ACET - NASDAQ

Jody Burfening - IR, LHA Bill Kennally - President and CEO Doug Roth - CFO Walt Kaczmarek - COO

Dewey Steadman - Canaccord Matt Hewitt - Craig-Hallum Capital Group Steve Schwartz - First Analysis

Good day and welcome to the Second Quarter Fiscal 2018 ACETO Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Jody Burfening with LHA. Please go ahead.

Thank you, Anita. Good morning everyone and welcome to ACETO Corporation’s second quarter fiscal 2018 earnings conference call. With me today and providing comments on the call are Bill Kennally, President and CEO; and Doug Roth, Chief Financial Officer. Walt Kaczmarek, ACETO’s Chief Operating Officer is also with us today to participate in the Q&A session. The Company issued its second quarter earnings press release yesterday after the market closed. For those of you who have not yet seen the release, a copy is available in the Investor Relations section of the Company’s website at www.aceto.com. Before starting the call, I’d like to remind you that today’s call will contain forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995 that can be identified by words such as believe, expect, anticipate, plans, projects, seeks, and similar expressions that involve numerous risks and uncertainties. The Company’s actual results could differ materially from those anticipated or implied by these forward-looking statements as a result of certain factors that are set forth in the Company’s filings with the Securities and Exchange Commission. Also on today’s call, management will be referring to certain non-GAAP financial measures. These measures, ACETO’s adjusted net income and ACETO’s adjusted earnings per share are defined as net income excluding amortization of intangibles, debt extinguishment, and amortization of debt discounts and debt issuance cost, transaction cost related to acquisitions, the impact of the Tax Cuts and Jobs Act and the impact of accounting standards update 2016-09. These non-GAAP measures allow investors to compare results of operations in the current period to prior period results based on the Company’s fundamental performance and analyze operating trends of the business. With those housekeeping items out of the way, I would now like to turn the call over to Bill. Good morning, Bill.

