Cambrex's (CBM) CEO Steve Klosk on Q4 2018 Results - Earnings Call Transcript

Feb. 13, 2019 12:06 PM ETCambrex Corporation (CBM)
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Cambrex Corporation (NYSE:CBM) Q4 2018 Earnings Conference Call February 13, 2019 8:30 AM ET

Company Participants

Greg Sargen - CFO

Steve Klosk - President & CEO

Conference Call Participants

Drew Jones - Stephens Incorporated

David Windley - Jefferies

John Kreger - William Blair

Matt Hewitt - Craig-Hallum Capital Group

Evan Stover - Robert W. Baird

Steve Schwartz - First Analysis


Ladies and gentlemen, good day, and welcome to the Cambrex Fourth Quarter and Full-Year 2018 Earnings Call. Today's conference is being recorded.

At this time, I would like to turn the conference over to Mr. Greg Sargen, Chief Financial Officer. Please go ahead, sir.

Greg Sargen

Thank you, David, and good morning everyone. Welcome to Cambrex's fourth quarter and full-year 2018 earnings conference call.

Today's discussion will contain forward-looking statements regarding expected operational and financial performance, and these statements may occur during our prepared remarks or during the question-and-answer session.

These statements are based on Cambrex's current expectations and involve risks and uncertainties that could cause actual outcomes and results to materially differ from those included in the forward-looking statements. For further information regarding such risks and uncertainties, please refer to the Risk Factors and forward-looking statements portions of our 2018 Form 10-K and the earnings release both of which were issued earlier this morning.

During this call, we will be referring to several times to changes in revenue, all of which are made on a constant currency basis. Also during this conference call, to provide greater transparency regarding Cambrex's operating performance, we refer to certain non-GAAP financial measures that are reconciled to the most directly comparable GAAP financial measure in a table at the end of our earnings press release issued this morning and available at our website at

A replay of this call will be available shortly after we end today through next Wednesday, February 20th, and will also be available on the Investors section of our website.

Before I turn the call over to Steve Klosk, our President and CEO, for a business review, I want to explain a few items related to our financial reporting that will be discussed on today's call and future calls.

The first item I would like to discuss is our segment reporting. As you know, we acquired Halo Pharmaceuticals in September of this year adding a new segment called Finished Dosage Form or FDF to our core active pharmaceutical ingredient or API. We reported results for these two segments with a separate breakout of corporate operating expenses for the third and fourth quarters of 2018.

On January 2nd, 2019, we closed on the acquisition of Avista Pharma Solutions, which focuses on early stage development & testing services for both APIs and Finished Dosage Form. As a result of this acquisition, we are adding a third reportable segment called early stage development & testing or ESDT. And as such, we'll have three reportable segments for 2019.

In addition to adding a segment as a result of acquiring Avista, we are renaming the segments to better match popular vernacular within the market sectors in which we compete. The Finished Dosage Form segment will now be referred to as drug product and it will continue to consist of the former Halo businesses that we acquired in September. The API segment will now be called drug substance. To avoid confusion, we will use only the new segment name throughout this discussion whether we are referring to 2018 results or 2019 expectations.

There's one other change that will affect segment reporting and accordingly the guidance we discuss on this call. The early stage development & testing or ESDT segment will consist of a business operations and our High Point, North Carolina site which we obtained with the acquisition of PharmaCore in 2016. High Point focuses on early stage drug substance projects and as such we believe it can be easily integrated into our early stage development & testing services segment.

As we report in 2019, we will restate prior-year segment results to move High Point's results out of the drug substance segment where it was previously reported and into this new segment.

So for clarity and to summarize, our Finished Dosage Form segment will be renamed drug product and continue consists of the results of the former Halo business. Our API segment will be renamed drug substance and will consist of all operations within Cambrex, prior to the Halo acquisition, with the exception of our High Point facility. The new segment early stage development & testing services or ESDT will consist of the former Avista business plus our High Point facilities. These segments best align with how we plan to organize and run the business moving forward.

The second item I would like to discuss is the transition from recognizing revenue under ASC 605 to ASC 606. During 2018, we reported both ASC 605 and 606 results. But since we only had ASC 605 results for 2017, all guidance and year-over-year comparisons discussed on our quarterly earnings releases and calls were based on ASC 605 results for both years including profitability. Today's discussion of our results will be a hybrid our discussion of fourth quarter and full-year 2018 results as compared to 2017 results will be based on ASC 605 results for both years. Any discussion of 2019 expected results and related comparisons to 2018 will reflect ASC 606 results for both years.

Now I would like to introduce Steve Klosk, our President and CEO. I will follow Steve with some comments on certain financial items before opening the call for Q&A.

With that, it is my pleasure to introduce Steve Klosk. Steve?

Steve Klosk

Thank you, Greg, and good morning ladies and gentlemen.

I'd like to open with a few thoughts on key recent developments in our business that we believe will drive performance in 2019 and beyond. We completed two transformational acquisitions over the last five months that we believe better positioned Cambrex for long-term growth.

