an active search under way for a new CEO of our China operations. This recruitment is a top priority for the board and for the management team. Under new executive leadership, and there's a potential to bring in additional talent, we believe we can bring greater experience and maturity to our organization, enhance some key roles and ensure that we remain on a strong growth track and continue to maintain high compliance standards. We think this is a good time for a seasoned China operations CEO to take the reins and participate as we reestablish SciClone on a sustainable growth path. We are confident that the steps we are taking, to enhance the performance of our marketed product portfolio, bring in additional valuable assets to maximize revenue and profitability, renegotiate our current collaborations at more favorable terms that are possible, add lucrative new alliances and bring new talent into the organization, will significantly strengthen our overall operations and drive performance.

As we look forward to the remaining months of 2012 and beyond, we remain optimistic about our growth prospects and positive outlook for our business. The China pharmaceutical market is predicted to continue to grow at a healthy 15-plus percent this year compared to the essentially flat or low single-digit growth rates predicted for the pharmaceutical markets in the U.S., Europe and Japan. There is growing demand for imported pharmaceutical brands such as SciClone, which we believe will continue to be widely favored over locally manufactured generic products among patients and physicians, even with the government implementation of cost containment efforts. We intend to build on our strengths, address our challenges and take advantage of the growth trends within the China pharma market to further build our presence and drive sales and profitability.

Now, I would like to ask Gary to discuss other corporate developments and our financial performance for the third quarter. Then we'll move to Q&A. Gary?

Gary S. Titus

As Friedhelm mentioned, there have been several developments in the third quarter that affected our financial results, which were described in our press release and we will describe in additional detail in our Form 10-Q to be filed today. I will provide some commentary on those matters as I review our third quarter performance including a discussion of the company's revised outlook for 2012. I'll begin with a review of our financial results for the third quarter and then address the company's stock repurchase program and the ongoing SEC Department of Justice investigations.

SciClone reported that revenues increased by 9% for the quarter to $40.7 million, compared to revenues for the same period in the prior year of $37.4 million. The increase in revenues in the third quarter was due to the continued growth of the ZADAXIN and, as previously discussed, during the third quarter, and particularly in September, we believe there was an increase in ZADAXIN channel inventory levels in China. For the third quarter, ZADAXIN revenues increased to 12% -- by 12% to $31.2 million, compared to revenues for the same period in the prior year of $27.9 million. The revenues attributable to the primary care and oncology product lines were $9.5 million for both quarters ended September 30, 2012 and 2011.

On a GAAP basis, SciClone's net loss for the third quarter was $13.5 million compared with net income of $10.2 million for the same period in the prior year or a net loss of $0.24 per share on a basic and diluted basis for the 3 months ended September 30, 2012, compared with a net gain of $0.18 and $0.17 per share on a basic and diluted basis, respectively, for the same period in the prior year.

SciClone's non-GAAP net income for the third quarter was $11.7 million compared with non-GAAP net income of $9.8 million for the same period last year or $0.21 and $0.20 per share on a basic and diluted basis, respectively, for the 3 months ended September 30, 2012, and $0.17 and $0.16 per share on a basic and diluted basis, respectively, for the 3 months ended September 30, 2011. SciClone believes this non-GAAP information is useful to investors, taken in conjunction with GAAP financial statements, because management uses such information internally for its operating, budgeting and financial planning purposes.

Non-GAAP information is not prepared under a comprehensive set of accounting rules and should only be used to supplement an understanding of SciClone's operating results as reported under GAAP. The non-GAAP calculations and reconciliation to comparable GAAP measures were derived principally as a result of the NovaMed acquisition.

Sales and marketing expenses for the third quarter were $17 million compared with $15.2 million for the same period in the prior year. The increase of $1.8 million was primarily a result of the additional expansion in China by approximately 130 sales, marketing and sales support representatives since last year, which significantly expanded SciClone's sales and marketing capabilities. The company now has a combined sales organization comprised of approximately 850 sales and marketing-focused professionals in China.

Research and development expenses for the third quarter totaled $900,000, compared with $3 million for the same period in the prior year. Following the company's announcement in March 2, 2012, regarding the futility of our SCV-07 clinical development program in oral mucositis, the company has reduced its future U.S.-based clinical development expenses this year and expects further substantial decreases in R&D expenses in 2013.