Thank you, Jody, and good morning, everyone, happy Friday. My first full quarter at the helm of ACETO was not unlike the sea captain that encounters rough weather on the maiden voyage. Although we anticipated generic market headwinds, the sea was a bit choppier, particularly for our Pharmaceutical Ingredients segment. Looking at the total Company results, we generated net sales of $171.2 million compared to $125.6 million last year, reflecting the addition of the Citron and Lucid products we acquired at the end of December 2016, offset in part by lower pharmaceuticals ingredient net sales. Gross profit rose 10% due to contributions from Citron and Lucid products. Stripping that out, our gross profit was down from last year. Non-GAAP EPS was $0.22 compared to $0.24 and included a favorable $0.06 impact due to lower effective tax rate resulting from the passage of the Tax Cuts and Jobs Act. All-in-all, it was a difficult quarter. Let’s take a look at the results for each segment. In Human Health, sales and gross profit were boosted by the addition of the Citron and Lucid products which more than offset declines in sales and gross profit on the legacy Rising side. Continued competition from new one entrants that have launched into the market and harmonization from the customer consolidations hit a few products in our portfolio especially hard. We finalized our negotiations with ClarusONE during the quarter and are wrapping up our discussions with EconDisc and now have greater clarity on the impact of harmonization from those customers going forward. While market conditions in the generics market have been and continue to be challenging, we have a solid portfolio of 140 commercialized products, covering diverse therapeutic treatments. We launched four products, bringing the total for the first half of the year to seven. We relaunched one product with two new SKUs that are closely linked with physician prescription habits, giving us what we believe will be a competitive advantage with this molecule. We’re optimizing our pipeline of products to give us better returns down the road and adding to the mix more-complex, high-value opportunities. Currently have 109 products in the pipeline versus 115 products reported on last quarter’s call. The variance reflects some puts and takes. Starting with the pipeline total of 115 products. We launched four products, placed five projects on hold due to changing market conditions, and we filed one additional ANDA product. We also brought two approved products which previously were parked due to more favorable market conditions and we added one new product we believe will contribute nicely as there currently is limited competition. During the quarter, two filed ANDAs were approved and are pending launch. We moved, the filed product, back into the product development area to strengthen the application and we anticipate refilling it by the end of this fiscal year. On additional ANDA was filed and on ANDA was put on hold due to unfavorable market conditions, giving us a total of 36 ANDAs on file with the FDA versus 39 from last quarter. Also during the quarter, we continued to implement two operational initiatives, expanding on our Rising warehouse and installing a new ERP system, and both projects should be completed and fully functional by the end of the fiscal year. It’s at this point we will start to realize the $4 million in annualized savings from synergies realized from the Citron and Lucid products we acquired. Our two other segments Pharmaceutical Ingredients and Performance Chemicals continued to contribute cash flow in the quarter, although each experienced some challenges. Our API business within Pharmaceutical Ingredients was negatively impacted by a variety of factors, timing issues, increased competition and discontinuation of four products due to an increased competitive environment. While some of these issues will impact revenue and gross [product] in the second half, we have identified the gaps and have begun to implement the necessary fixes including a leadership transition that is currently underway for our API business. In Performance Chemicals, we experienced increased competition on several of our agricultural protection products; one in particular was contributing to a higher gross profit, while our specialty chemical business performed well despite temporary shutdowns at many producers in China during the quarter. As we move into the second half of the fiscal 2018, we are focused on executing Rising’s operational initiatives as planned, meeting budgets and timetables and taking costs out of the system where we can. Having devoted my time during the quarter to immersing myself in the business and meeting many of our colleagues and some partners, I am confident that our opportunities are abundant. Our new leadership team at Rising is clicking, and our go-to-market strategies have improved significantly. We have excellent regulatory support across each of our businesses as well as great customer interface and support teams. Still, as I mentioned, at the beginning of my remarks, we don’t expect to see any easing of adverse generic market conditions in the near team. We will continue to deal with the market dynamics while working through the supply chain challenges we mentioned on all last quarter’s call. We still expect these challenges to be resolved by fiscal year end. We still plan to launch 15 to 20 finished form generic products this year, although various market dynamics will cut into the profit contribution we previously anticipated from these launches. Also, we expect to record short-dated inventory charges related to some Rising products, primarily due to increased competition which will impact our profitability in Human Health. In our Pharmaceutical Ingredients segment, as I said earlier, some of the issues that hit our API business this quarter will stretch into the second half of the year. These include discontinued products and reduced demand caused by adverse market conditions and operational and technical challenges which we are addressing. And as a result, we expect net sales growth of 10% to 15% with Pharmaceutical Ingredients accounting for more than half of the revision, reported GAAP earnings per share to be in the range of a loss of $0.22 to $0.32, and diluted non-GAAP earnings per share to be between $1 and $1.05. Our results for the second half of fiscal 2018 are expected to be modestly better than the first half of the year. And regarding R&D, we now anticipate spending approximately $9 million in fiscal 2018 for our finished dose generics pipeline versus the previous expectation of $10 million. And just as a reminder, our R&D expenditures are milestone-based. And before I turn the call over to Doug, I want to briefly touch on longer term opportunities at ACETO. For those of you, who were not able to attend our fiscal 2017 annual shareholders meeting last December, you may not have seen the slide from my presentation that displays a potential future business model for the Company. We have added that slide to our investor deck in its slide 13. The slide describes the current state of our asset light model and the need to capture synergies within our Pharmaceutical Ingredients business versus a future state where we can add a vertical integration strategy along with owning our own intellectual property around ANDAs and APIs including DMFs and potential formulation expertise. The goal here is to balance our asset light model with more ownership, which will allow us to create more profitability for the business. And now, I’d like to turn the call over to Doug to provide a more detailed review of our second quarter financial results. Doug?