In September of 2018, we acquired a leading Finished Dosage Form Contract Development and Manufacturing Organization or CDMO that provides product development and commercial manufacturing services to the innovator and generic pharmaceutical markets. With that acquisition, we gained two excellent drug product facilities in New Jersey, and in Canada, and 450 highly skilled employees.

On January 2nd, 2019, we closed on the acquisition of Avista. Avista is a contract development manufacturing and testing organization focused on pre-clinical and early clinical phase projects covering both drug substance and drug products. With this transaction, we acquired four state-of-the-art facilities that provide analytical testing, a broad array of drug substance, and drug product services, microbiological testing, solid state chemistry, and animal health service.

We believe that combining these businesses with Cambrex's core Legacy drug substance business positions Cambrex as the leading fully integrated small molecule CDMO across the entire drug lifecycle. Adding Avista and Halo to Cambrex significantly increases our customer base, adding hundreds of new customers. It also significantly increases our pipeline of projects in both drug substance and drug product, creating a feeder for later stage manufacturing facility.

The acquisition should create extensive cross-selling opportunities and allow us to provide an integrated service offering from most small molecules from the preclinical stage through the commercial stage covering both drug substance and drug products and a full range of analytical testing capabilities.

In summary, we can now offer our customers virtually all the services they need to develop their small molecule therapeutics. The integration of these businesses is well underway. Importantly, we have formed a single commercial team expanding the entirety of our CDMO services.

Within the drug substance segment, our generics commercial team will operate separately to serve its distinct sales channel as it has in the past. Within the CDMO commercial team, we are organizing so that each business development professional will cover our full range of services for his or her respective customers.

We believe this structure will be most efficient for our customers and ultimately lead to broader and deeper customer relationships across our full range of services. When I talk about expectations for our business segments, I think you'll see that we believe we are well-positioned for significant growth from the new capabilities we acquired. Growth that exceeds what would be possible if each segment was a standalone business.

Operational integration teams have been formed and we are integrating processes on a function-by-function basis with priority given to those that impact our customer interactions. Our goal is to provide world-class customer service and become the easiest and most effective CDMO for our customers to do business with. Whether the customer is interacting with one site or multiple sites, we are building processes, systems, customer interfaces, and most importantly, a culture so that the customer experiences that are being served by one fully integrated organization.

This is a top priority for 2019 and it will take time and resources during the year to get it right. But we believe it is critical to creating a sustainable competitive advantage and leveraging the growth synergies that we expect to achieve.

In addition to the transformational acquisitions we made, we continue to invest internally. We expect our new high potency API facility in Charles City, Iowa, to come online during the second quarter of 2019. We added laboratory capacity during 2018 at all four of our drug substance sites in order to increase our capacity to complete more new projects at each of our sites. These new projects even if they are later-stage products generally start at smaller scale before being scaled up to larger assets and this laboratory capacity is a critical front-end capability for growth.

We also continue to build out our continuous flow chemistry platform in High Point, an area of increased focus for our customer base.

Lastly, we had a strong year of operational excellence with our teams driving significant savings throughout the business, helping us come in towards the high-end of our adjusted EBITDA expectations despite revenues being on the low-end of our guidance. We will continue to aggressively drive efficiency improvements throughout our operation in 2019 and beyond.

Now I'd like to comment on our performance during the fourth quarter and full-year as well as our expectations for 2019. As Greg explained, all comments comparing 2018 performance to the respective period in 2017 including profits will be on an ASC 605 revenue recognition basis. All comments regarding 2019 expectations either absolute or in comparison to 2018 will be based on ASC 606.

Fourth quarter 2018 consolidated net revenues were $212 million. This included $189 million of revenues in our drug substance segment formerly known as API, a 5% improvement excluding the impact of currency compared to the same quarter last year. Additionally, net revenues in our drug products segment formerly referred to as Finished Dosage Form were $23 million in the quarter. Within the drug substance segment, controlled substances were the primary driver of the increase doubling to $23 million versus $12 million in the fourth quarter last year.

Innovator net revenues were $134 million down 1.8% versus the same quarter last year primarily due to a decline in sales of our largest products compared to the same quarter last year.

Net revenues for Innovator products excluding our largest products were up 25% over the same period last year.

Generic net revenues were $32 million, up 2.3% versus the same period last year.

Adjusted EBITDA in the fourth quarter was $76 million which includes $5 million for the drug products segment. Excluding drug products adjusted EBITDA increased 9% over the same period last year.

Consolidated net revenues for the full-year 2018 were $552 million. Full-year net revenues in our drug substance segment were $522 million or a decline of 3.1% compared to the full-year 2017. Full-year drug product revenues were $30 million in line with our prior guidance. Cambrex had no drug products revenues in 2017.

Within the drug substance segment, full-year 2018 Innovator revenues were $331 million down 6.8% compared to the full-year last year and excluding sales of our largest product Innovator revenues increased 3%. This slower than expected growth primarily reflects slower progression of certain late-stage clinical projects.

Full-year 2018 net revenues for generic APIs were $109 million flat versus the prior year and rounding out the drug substance segment, 2018 full-year controlled substance net revenues were $82 million, an increase of 10% versus the prior year.