General and administrative expenses for the third quarter were $5.7 million compared with $5.2 million for the same period in the prior year. The increase in 2012 was primarily due to higher professional expenses related to legal, accounting and tax matters. We have taken 2 significant accounting adjustments this quarter related to the acquisition of NovaMed last year. First, a non-cash impairment loss of $42.7 million to fully write down the value of the company's promotion and distribution contract rights, intangible asset recorded as part of the acquisition of NovaMed recognized during the third quarter and 9 months ended September 30, 2012, as the undiscounted cash flows estimated to be generated by those assets were less than the carrying amounts of those assets. There were no similar charges recorded during the same periods last year. As Friedhelm previously mentioned, 3 of these promotion contracts relate to collaborations with Sanofi, Pfizer and Baxter that are facing exploration dates in the near future. We are taking advantage of these pending expirations to renegotiate contracts with the goal of achieving more favorable terms and conditions.

Secondly, contingent consideration remeasurement related to the estimated fair value of the contingent consideration resulted in a gain of $12.8 million for the third quarter compared to a gain of $2.2 million for the same period in the prior year. The gain related to the decrease and the estimated probability of achieving targets relating to product distribution agreements. At September 30, 2012, cash and cash equivalents and restricted cash and investments totaled $89.2 million compared with $67 million at December 31, 2011. The increase in SciClone's cash balance was primarily due to the cash generated by the company's commercial operations partially offset by $18.5 million used in the 9 months ended September 30, 2012, by the company's stock repurchase plan.

In the third quarter, we identified deficiencies in the design and operation of controls primarily associated with our Aggrastat product line in the NovaMed subsidiary. As a result, we are reporting these deficiencies as a material weakness in our financial controls. One of the issues related to an individual overriding an internal control, and we have moved expeditiously to correct these deficiencies and to terminate personnel involved. As a result of these developments Friedhelm described in his comments, we are revising down our anticipated 2012 revenues to be between $152 million and $157 million from previously anticipated revenues of between $165 million and $170 million. The company's also revising its previously anticipated non-GAAP earnings per share for the full year to be between $0.62 and $0.68 from the previously anticipated range of $0.72 and $0.78 per share. The company is revising up the anticipated year-end cash, restricted cash and investment balances to greater than $90 million from the previously anticipated cash balances of greater than $85 million, excluding the cash impact of any future repurchase of common stock from that share repurchase program.

And now I'll briefly address 2 additional issues, the company's stock repurchase program and the ongoing SEC DOJ investigations. As we continue to believe our stock is undervalued and that repurchases are in the interest of all of our stockholders, our board has approved an increase in our reserve for our share repurchase program of $10 million. The balance available for repurchases as of today is $16.2 million. We consider several factors in determining when to make share repurchases, including among other things, our cash needs, the availability of funding and the market price of our stock. We expect that cash provided by future operating activities as well as available cash and cash equivalents and short-term investments will be the sources of funding for our share repurchase program.

Relative to the SEC DOJ investigations, we do not yet have visibility on the timing of the conclusion of these investigations. We remain absolutely committed to operating our business in compliance with the laws in the territories that we operate, with particular emphasis on the U.S. Foreign Corrupt Practices Act and with Sarbanes-Oxley internal control requirements. Including internal audit and compliance training and certifications for employees, importers and distributors and maintaining oversight and coordination with our U.S. corporate office.

And with that, I'll now turn the call back to Friedhelm.

Friedhelm Blobel

Thank you, Gary. We are addressing the operational matters discussed today expeditiously, plan to stay focused on our strategic initiatives and look forward to building on our success and continuing to deliver value to our shareholders.

Now, I would like to ask the operator to open the call for questions. Operator?

Question-and-Answer Session


[Operator Instructions] And we do have a question from Hamed Khorsand from BWS Financial.

Hamed Khorsand - BWS Financial Inc.

Just wanted to talk with you about this inventory buildup you were talking about. Do you think some of that buildup was because natural demand market after price decline?

Friedhelm Blobel

Well, I do not believe so, Hamed, because I think from what we know the overall market continues to grow not as much as last year, but still continues to grow for thymalfasin in maybe 15% to 20% range. And so we think that one part which had an effect with all likelihood was this announcement of the new NDRC price because hospitals certainly were reluctant to order anymore at the old price and were just waiting and kind of taking down their internal inventories as much as possible. But this is probably not all of what the effect is and we are working closely with our importers and distributors to make sure that we fully understand it and we are very focused on whatever we are doing in order to increase and build further demand.

Hamed Khorsand - BWS Financial Inc.