Thank you, Bill, and good morning, everyone. Now, I’ll take you through our financial results for the second fiscal quarter. Net sales were $171 million, an increase of 36% from the $125.6 million reported in the second quarter of fiscal 2017, reflecting in large part the addition of the Citron products. Gross profit was $34 million, an increase of 10% compared to $30.8 million in the second quarter of fiscal 2017. Gross margin for the first quarter was 19.8% compared to 24.5% in the prior year period. On a reporting segment basis, Human Health segment sales were $103.5 million, an increase of $49.5 million or 92% from the second quarter of fiscal 2017. Of this $49.5 million variance, sales from Citron and Lucid products which we acquired in December 2016, contributed $53.8. Sales from our legacy Rising business declined $6.8 million on a year-over-year basis while our Nutritional sales increased $2.5 million. Gross profit increased 35% to $22.9 million, reflecting the addition of Citron and Lucid sales, which more than offset the lower gross profit from the legacy Rising business. Human Health gross margin was 22.1% compared to 31% last year and in the range of the segment’s gross margin we reported during the past two quarters. As has been the case in these two preceding quarters, the year-over-year decline in gross margin was primarily due to the lower gross profit of the Citron and Lucid products, and lower gross profitability on legacy Rising products, reflecting, as Bill mentioned before, increased competition on certain products, unfavorable product mix and customer consolidation. The Pharmaceutical Ingredients segment sales were $33.6 million, a decrease of 8.7% compared to the second quarter of 2017, largely due to lower API sales, which declined for several reasons, including some shipment slippage into our second half of certain products, discontinuation of select products, and delayed customer launch of another product. Gross profit for the second quarter decreased 22.6% to $4.4 million from $5.7 million in the second quarter of 2017, primarily due to reduced APIs volumes as well as product mix. Our gross margin was 13% compared to 15.4% last year. Performance Chemicals segment decreased 1.8% -- pardon me, the sales decreased 1.8% to $34.1 million from $34.8 million in the second quarter of 2017 as lower sales for agricultural protection products was partially offset by larger sales or higher sales of our specialty chemicals. Gross profit was down 18% to $6.7 million from $8.2 million in the prior year period with all the decline stemming from lower sales and reduced profitability of our agricultural protection products. Our gross margin was 19.6% compared to 23.7% last year. Our operating expenses in the second quarter of fiscal 2018 were flat at $28.1 million, although as a percentage of sales, we saw a decline to 16.4% versus 22.4% in the prior year period. This year’s SG&A includes $5.4 million attributable to the amortization of intangible assets, and transition and administrative services costs associated with the acquisition of Citron and Lucid products versus the comparable figure of $600,000 for the second quarter of fiscal 2017. Last year’s second quarter also included $7.2 million of transaction costs related to the product purchase agreement. Our R&D expenses which represent investments in our generic pharmaceutical product pipeline and are milestone based, included -- totaled $2.1 million in the second quarter, up from $1.3 million in the prior year period. With SG&A and R&D growth collectively below our gross profit growth, our operating income rose to $3.8 million versus $1.4 million last year. Moving down the income statement, let me spend a minute on discussing how the Tax Cuts and Jobs Act, signed into law in December of 2017, impacted our results this quarter, as well as our full year tax rate. During this fiscal year, we recorded an additional tax expense of $13.9 million or $0.39 per diluted share, which was comprised of $3.2 million related to the remeasurement of our deferred tax assets arising from the lower U.S. corporate tax rate, $5.8 million related to the deemed repatriation of unremitted earnings of our foreign subsidiaries, and finally, $4.9 million related to the deferred tax liabilities for foreign tax jurisdictions. In terms of our effective domestic tax rate, we saw a decline from 38% to 31.5% for the first half of the fiscal year, as only half of ACETO’s fiscal year will enjoy the lower corporate tax rate that begins in calendar 2018. The lower rate resulted in a year-to-date tax benefit of approximately $0.06 per diluted share on non-GAAP basis. The net loss in the second quarter was $13.9 million or $0.39 per share compared to a net loss of $600,000 or $0.02 per share for the second quarter of last year. Our non-GAAP net income was $7.6 million or $0.22 per share for the second quarter compared to $7.3 million or $0.24 per share last year. Our EBITDA for the second quarter of 2018 was $12.8 million, an increase of $7.3 million versus the prior year’s quarter. Now, turning to the balance sheet, as of December 31, 2017, cash, cash equivalents and short-term investments totaled $68 million, our working capital was just short of $239 million and shareholders’ equity was $397 million or $12.91 per share. Our total bank and convertible debt was $326 million, including $202 million under our senior credit facility. Our net debt leverage ratio was 4.3 times. Our trade receivable decreased by just under $19 million to $242 million at quarter-end, versus $261 million for our fiscal year-end June 30, 2017. As a result, I am pleased to report that our DSOs came down to 72 days as of December 31st, down from 99 days as of June 30, and 74 days as of September 30. Additionally, our Rising DSOs as of December 31st were a healthy 82 days. We remain focused on keeping ACETO financially strong with ample capital resources to support our future growth plans and meet our financial obligations. Now, I would like to turn the call over to the operator.