Consolidated adjusted EBITDA including drug products for the full-year 2018 was $165 million. Excluding drug products adjusted EBITDA was $158 million near the upper end of our guidance range. Strong controlled substance sales and better than planned cost improvements driven by operational excellence programs were important drivers of our high profitability despite slightly lower than expected sales.

I now want to spend some time talking about our view of the markets that we compete in and our 2019 targets for all of our segments. The positive trends that we've seen in the Innovator CDMO market over the last several years continue and all signs indicate that these trends are likely to continue in 2019. There is a strong preference among innovators for large Western suppliers with end-to-end drug substance and drug product development and manufacturing capabilities.

The small molecule clinical development pipeline is robust and we continue to see large pharmaceutical companies reducing their small molecule manufacturing footprint and outsourcing more. Small molecule approval trends remain strong with 34 new chemical entities approved by the FDA in 2017 and 42 approvals for the full-year 2018.

Our goal remains to aggressively grow our drug substance segment by increasing the number of later stage clinical projects that we're working on and securing additional supply positions for already commercial products. In 2018, we won five late-stage projects, one has graduated to commercial status and two did not meet their primary endpoints in the clinic. We now have 18 late-stage drug substance projects in our portfolio and our goal is to steadily increase this number.

During the fourth quarter, we added one new late-stage innovator project to our pipeline that we expect to generate $1 million to $5 million in annual drug substance revenue at maturity.

One late-stage product failed in the clinic and that product was projected to generate $10 million or more annually at maturity. We continue to have a robust set of late-stage projects that we are actively competing to win. We characterize the project as late-stage from the time the product is in Phase III until it is approved and the production process is validated in our facility.

We generally group our late-stage portfolio into three categories, those that we expect to generate over $10 million in annual revenue for Cambrex at maturity, those between $5 million and $10 million, and those less than $5 million in sales. As these projects progressed through the development stage, we often adjust our initial estimates of the volume potential.

Our current late-stage portfolio breaks out as follows: we have five products that we expect to generate over $10 million in revenue each, seven products that can generate between $5 million and $10 million, and six products that are each expected to generate less than $5 million annually.

Future Cambrex revenue from the products in our pipeline will of course depend on each product's regulatory approval, success in the market, and the share of commercial supply that we secure among other variables.

ASC 606 sales of the antiviral that is our largest product which is within our drug substance segment were $121 million in 2018 consistent with the related disclosure in our 10-K filed this morning. We expect 2019 sales for that product to be approximately $50 million to $55 million and expect 2020 sales to be approximately $15 million to $20 million.

As we have stated previously 2020 is the last year of our current supply agreement for that product. And while we cannot predict what our revenues will be beyond 2020, we do expect to remain a primary manufacturer of that product throughout its life to meet our customers' future needs. Net revenues from the Innovator drug substance products excluding our largest product are expected to grow between 10% and 14% in 2019.

Our strategy for sales of generic drug substance continues to be focused on the high value lower volume niche products to support future growth which we expect to be low-single-digits over the medium-term, we expect to continue to have between 10 and 15 new products in the generic API development pipeline. We will continue to increase our businesses present in certain growing markets and to pursue opportunities to win new business due to ongoing quality and regulatory issues at certain low cost competitors.

The market for generic pharmaceuticals especially in the United States has been under substantial competitive pricing pressure and that has caused a few of our customers to discontinue marketing some of their products in the U.S. As such, we expect to continue to see pressure on revenues in the U.S. and we endeavor to offset that pressure with growth in Europe and certain other geographies. Overall, we expect generic drug substance revenues to be flat in 2019.

Controlled substances which we define as DEA Schedule II products have outpaced our initial expectations on multiple occasions. And this is a testament to our team's strong commercial positioning with existing and new customers and excellent management of the DEA quota process allowing us to steadily take market share within the ADHD sector.

There continues to be moderate but steady pricing pressures in the market for our key products with a limited number of impactful new products entering the market in recent years.

In 2019, we anticipate that volume increases will more or less offset moderate price declines and we therefore expect controlled substances net revenues to be approximately flat in 2019.

Please note that we have no meaningful exposure to the opiate market. We expect 2019 full-year drug substance revenues as reported under ASC 606 to decrease between 7% and 11%. Excluding our largest products, we expect net revenues to increase between 5% and 10%. For clarity, results of our High Point facility will be moved out of drug substance and into the early stage development & testing segment for 2019.

Now I'd like to say a few words about our drug product segment. As previously described, this segment consists of the Halo business that we acquired in September of 2018. Along with the Halo sites and employees that I mentioned earlier, we also added approximately 15 new customer relationships and acquired business highly focused on later-stage and commercial drug product. We've previously distilled our strategic rationale in a fair bit of detail. But in short, we believe having a broad range of drug product and drug substance capabilities will allow us to provide a full range of services to those customers that find it preferable to reduce the number of suppliers they have to manage and have one CDMO make the drug substance and the drug product.