Yes, and that was my other question was going to be, what actions are you taking with the sales force now, given that the price decline has occurred? I mean, what's the strategy here making it more favorable as far as the prescription writings go?

Friedhelm Blobel

Right. The 18% is certainly -- for many people has a market impact, an 18% reduction, so it's becoming affordable for substantially more people. And as we highlighted, we are very pleased with the price we were able to negotiate with our importers and, I mean, that's the one element which should be quite a positive. We have started within the sales force to also look more into Tier 2 regions into the next smaller-sized hospital because that is a market which certainly is more open to us with the new price and with the larger reach of our organization, we also have better chances to do so. There is, in a number of companies, the big MMCs, they are looking at what they call nontarget strategies or nontarget hospital strategies, which are kind of lumping together all those hospitals in rural areas, in smaller hospitals in cities where their own [ph] sales forces don't go to. And there are various pilot models which the MMCs are trying how to really reach these additional market segments, which so far, MMCs typically have not addressed at all. And that's another part which we are looking at to see if we could create additional demand through these nontarget hospitals. A more straightforward approach is the cross-selling between our oncology sales force, who goes to some oncology centers where the ZADAXIN people don't go, and certainly also in the gynecology and urology tumor departments or segments or sections, there is demand for thymalfasin. So we are looking at a number of strategies to really address further demand for ZADAXIN.

Hamed Khorsand - BWS Financial Inc.

Okay. And my last question is, do you think there's going to be more profound impact in Q1 given that Q1 is usually a seasonally weak quarter for you? I'm just referring to what your inventory issue is right now.

Friedhelm Blobel

Well, I mean, I want to be careful to give anything which might be getting close to a partial guidance for 2013. So we are certainly working through the current situation. And as we have said, we think there will be a clear impact in Q4 but we hope that we can minimize an impact in Q1, but I think it's a bit too early to make definite statements around that.


Our next question is from Reni Benjamin from Burrill & Company.

Reni J. Benjamin - Burrill & Company, Research Division

Friedhelm, could you talk with a more about something that you mentioned earlier, price capping at the hospital level or sort of the maximum amount that a hospital might be able to spend on drug purchases?

Friedhelm Blobel

Sure. Reni, that's a very good question. There has been, in the last 12, 18 months a number of various approaches being piloted in a couple of hospitals. Typically, in very few hospitals but in very large hospitals and in what one may call leading hospitals and the models they have been experimenting with is that they say there is a overall cap of X for this hospital for the group of immune stimulators or for the group of oncology drugs or for infectious disease drugs and that needs to last for the whole year. These caps are typically such that late or mid-Q3, late Q3, most hospitals who are experimenting with this run into the cap and have used their contingent money, so to speak. And then they try, in some cases, they only use then more expensive drugs in case people pay out of pocket everything, and sometimes they go towards generic products just to make sure that the overruns for this capping or for the caps is not getting too dramatic. Now there has been -- that started a year, 1.5 years ago. First, in very few hospitals. These pilots have been expanded and 2 things make it certainly more problematic. One is that it's typically the leading hospitals who try to be good citizens and support the government with its healthcare reform efforts by piloting such programs. And second thing is that the government has put some competition among those piloting hospitals in the form of saying, okay, for some of these health care reform measures, we look for champions, who is doing the best and they have developed some of point systems and capping is one piece of that. And if they do well with their caps, then they get more points than if they get -- if they have more problems with the cap and exceed the caps. So there is, the government puts in some benefit. These are more moral benefits or you can get a gold level health care reform hospital if you do well there. And so these activities certainly are -- have been taking place more frequently this year than last year, and it's not quite clear how this will continue. But I think it is fair and appropriate to assume that they will continue to try various versions of such capping and that addresses or it's certainly disadvantageous particularly for expensive drugs because they, at the time they run into the caps, might replace them with lower cost generics or similar products.

Reni J. Benjamin - Burrill & Company, Research Division

Did you have a sense as to, at these pilot hospitals, what sort of budgets or caps are being implemented or tried out for therapeutics like ZADAXIN or other immunomodulators?