[Operator Instructions] The first question comes from Dewey Steadman with Canaccord. Please go ahead.

Good morning, gentlemen, and happy Friday to you all. Bill, you’ve been in this role for 129 days now, and what surprised you, both positively and negatively, in your first days as a CEO? And then, in the API business, what steps can you take to stabilize that business? And fiscal 3Q is seasonally strong quarter for API, are we expecting that to repeat again this year?

So, good morning, Dewey. Nice to hear from you. And, yes, I will be happy to comment. I missed the last question, the last portion of your question. So, could you just repeat that for me?

Yes. So, in API, fiscal 3Q tends to be a seasonally strong quarter for the API business from a revenue perspective. Given the challenges in that business, do you expect that to repeat again this year?

Okay. So, look, in the first two quarters, it’s been certainly an interesting experience there at ACETO. I’m really excited about the future. But, we’re really trying to -- we’re focus on the present and trying our best to manage through these headwinds. I think, one of the things that’s been a pleasant surprise is -- I think you have to start with the people. Our people are very committed and they’re working hard across all of the businesses. We have excellent regulatory support. Our sales and sales support folks for all of our businesses, I think, are excellent. And these are -- the people that we’re bringing into the organization and we have hired a number of new colleagues over the last say 30 to 60 days are an improvement, and our bench strength, I think, is really improving significantly. From a surprise standpoint, I think that some of the operational challenges that we are having as a result of the Citron acquisition have presented challenges to the business. And, I think, the new team, in particular, the operations folks have done a nice job in kind of recognizing some of those challenges and are addressing them. So, for example, there is a robust S&OP process that’s been established over at Rising, and that really hadn’t historically been the case. As a result of that, the new team has also identified lead times and increasing our lead times with some of our partners in terms of getting product over to us, so that we can sell it and that our safety stock has and will be improved. This is also helping from our freight standpoint. So, when we have short supply, the freight costs have been increasing. And as a result of this new S&OP process, we’ve seen a nice decrease in our freight charges. So, it surprises like that. The operational issues, I think, have probably been the most surprise. Turning to the API, we’re experiencing headwind similar to what we’re seeing in the generics industry, and it’s kind of crossing over to some degree on the API side. And that’s really -- increased competition has really been the result of some of the shortfalls that we’re seeing there. But, like our competitors, we are looking for new opportunities to stabilize the loss and potentially grow the business down the road. In terms of the third quarter performance for the API business, we do expect to see an increase in the performance. However, for the full year, API is a significant factor in why we took our revenue base down. So, I hope that -- it’s a longwinded answer, but I hope, I answered your question, Dewey.