We expect that the drug product segment will benefit from a growing pipeline of early-stage formulation and first in-human projects coming from our early stage development & testing customers. This market like the drug substance market is large fragmented and growing in the mid-to-high-single-digit percentage range. There is a relatively low level of outsourcing penetration in the drug product market estimated at less than 35%. But this penetration level is estimated to be growing by about one percentage point a year. We believe our assets and broad capabilities are well-positioned to grow with the market. And as we start to see synergies from the opportunity to sell drug product services to the customer bases of legacy Cambrex and Avista, we would expect to grow faster than the market.

Our strategy to grow the drug product segments similar to our drug substance strategy is to win product development projects with the expectation that many will eventually progress to become commercial product at a higher and more predictable annual target.

Product development revenues in this segment consist of both Innovator projects in clinical development and generic products being developed under agreement with specific generic drug product marketers. As part of this strategy, we will target winning a higher number of Innovator projects in order to create a larger growing and more predictable commercial revenue base over time as some of these projects get FDA approval.

We expect drug product net revenues to be between $105 million and $113 million for 2019. This represents an approximate 10% to 18% improvement over 2018 net revenues for Halo of approximately $95 million on a pro forma full-year basis. Cambrex acquired Halo in September of 2018.

Now I'd like to address expectations for our early stage development & testing segment. We closed on the acquisition of Avista Pharma Solutions in early January. So this will be an entirely new reporting segment for Cambrex beginning in the first quarter of 2019. The market for outsourced early-stage services well not as large as the outsourced drugs substance or drug product market is still large fragmented and growing nicely. It is estimated to be a several billion dollar market and growing in the high-single-digits to low-double-digits annually driven by strong funding of pre-clinical projects and like our other two segments, a steadily increasing level of outsourcing penetration.

While we have recently described our strategic rationale for acquiring Avista, I will reiterate that Avista brings a broad funnel of over 200 new customers for whom they work on hundreds of molecules. We will seek to deliver later-stage drug product and drug substance services to these customers over time which creates the potential for a significant future growth synergies.

We expect 2019 revenues to the early stage development & testing services segment to be between $105 million and $113 million representing a 24% to 33% growth rate over the full-year pro forma results for 2018. As Greg previously mentioned, results from our High Point North Carolina business will be included in this segment for 2019 and 2018 results will be restated for comparison purposes as we report in 2019.

For reference, full-year 2018 revenues from our High Point facility were $20 million. 2018 pro forma revenues for the Avista business excluding High Point were $65 million.

To summarize, we expect 2019 consolidated net revenues excluding the impact of currency and not adjusting 2018 to reflect pro forma net revenues of acquired businesses to increase between 21% and 25% under ASC 606. When we include full-year pro forma net revenues of acquired businesses for 2018, we expect 2019 consolidated revenues excluding our largest product to increase between 10% and 15%.

We expect 2019 adjusted EBITDA to be between $150 million to $160 million.

In conclusion, we are very excited by the transformation of Cambrex into a fully integrated small molecule CDMO. We significantly broadened our customer offering, diversified our customer base with hundreds of new customers, established a larger pipeline of new projects, and position the business for stronger future growth. I look forward to updating you on our progress after the first quarter.

And with that, I'll turn the call over to Greg.

Greg Sargen

Thanks, Steve.

I'd like to comment on a few financial statement line items related to 2018 and then a few guidance related items that Steve didn't comment on.

Consolidated gross margin under ASC 605 for the fourth quarter was 41% compared to 43% in the same quarter last year with the decline primarily reflecting the addition of the lower margin drug products segment. Drug substance segment gross margin was 43% for the fourth quarter and drug product gross margin was 24%.

Consolidated ASC 605 gross margins for the full-year 2018 were 38% compared to 43% for the prior year. ASC 605 drug substance segment gross margin for the full-year was 39% with a decline versus prior year driven by a higher number of clinical-based projects where cost efficiencies are more difficult to realize and an unfavorable mix of product margins for commercial products, partially offset by certain take-or-pay cancellation arrangements.

Full-year 2018 drug product segment gross margin was 25% under ASC 605. Consolidated gross margins under ASC 606 were 36% and 37% for the fourth quarter and full-year 2018 respectively.

Selling, general and administrative expense for the fourth quarter excluding M&A and integration costs were approximately $3 million higher than the same quarter last year, primarily driven by the addition of $5 million of drug product segment expenses of which $3 million represented amortization of purchased intangibles. Full-year consolidated SG&A expenses excluding M&A and integration costs were flat compared to the prior year with cost added by the drug product segment being offset by lower expenses in the corporate call center and the drug substance segment.

Expenses related to M&A and integration of the Halo acquisition, now our drug product segment were $3 million during the fourth quarter and $11 million for the full-year.

During the quarter, the company recorded an unrealized gain in other income of $2 million related to an equity investment in a European company. For the full-year, other income related to this investment was $13 million. This investment is subject to a lockup period ending during the second quarter of 2019 and our equity share is substantially greater than the current daily trading volumes of the stock. As the value of the stock can be very volatile and is unrelated to current operations, we have excluded the gain from any profit metric in 2018 results and 2019 guidance.