Friedhelm Blobel

Well, I mean, there is -- this takes various forms and that's -- I mean, at the moment, these are still pilots but it's the big hospitals and we have typically enjoyed particularly good business with the leading institutions. And that, therefore, I mean, we may be affected maybe a little bit more than some other products. Because of that and because of another point I will make in a minute, we feel that it is the appropriate focus to add additional and to focus the additional resources more on second-tier hospitals or the Class 2 hospitals and also more in Tier 2 cities. And the second point which I wanted to make is if you look even the overall GDP growth in China, it is not anymore Beijing, Shanghai and Guangdong, which are having the highest growth rates. It's the smaller provinces which still grow on the GDP level, 10-plus percent and Shanghai and Beijing are more around 5%, and the same you see through many industries but also through the health care sector and drug sales. And the bigger growth rates, the aggregate somehow was 18% growth, are probably, if you look from a regional or geographic level it's in the more countryside, rural or second-tier areas, still 25%, sometimes 30%. But in Beijing and Shanghai, you may find it sometimes below 5%. So the big growth engines were the big cities some 3 or 4 years ago and that's shifting also towards, to the smaller places and that applies to us. So we think that redeploying particularly some of those new people which we hired last year, end of last year, will be an appropriate and helpful strategy.

Reni J. Benjamin - Burrill & Company, Research Division

Okay, okay. That was very helpful. And I guess just the other the side of that coin, besides let's say focusing the sales effort in these much more faster growing markets, is, at least in my mind, expanding the indications for which ZADAXIN is being used. And I believe you mentioned in your call, sepsis and in the operating room. Can you take us through or just give us a sense as to what other indications are being explored? Are there clinical trials that are being done even if they're investigational sponsored studies or investor-sponsored studies?

Friedhelm Blobel

Right. I mean, I think the biggest opportunity there is really in the area of sepsis, where a very substantial trial has been done, has been completed, in the southern region in Guangdong. The key PIs [ph] are really leading people in emergency care in China and they are working on publishing this in an international journal. And I think that will have certainly a positive effect. And once this is published, we will certainly try to replicate this in a number of other geographies in China, and that might lead over some period of time that ZADAXIN or thymalfasin might also be added to treatment guidelines. Therefore, I mean, this is not happening in the next 3 months. But if you think on maybe 12-, 18-month time horizon, that is certainly something which could be possible, and I think that's an interesting opportunity. The other part is really general surgery, where the opportunity is more driven by the restricted measures the government takes against antibiotics and antibiotics overuse. And many Chinese physicians are convinced about the immune stimulatory capabilities of thymalfasin and therefore use ZADAXIN and similar products for patients in case of serious surgery like neurosurgery, like heart surgery and the like. That's also happening but there are no specific trials of any meaningful size in that regard.

Reni J. Benjamin - Burrill & Company, Research Division

I guess just a question on the inventory channel. Should we be thinking about it -- should I be thinking about in terms of the hospitals just didn't draw down on that inventory that was available on the wholesalers because they were waiting for the price decrease? As opposed to, let's say, wholesalers just continuing to increase the amount of ZADAXIN they were buying from you? And I guess embedded in that question is, when do you guys recognize -- can you remind us, when you guys recognize the revenue? And based on where we are in the quarter, fourth quarter right now, do you have a good sense as to how much of that channel has been drawn down?

Friedhelm Blobel

I mean what you described is certainly one piece of the equation that the hospitals, knowing that the price reduction will come, have been careful to really to buy what they typically have. And -- but there is also, I think, a piece that the demand has not -- the demand for ZADAXIN has not grown commensurately with what I think probably the market has grown in the last 6 months. And I think that's the piece where I think some of the internal issues with some of the people leaving, and Gary addressed some of the issues with material weakness, that has some impact. And we are certainly going and making it very clear that compliance is crucial, and there is no interest of the company in business other than in compliant business. That -- this is also a situation that maybe the one or the other junior-level person or mid-sized level management person feels that's getting more difficult to sell so why not go to a local company where they feel they could have easier ways to sell. But I think that's, to some extent, I think there is an element where we think we will have to continue to really reposition our internal organization. We have started doing this, but that had also some effect that the demand growth has not been quite as big. And you can imagine if the demand does grow, then it certainly gets kind of sucked [ph] pretty quickly, but it was particularly in September and we are still looking into this. Gary, feel free to add any perspective from your side.

Gary S. Titus

The revenue recognition, Reni, is when the company sells to the importer. So we recognize revenue at the point-of-sale to import of ZADAXIN. That's the same for Aggrastat. For the promotion business, it's a little bit different. It happens in a slightly different stage but essentially, that's I think the key point for your question.

Reni J. Benjamin - Burrill & Company, Research Division

Okay. And do you have a sense, Gary, as to how things are going through the channel now, now that we're 1.5 months into the fourth quarter?