Yes, thank you. And then, on the tax rate. Thanks for the color on the tax movements, Doug. But, how should we model the tax rate for second half of ‘18 and then fiscal ‘19 and beyond? Is that something we’re going down into the low-20s or should you use that 31% right that you have indicated?

Okay. Dewey, that’s a great question. And don’t forget, for the balance of this year, right, we have a blended rate. So, domestically, we’re using 31.5%, which is reflective of the new tax rate plus our stake rate. So, for the domestic, it should be 31.5%. But then, we also have foreign earnings. So, on average for this year, for the second half of the year, I’d use 30%. In terms of 2019, on 2019, yes, we do have the full year benefit of the new fed rate of 21%, but then you have to add stake. So, domestically, here, it’s going to be 24.5 or 25. But, then, the foreign, once you include that, we’re expecting a range of mid-20s, 26% 27%.

Okay, great. And then, I guess, it’s Groundhog Day and Punxsutawney Phil saw his shadow, so six more weeks of winter. How does that flow into contracting and working with buyers? Is it six more weeks for winter or do we see the spring coming seeing now that most of the dust is settled with the purchasers?

So, the only thing I’m concerned about is that the Punxsutawney Phil had an Eagles jersey on. That would not be a good thing for me anyway. But, look, I think in terms of the winter versus the spring. We’re going to continue to see some rough headwinds, and we’re hunkering down to kind of manage through it, by taking some necessary steps to remain focused on the business, and to try to take cost out of the system where we can. So, is that where you are going, Dewey, or is there something more specific?

Yes, thinking about pricing and how the purchasers are acting. You mentioned that you’d completed some contracting with ClarusONE and then there is another contracting that’s coming up. Is it something where we’re now round-tripping those initial price cuts, and so we’re seeing a bit more stability in the market or do you think there is more room for cuts to come?

I see. Okay. Well, so, yes. We do believe that with the harmonization of ClarusONE and EconDisc that we have a little bit more visibility into what we can expect going forward. So, I would say that most of the pricing hits that we’ve taken as a result of that are probably over. On the other hand, there is 50% more ANDAs that were approved in 2017 than you saw in 2015. So, the pricing headwinds are more going to come from increased competition that we’ll see as those products get approved versus from our customers with the exception of customers that may annualize their RFP process.

Okay, great. Thanks, gentlemen. And I’ll hop back into queue.

Thank you, Dewey.

The next question comes from Matt Hewitt with Craig-Hallum Capital Group. Please go ahead.

Good morning, gentlemen. Thanks for taking the questions.

Good morning, Matt.

First one, given the increasing competition, given some of the other headwinds that you’re facing, at what point, particularly within the legacy Rising portfolio, but at what point do you start to consider or look at discontinuing products where they’ve become unprofitable?

So, I think there have been puts and takes in the portfolio. And I can’t tell you that like one -- for example, if we were down one quarter, that wouldn’t be enough time, to really assess. The buying patterns of the customers vary. And as a result of that the charge-backs that see, vary as well. So, you could potentially be upside down one quarter on charge-backs based on buying patterns which would send your product into loss mode. So, I think you have to look at it over the longer term; that’s part of it. And then, the other thing is that we have agreements with our partners on portfolios of products. So, for example, we might have to carry a product at a loss, based on an agreement that we have with a partner. But, I think the bottom-line is that we have great visibility into the products that are marginal and there are strategies that we’ll take try take whether it’s pricing or what have you, to try to change that around. If at the end of the day we don’t have commitments with our partners and there really isn’t much more than we can do to stem the loss, then, we’ll discontinue the product where we can.

Okay, great. Thank you. And then, as you look at the business now having been on Board for a little while here, where do you see or I should say, what is your priority, as it relates to bringing in your own manufacturing on the generic side? Is that a high priority, is it dependent upon the market may be showing a little bit of stability or how are you thinking about that?