The actual tax rate for the quarter reflects among other items a $12 million expense for state valuation allowances and the revaluation of state deferred tax balances due to Tax Reform in New Jersey and the benefit from immediate recognition of the effects of share-based compensation. These items are included in the table at the end of this morning's release. Excluding these items, the effective tax rate was approximately 22% for the quarter and 21% for the full-year 2018.

Cash taxes for 2018 were approximately $16 million.

We expect the normalized tax rate for 2019 to be between 25% and 27%. The increase in normalized rate as compared to 2018 is driven primarily by the decline in export sales for our largest customer and New Jersey Tax Reform and to a lesser extent changes in the 2019 geographic mix of income.

Adjusted income from continuing operations under ASC 605 which excludes Halo results was $1.44 per diluted share for the fourth quarter of 2018 compared to $1.26 for the same period in the prior year. Full-year 2018 adjusted income from continuing operations under ASC 605 and excluding Halo was $3.07 per diluted share compared to $3.16 for the same period in 2017.

We expect adjusted income from continuing operations for the full-year 2019 to be between $1.87 and $2.09 per share. Adjusted income and related earnings per share for 2019 will be computed in a manner consistent with the table calculating adjusted income and earnings per share for 2018 at the end of this morning's release.

Capital expenditures for the fourth quarter and full-year 2018 were $19 million and $63 million respectively.

We expect full-year 2019 capital spending to be between $60 million and $70 million. As previously announced, the company closed on a new five-year $800 million credit facility in early January. The new facility which replaces Cambrex's prior facility includes a five-year $200 million term loan and a $600 million revolving credit facility.

Loans under the new facility will initially bear interest at LIBOR plus 1.75% subject to adjustment each quarter depending upon Cambrex's total net leverage ratio. We ended 2018 with net debt of $204 million which reflects a $24 million reduction during the fourth quarter.

Net interest expense for 2018 was $3 million. We added approximately $252 million of debt in early January to support the acquisition of Avista and accordingly we expect net interest expense in 2019 to be between $22 million to $24 million. For the full-year 2018, adjusted free cash flow was $51 million excluding the effect of currency on foreign cash balances and M&A and related expenses.

We expect 2019 free cash flow which we define as the change in net debt excluding any M&A or related expenses to be between $60 million and $70 million. We expect M&A and related integration expenses for 2019 to be between $9 million and $11 million. These amounts are excluded from our consolidated EBITDA and earnings per share guidance. These expenses consist of approximately $4.5 million of transaction expenses paid in conjunction with our acquisition of Avista in early January and the remainder is expected to consist of integration expenses incurred across most functional areas throughout 2019.

For clarity, cost to upgrade the two newly acquired businesses to SAP which are already underway and will likely occur over the course of 2019 to 2020 are included within our capital expenditure and profit guidance.

In summary, in 2018, we transformed Cambrex's business with two strategic acquisitions that significantly expand our capabilities and customer base and should accelerate our growth in the years to come. In 2019, we will focus on integrating these two new businesses while continuing to invest internally so that we are positioned to capture these growth synergies as soon as possible.

David, I would now like to open up the call for questions.

Question-and-Answer Session


Thank you. [Operator Instructions].

Our first question comes from Drew Jones with Stephens Incorporated.

Drew Jones

Greg, thinking about the EBITDA guidance, when you guys acquired Halo and Avista you obviously set some parameters out there for EBITDA run rate, do those hold when we're thinking about inorganic contribution for 2019?

Greg Sargen

Yes, the Avista guidance holds and we didn't give any 2019 guidance for Halo specifically. We just gave a trailing 12-month run rate and the numbers moving forward are relatively consistent with that they're not too far off.

Drew Jones

Okay, okay. And where are we right now in terms of capacity utilization and what's the expectation for how that will look exiting 2019?

Steve Klosk

Drew, are you talking about the two new businesses?

Drew Jones

No, I guess I'm talking for the legacy business.

Steve Klosk

We've got enough large scale capacity to continue to grow that business nicely ex the largest product.

Greg Sargen

Yes, so let me just add a bit there. I think our CapEx includes kind of what I'll call ordinary maintenance capital maybe just to extend your question and put a little color or commentary to it. We're going to finish the high potency investments which will add another $6 million to $8 million of CapEx in 2019 and then we'll invest in the two new businesses that we brought on. So large scale capacity pretty much not on the table as far as investing but we will continue to invest in mid, small, and specialty types of capacity as we bring on new products.

Drew Jones

And then last one for me anything different that we should think about in terms of quarterly sequencing for 2019, Greg, versus maybe what the ASC 606 restatement -- or not restated, ASC 606 for 2018 look like?

Greg Sargen

Right now, I would say that it looks much smoother than it has in the past and which makes sense on a pure production basis. I think if you look at the 606 results, it was smoother than our 605 results for 2018 but as not as smooth as we probably might have projected. So I have a pretty smooth projection right now. But I won't be surprised if that moves around a bit just based on production schedules. But it shouldn't be nearly as dramatic as we've seen on a delivery based model.