Gary S. Titus

We have seen essentially the same result in October as we saw in the fourth quarter in terms of market sales, so they're not yet picking up, they're not declining. So it looks like a similar picture so far. But it's too early in the quarter to really see where we end up. So let's hold off on making final judgment on that until we see where the full quarter goes.

Reni J. Benjamin - Burrill & Company, Research Division

Okay. And I guess just one last question regarding the deficiencies of an employee overruling something that was in your prepared remarks. Can you just give us a little bit more color here if it's possible?

Gary S. Titus

Probably not a lot more we can add on that right now, Reni, I'm afraid to say. But essentially, it was overriding a control related to the sale of Aggrastat product and that did result in terminating a key employee in the company.


And our final question is from Yi Chen from Aegis Capital.

Yi Chen - Aegis Capital Corporation, Research Division

My first question is regarding the impairment of intangible assets. So considering this quarter's $43 million of impairment, there's pretty much nothing left on the balance sheet for intangible asset. But there is still $32 million of goodwill on the balance sheet. So I'm just wondering whether there's a possibility in the near future that there will be an impairment to that goodwill.

Gary S. Titus

Good question. Friedhelm, if you don't mind, I'll take that. The goodwill is not likely to have an impairment. It's measured in a different way and so I would not expect that the company would have to write off the goodwill in any period in the near future.

Yi Chen - Aegis Capital Corporation, Research Division

My second question is considering this quarter's ZADAXIN sales is pretty much flat, what is your general outlook going forward for ZADAXIN sales in China?

Friedhelm Blobel

Well, I think the longer-term outlook, I think, in my mind has not changed. There is a robust growth. The market has been growing also this year but we haven't been able to, in the last couple of -- maybe a couple of months, certainly, maybe 2, 3 quarters, to grow quite with the market and that is something which we certainly are addressing. But long term, I'm quite optimistic about that there is more growth in ZADAXIN. And frankly, a second element which is not necessarily ZADAXIN-specific but the fact that we have been able to really upgrade the level of quality and skills in the organization in the last 12 months through 6, 7 people, really senior level Chinese employees in various functions. And I mean, we have a much, much stronger organization overall there and that is something which makes me quite positive because it's so difficult and sometimes growth in China has a lot to do with the quality of people a company can attract, and that's clearly a positive and will help us. That, I mean, the NovaMed acquisition, as we said, was -- had also quite disappointing aspects, but I think coming out of that, I expect the company to be stronger and very well positioned to really continue its growth path.

Yi Chen - Aegis Capital Corporation, Research Division

So do you anticipate to have a full operational Chinese operation team by the end of this year?

Friedhelm Blobel

Well, I mean, what is full. If you particularly refer to the search for a China CEO, that could be the case but it could also take a little longer. So I don't want to make any kind of definite statements there but we have a couple of [indiscernible], not only in line of CEO, running. And that is, we made good progress and I'm overall very pleased with the quality of people we can address and have been able to attract to the company.


And we have a question from Jason Aryeh from Jalaa Equities.

Jason M. Aryeh - Jalaa Equities, L.P.

So you're still generating a tremendous amount of cash here despite these very unfortunate hiccups. And we would really like to see you return that cash. Clearly, the NovaMed acquisition was not a good use of shareholder capital, and you have $90 million of cash at year end. Why not do a very significant return of capital to shareholders or even a Dutch tender with the stock now trading at $3.81 a share? There's almost no enterprise value left here instead of just a regular buyback.

Friedhelm Blobel

I mean, that's a point which the board certainly will look at any time. And when they meet and discuss this. I think, we have taken at least one step, you may feel maybe not sufficient step, was expanding the repurchase program by another 10 million because we feel that, that is certainly a good use of the cash, but I think we will certainly have to readdress that matter in the board, and the board will discuss it seriously.

Jason M. Aryeh - Jalaa Equities, L.P.

Okay, great. Yes, I mean, the strength of the company is clearly your cash flow and cash generation and balance sheet, and I think with basically nearly no enterprise value, that would be either a Dutch tender or a significant return of capital would be the better way than to piecemeal it slowly with a buyback.

Friedhelm Blobel

I hear you.


We have no further questions at this time, and I'll turn it back over to you, Friedhelm, for any closing remarks.

Friedhelm Blobel

All right. Thank you very much for participating in our quarterly conference call. Please feel free to contact us directly should you have any further questions. Thank you for participating.


Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to All other use is prohibited.


If you have any additional questions about our online transcripts, please contact us at: Thank you!