Well, it’s a high priority for us and it’s one of the reasons why I posted the slide because although I think the asset light model offers some real advantages, and we do a good job in that environment, holding our own intellectual property, our ANDA and DMF, being a little bit more vertically integrated, those are all things that we are going to be able to increase our control and increase our gross profit. So, the assets out there aren’t necessarily readily available in accordance with some of the things that we’re looking at. But, we’re looking at trying to bring those assets into the organization to strengthen us. So, it’s a high priority.

Okay, great. Then, maybe one last one for me. As you think about the second half of this year into next year, generating positive cash flow, is the expectation, anticipation that you will be using that to pay down debt or if the right opportunity, either from a facility standpoint or portfolio of ANDAs came up for sale, would you consider that? Thank you.

Yes. Thank you, Matt. And the answer is both. So, we will pay down some debt; and if there’s an opportunity to bring some assets in to the organization, then, we will certainly welcome that.

The next question comes from Steve Schwartz with First Analysis. Please go ahead.

Hi. Good morning, everyone. Hey, Bill, in your prepared remarks you talked about harmonization in ClarusONE. Can you just give us a little color on exactly how that’s impacting you business? Is it just a hiccup in the purchase pattern, is it lower pricing? What exactly is it that hits you with that?

Hey, Steve. I will tackle that question. So, good morning. So, harmonization in effect, what happens is, when McKesson gets together with Walmart and forms ClarusONE, what they do is they take a look at the portfolios and basically go to the lowest common denominator. So, what that does is it just resets the portfolio as a lower cost basis. So, in essence, it just drives the ASP down on your current book of business.

Okay. So, it is through pricing? But then, with respect to volume, you don’t necessarily see a hiccup then, everything just moves along…

It depends. Once again, if you have the business at McKesson, but don’t have it at Walmart, then, it becomes a little bit of a negotiation. It’s going to be predicated on your willingness to obviously drop down to the harmonization price point. And normally, if you do that, you can maintain your market share position. But, there are some puts and takes there as well.

With respect to your R&D spend, you’ve been clear that that’s related to milestone payments. In this case, you’re reducing your outlook or spend for the fiscal year by 1 million. Can you give us some perspective? Is that on one product in development, is that for multiple products? What does that 1 million mean?

It’s a combination of products that we take out of the system, Dewey. I mean, we’re still maintaining the 15 -- sorry, Matt, we’re still maintaining the 15 to 20 products that we plan to launch this year. And it’s really the result of products that have been taken out. Steve, I’m sorry. I called you Matt and I called you Dewey, so.

Went through the whole list there.

I got through the whole list, exactly, my apologies.

Okay. And then, my last one is just with respect to ag products. Is the weakness there volume or is that price, what’s happening in that business?

On the ag protection?

So, we had a competitor come in to one particular product and they took a little bit of market share. And as a result, we had to lower the rest of the market to that price point.

What’s happening in the broader world of ag products like FMC DuPont and they are -- where you see FMC getting bigger. Does that have a significant impact on your business or are you guys flying the radar at that level?

We really attempt to fly under that radar, under that level. So, what we’ll do is we’ll try and target those particular products that are very nichey and don’t attract a lot of competitive pressures. So, we’re looking at smaller volume products in the context of the huge Dow Chemical. So, those are the areas in which we concentrate.

And I have it in my notes that you were looking to sell one product. Do I have that correct, a pecan product or something like that? Did that go through?

No. I think your notes -- I don’t believe we’ve ever said we’re looking to divest ourselves of one particular agricultural product. So, maybe, either we misspoke or you misheard.

It could be error on my end, I’m not beyond that. Anyway, thank you for taking the questions.

Thank you, Steve.

[Operator Instructions] Since there appears to be no further questions, this concludes our question-and-answer-session. I would like to turn the conference back over to Bill Kennally for any closing remarks.

So, thank you, Anita. I appreciate your help on the call today. And thanks again everyone for joining us today. We appreciate your questions and comments and support, and look forward to speaking with you again in early May on our third quarter fiscal 2018 conference call. Have a great weekend.