Thank you. Our next question comes from David Windley with Jefferies.

David Windley

Hi. Thanks for taking my question. So kind of dovetailing off the last question. As it relates to the differences, I know you won't be reporting 605 in 2019 anymore. I'm interested though in whether there's still a difference between how 605 would be calculated in your guidance versus the 606 the guidance that you're actually giving, in other words are there still timing differences or has that now converged in a way that they would be more similar either way?

Greg Sargen

Yes, I think the latter. I think they're pretty similar and they've converged that if you look at the fourth quarter, we evened out some of the imbalances that were created during the first three quarters of 2018. So I think it's about a $20 million difference.

We're not going to track 605 for 2019 but if we did my guess would be that we're going to be in that plus or minus $10 million range of our results. But that's just a speculation at this point. But I do think they will be pretty convergent.

David Windley

Got it. Thanks. Steve, how with the acquisitions you mentioned several times in your prepared remarks, the expansion of customer base and the implied opportunity to cross-sell there. I'm curious how that has progressed and in regard to kind of filling that late-stage pipeline, how might we expect that to grow from your kind of high-teens to the goal of 20s. What's the pipeline look like in terms of feeding that that funnel?

Steve Klosk

Okay, Dave. So I'll take, I'll try to address the first one. So obviously, it's early days. We closed on Avista January 2nd, so it's relatively early days in terms of seeing cross-selling opportunities there. But I will tell you soon after the closing we had our first success in a piece of business with a customer that was an existing customer using going to scale at one of our larger plants. So that's encouraging. That's what we would expect to see but its early days.

We should see the late-stage pipeline, we're confident that over a period of time with these two businesses with many more customers with many more capabilities touching many more molecules that we're going to see a natural pipeline eventually going into the late-stage. I think what ultimately probably will happen, if I had to guess is some of the early-stage drug substance business will go towards High Point and the High Point which has naturally as you know successfully tech transfer products into Charles City.

And I think likewise drug product work, early-stage drug product work that's being done in the early-stage segment will make its way into the drug product segment. So I think we're going to see that it's natural the more customers you have and the more molecules you're working on, we expect to retain those obviously all the way through commercial if they get approved.

David Windley

Okay great. And maybe the last one for me, you appreciate the visibility on your largest product and the expectation is now for both 2019 and 2020. I believe that earlier in 2018 maybe even late 2017 you had negotiated this minimum agreement for 2019 as an addendum to the basic contract. I guess I'm curious if that change -- is this -- is the 2019 guidance consistent with that from almost a year ago I guess or has that changed over time based on circumstances facing that client?

Steve Klosk

Well, I will say it this way. We've agreed with our customer on a total volume for the remaining two years of the contract as I said in my remarks and that volume is committed. So you recall what we've said for a while that we expected would have a significant decline, we had a minimum for 2019, we had no minimum for 2020. So at this point, we've agreed really on a total volume covering those two years and that's committed business.


Thank you. Our next question comes from John Kreger with William Blair.

John Kreger

Hi, thanks very much. Steve, just to clarify what you just said, so the total sales amounts for your largest plant are pretty much locked-in in 2019 and 2020. Do you also have relative clarity about what will happen in 2019 or 2020 or is that just sort of your best expectation?

Steve Klosk

I mean at this point that's our expectation for the level of business for 2019 and 2020.

John Kreger

Okay. So there could be some shifting but overall you've got commitments on that total amount over the next two years?

Greg Sargen

Yes, if there's shifting it's -- that's why we kind of gave 5 million dollar-ish kind of shifts there depending on how production ends up.

John Kreger

Great, thank you. So next question, so now that you've got more clarity about the largest product but also you've made some significant strategic changes in your portfolio. Could you guys maybe just sort of update us on your thinking about sort of longer-term gross margin trajectory and how that might differ across your new segment structure?

Greg Sargen

Yes, sure. So obviously all this because of the fixed cost nature of the business is going to be dependent on how quickly the top-line grows. So take that all the grain of salt that we grow the top-line like we hope to, I think we'd see the margins on the early-stage business and the drug substance business kind of be in the mid to high 30s again depending on how we get there, I know previously there was a 40 out there. I would consider that kind of the upside or best case.

And then on the drug product business, we're seeing margins right now in the mid-20s and I think we have some capacity that we need to fill there and kind of some leverage to be obtained there especially if one of the facilities which is a bit underutilized which is we just use flat out opportunities.

Yes, I think we would like to see margins step up from there over time but it's all going to be driven by the top-line just given the fixed cost nature of the business.

John Kreger

Okay great. Thank you. And then one last one, Steve, just to follow-up on Dave's question about cross-selling I realize that's generally a long cycle business other than in early-stage. So as you sort of think about the cross-selling strategy and the plan, should we think about that as sort of a two to three year process or do you think it can happen faster?

Steve Klosk

I mean I think that's a good way to look at it as you get to really late-stage and commercial. I think we're going to see cross-selling occurring all the time now. We're going to have customers who were early-stage development customers who because they needed larger scale would have fluffed that business and I think we're going to be successful moving that into either the drug substance or the drug product. But you're right, this cycle takes time to work its way through then getting to our late-stage facilities and then hopefully with them getting approved.

But you'll see -- we'll see business start to go into the drug product large scale and the drug substance large scale along the way. But I think it'll take time. You can't expect a big ramp-up in the first year.

John Kreger

Understood. Okay, one last question for me. Now that you've got more clarity around the trajectory with your largest product, are you comfortable that you can grow the EBITDA base from 2019 to 2020. It's obviously a long ways off but or should we be thinking about maybe another step down in earnings before you can kind of return to growth?

Greg Sargen

Well, there's a -- there's a -- I'm not going to venture out there for 2020 profit guidance right now. So look I think we expect that we're going to continue to grow the Innovator business ex the largest product we'll see where controlled substances, generics look when we get later into 2019. For 2020, we expect to continue to grow the drug product in early-stage businesses. Hopefully that's more than enough to offset the $30-ish million decline that we're expecting in our largest product but we'll see that would be the goal.


Thank you. Our next question comes from Matt Hewitt with Craig-Hallum Capital Group.

Matt Hewitt

First up, touching on the gross margins, how should we be thinking about those sequentially in 2019, with the Avista closing in Q1, does that create a little bit of a distortion in Q1 and then maybe we see things sequentially moving up or any color there would be helpful?

Greg Sargen

Yes, I think again I dread giving margin guidance because it moves so much with production but I'll throw this out there and when you say sequential, I hope you're not speaking quarter-to-quarter-to-quarter but more just kind of coming off of where we were. I think we'll be looking at low to mid 30s in the early-stage business, mid-30s in the drug substance business, and mid-20s in the drug product business, how that plays out quarter-by-quarter, I'm not going to venture to get that specific.

Matt Hewitt

Okay, fair enough. And then last year at the beginning of the year there was some disruption with the controlled substance not getting quotas out by the government in time. What is the experience so far this year is it too early and how do you think that plays out for like the first half of the year?

Steve Klosk

Now we haven't seen the same issue that we had going into Q1 which was pretty material as you remember on Q1, controlled substances results. So we have quota. I think we're in good shape. Well as we usually do request supplemental quota throughout the year when we get purchase orders from our customers.

Matt Hewitt

Okay great. And then one last one from me, the pipeline that -- the late-stage pipeline that you provided is obviously helpful for us. I'm wondering if there is something comparable that you could provide now that you've added the early-stage side of the equation and I don't know how that would -- how you would calculate that but is there something either from a number of new customers, number of new projects that you're working on anything along those lines.

Steve Klosk

Yes. So we've talked about this, Matt, and obviously we're early on still learning this business. So we think the primary growth driver in drug product is going to be to win more product development project. And if you will product development is sort of the equivalent of what we used to call custom development work, clinical phase development work as opposed to commercial.

And so we want to win more and grow that pipeline because that's going to be the driver of those late-stage products and hopefully commercial. We also think that one of the things that we'll be successful doing with our integrated CDMO sales team is to change the mix of that business to be higher in the Innovator business as opposed to the generic. And we want to do that because we think there is the potential for larger products, more steady products that you're getting commercial revenue on and you're getting multi-year supply agreements for. So that's probably that second way that we're going to look at the business to see that we can change it.

And then I think last is the key of the pipeline of the early-stage segment is being able to transfer early stage products into probably later-stage again product development projects, you're not going to have would be a rare occurrence from the early-stage to go directly from a commercial product into a larger drug product plant. It will go into maybe Phase II and then you're hoping those will progress to the clinic to Phase III.

So I think that's the way in the first year, if you will, we're looking at how to grow that business and then I think we will re-examine after a year where we are vis-à-vis talking about late-stage project.

Greg Sargen

And maybe just a bolt-on to that as the year progresses to the extent that we kind of settle in on metrics that we think most appropriately describe the trends and where the business is headed, we will kind of solidify those and start talking about them. But right now I think we still feel like we're not exactly sure what those key performance indicators are that we should be talking about externally. And we don't want to put some out there and then have to shift gears mid-year. So we have a multitude of ways to look at it and I think as the year progresses and we start to get a better handle on what the key drivers are, we're seeing momentum in trends, we will comment accordingly.


Thank you. Our next question comes from Evan Stover with Robert W. Baird.

Evan Stover

Yes. Thank you. I wanted to talk about the EBITDA margins. It looks like 606 basis 2018 was about 29% and your guidance implies something around 24%, 25% in 2019. I know parts of that are due to bringing on Halo and Avista at lower margins and obviously I think part of that is due to -- we have seen mix as well. But is there any other factors you can talk about where your EBITDA -- why your EBITDA margin is headed down in 2019 and I guess really the thrust of that question is as we look to 2020 really appreciate some of the clarity on Hep C but I think a lot of us are trying to get some understanding if the significant EBITDA margin step downs we've seen the last two years are another leg of that to go in 2020. So we could talk about some other considering mitigating factors in 2019 that would be helpful?


Yes, so I think you nailed the primary drivers. There's no question those are the overwhelming drivers of the EBITDA decline. And anything else would be more or less noise frankly would be just driving some puts and takes here and there.

And as I said earlier on another -- in response to another question we look into 2020, it's about getting better scale on the two businesses that we bought being better capacity utilization and leveraging the SG&A cost there and leveraging the fixed cost infrastructure especially on the drug product business and driving the top-line. So we have another step down which is transparent with respect to the large product in 2020 and our ability to grow through that as we get closer to 2020, we can give you a little bit more color on that but right now it would be premature to kind of suggest anything specific.

Evan Stover

Okay, thank you. On Halo, I do appreciate the revenue growth there guided up I think 8% to 10% this year but a little bit of a -- maybe narrow just a bigger picture question. It does look like the revenue was actually on a pro forma basis for Halo down in 2018 versus what you reported at the time of the announcement of that acquisition. So can you talk to maybe just some of the fluctuations and volatility that's -- that's going on in your drug product business?


Yes, I think some of the stuff we saw in our drug substance business we see in the drug product business where they had some projects that were either complex generics or Innovator projects that were in the development stage and just took longer to get to fruition. I'm not sure exactly of the seasonal effect of the trailing 12-months numbers that we gave around the time of the announcement. So there might be a little bit of that going on there. But I will say that that business was probably $5 million to $7 million late versus what we would have expected when we closed on it in September for the year. So hopefully we can make that up and that's part of the growth going forward.

Evan Stover

Okay. A couple of more quick ones. Is the new tax rate that we talk about in 2019; is that an appropriate run rate now with new -- New Jersey taxes, new Gilead, and mix et cetera?

Greg Sargen

I'm sorry. I didn't understand the question.

Evan Stover

The tax rate is up this year 25%, 27%. I'm just wondering if that's the right run rate going forward even beyond 2019?

Greg Sargen

Probably yes, it's in that zone yes, unless New Jersey does something else with their tax law or mix of geographic income changes dramatically, I think that's the right range.

Evan Stover

Okay. And final question for me. Can we talk about the CFO search or the process there, Greg, the idea that you're going to continue to wear a couple of different hats for the foreseeable future? Are we working towards some sort of permanent resolution there?

Greg Sargen

Yes, I think you characterized as well as I could there. I'm going to continue to wear a couple of hats and we'll work towards a permanent resolution.


Thank you. Our next question comes from Steve Schwartz with First Analysis.

Steve Schwartz

Just one last, I think I missed part of the call but can you talk a little bit about the capital expenditure outlook for 2019. It looks like you'll continue to spend but I know you've already done quite a bit. I think, Steve, you outlined in your prepared remarks the number of laboratory expansions and what have you, so if you could give us some color there? Thanks.

Greg Sargen

Yes, so I think regarding the 60 to 70 in the drug substance business that's about $15 million a portion of it's about $15 million lower and that's more or less offset by the Avista and Halo businesses as far as capital that they're going to spend there so no major expansion projects. We'll spend I commented earlier about $6 million to $8 million to finish the highly potent facility, we have $8 million to $10 million of maintenance CapEx at our key drug substance businesses. And then there's another $10 million to $15 million of our projects that would be growth oriented or specific to each of the sites and their initiatives.

Steve Schwartz

Okay, that sounds good, Greg. Thanks. And then as a follow-up if I look at your revenue guidance for 2019 and I back out a forecast for an Avista contribution back out a forecast for the Halo contribution, and then I back out the impact of your major commercial customer. It looks like you're forecasting a growth rate of 10% to 14%. Can you talk a little bit about what your expectation is there with respect to the growth of the business outside of those three elements that have taken out?

Greg Sargen

Yes. So I mean that you've just pretty much echoed what Steve's prepared remarks said on the Innovator business ex the largest product and that's just growth in other Innovator late-stage projects and/or commercial projects. It's across the board. So and as usual, some may go down and some may go up but we would expect that to be net growth if we continue to bring in new business.

Steve Schwartz

Is it the conversion of some of those 18 projects you have or is it growth of existing work. What do you see there?

Greg Sargen

It's an expectation of landing business that's in the pipeline of course which would be new projects. It's the extension and/or growth of some of the projects that we brought in that are entering later stages and higher volumes and then hopefully we have a couple that go commercial and start to drive large quantities and/or commercial volume. So there's always kind of a hedging and probability weighting that goes on when we put all that together, project-by-project.

Steve Schwartz

Very good. And I think you said your generics business itself you expect to be somewhat flat volume offsetting price or vice versa?

Greg Sargen

Yes and there's not much price decline there. So it's really more a U.S. decline being offset by other geography increases which is consistent with the last two years. It's a tough market in the U.S. right now.

Steve Schwartz

Yes it is. Okay great. Thank you, Greg.

Greg Sargen

Great, thank you.

Greg Sargen

So David, that's the last call for the day. So we'll thank everyone for their time and look forward to talking to you at the end of the first quarter.


Ladies and gentlemen that concludes this morning's presentation. You may disconnect your phone lines and thank you for joining us this morning.

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