Catalent Inc (CTLT) 2018 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Catalent First Quarter Fiscal Year 2018 Earnings Conference Call. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to turn the conference over to Tom Castellano, Vice President, Investor Relations and Treasurer. Sir, you may begin.

Thank you, Shannon. Good morning, everyone, and thank you for joining us today to review Catalent's First Quarter Fiscal Year 2018 Financial Results. Please see our agenda on Slide 2 of our company's presentation, which is available on our Investor Relations website.

Joining me today representing Catalent are John Chiminski, Chairman and Chief Executive Officer; and Matt Walsh, Chief Financial Officer.

During our call today, management will make forward-looking statements and refer to non-GAAP financial measures. It is possible that the actual results could differ from management's expectations. We'll refer you to Slide 3 for more detail.

Slides 3, 4 and 5 discuss the non-GAAP measures and our just issued earnings release provides reconciliations to the nearest GAAP measures. Catalent's Form 10-Q to be filed with the SEC later today has additional information on the risks and uncertainties that may bear on our operating results, performance and financial condition.

Now I'd like to turn the call over to Chairman and Chief Executive Officer, John Chiminski.

Thanks, Tom, and welcome everyone to our earnings call. We're very pleased with our first quarter fiscal year 2018 results providing us a strong start to our fiscal year.

For the first quarter, we recorded double-digit year-over-year revenue and adjusted EBITDA growth in constant currency across all 3 of our reporting segments. As you can see on Slide 6, our revenue for the first quarter increased 23% as reported and increased 22% in constant currency to $543.9 million with 14% of the 22% being organic and with all reporting segments contributing to the growth.

Our adjusted EBITDA of $90.9 million was above the first quarter of fiscal year 2017 on a constant currency basis by 22%, of which 13% was organic, again, with all segments contributing to year-over-year EBITDA growth. Our adjusted net income was $27.1 million or $0.21 per diluted share for the first quarter, an increase of $0.05 per share versus the prior year.

Now moving to our key accomplishments during the quarter. First, we announced the acquisition of Cook Pharmica, a privately held biologics-focused contract development and manufacturing organization. The company was founded in 2004 as a unit of the Cook Group. Since then, the business has developed with careful attention to staffing, operational excellence and best-in-category fixed asset investment.

Today, the company operates a world-class 875,000 square foot development and manufacturing facility in Bloomington, Indiana, where it employs more than 750 people. The combination of Catalent and Cook Pharmica significantly strengthens our position as a leader in biologics development and manufacturing. Together, we'll provide customers a single partner to accelerate biologic drug development programs for our customers and bring better treatments to patients worldwide through a comprehensive portfolio of integrated solutions.

The acquisition closed on October 23 and the integration is well underway, already creating value for the company, our customers and our shareholders.

To fund the Cook Pharmica acquisition, we are active in the capital markets and issued 7.4 million new shares of our common stock at $39.10 per share before underwriting discounts. The share count includes a full exercise by the underwriters of their overallotment option and the offering price was only 0.3% less than the closing price the day before the offering.

Since the late September offering, of course, our stock price has risen well above the offering price. After the end of the quarter, we used the net proceeds of this offering together with cash on hand and the net proceeds of an October offering of $450 million aggregate principal amount of 8-year U.S. dollar-denominated senior notes to pay the portion of the purchase price due at the closing of the acquisition. The remaining portion of the Cook Pharmica purchase price, $200 million, will be paid directly to the seller in 4 equal installments without interest over the first 4 anniversaries of the October 23 closing.

Concurrently with the notes offering, we completed an amendment to our senior secured credit facilities to lower the interest rate on our U.S. dollar-denominated and euro-denominated term loans and on our currently undrawn revolving credit facility. Matt will discuss the new terms in more detail later in the presentation.

We couldn't be more pleased with the outcome of the financing transactions recently completed and look forward to continuing to create value for our debt and equity stakeholders and realizing the benefits of the Cook Pharmica acquisition.

Second, I'll provide a brief update on another component of our biologic strategy, which continues to make great strides. The expansion of our facility in Madison is progressing well and we continue to be on pace for engineering runs in the next few weeks.

Additionally, we've already signed a number of customer contracts for the third train while also growing a robust funnel of late-stage clinical opportunities, which together should lead to significant utilization of the new capacity on the fast pace we were anticipating.

Last, I want to reiterate that the dynamics of our industry and market continued to remain very strong and our customers' needs for fewer, bigger, better development in manufacturing partners will continue to be drivers of long-term growth.

Now I'd like to turn the call over to our Chief Financial Officer, Matt Walsh, who'll take you through our first quarter fiscal year 2018 financial results as well as provide our revised outlook for fiscal year 2018.

Thanks, John. Please turn to Slide 7 for a more detailed discussion on segment performance, beginning with our softgel business. As a reminder, my commentary around segment growth will be at constant currency.

Softgel revenue of $219.7 million grew 16% during the quarter with EBITDA growing at 15%, which was primarily driven by the acquisition of Accucaps. As a reminder, Accucaps is a Canada-based developer and manufacturer of over-the-counter, high potency and conventional pharmaceutical softgel products when we acquired the business during the third quarter of fiscal year 2017.

In the first quarter of the current fiscal year, the business continued to perform well above our expectations and contributed 14 percentage points to the segment's revenue growth and 18 percentage points to the segment's EBITDA growth. Excluding the acquisition, our softgel business grew 2% organically at the revenue line, but decreased 3% at the EBITDA line, driven by unfavorable product mix within Europe and volume declines for both consumer health and prescription products in our Asia-Pacific region.

Our softgel North American and Latin American businesses performed in line with prior year levels. It's important to note that we believe that somewhat lower organic growth experienced in the first quarter within the softgel business is timing-related and we expect the segment to show stronger results over the remainder of the fiscal year.

An update for the Drug Delivery Solutions segment is shown on Slide 8. The DDS segment recorded revenue of $225.8 million, which was up 17% versus the prior year with EBITDA growing 12% during the quarter. Recent investments in our biologics business continued to translate into growth during the first quarter and it remains the fastest-growing business within Catalent.

We recorded strong revenue and EBITDA growth at our Madison facility, driven by the completion of project milestones and larger clinical programs. The SMARTag technology continues to meet proof-of-concept milestones and customer interest remains strong. We continue to believe that our biologics business is positioned well to drive future growth as indicated by business development signings with Roche, Moderna Therapeutics, Triphase Accelerator, Therachon AG and Grid Therapeutics.

As John mentioned, the acquisition of Cook Pharmica strengthens our position as the leader in biologics development, analytical services and finished product supply. The combined business will be able to provide integrated solutions from protein expression through commercial supply of biologics in a variety of finished dose forms. This helps fill one of the major gaps in our biologic strategy by adding fill-finish formulation development and manufacturing capabilities that we did not have in the Catalent network prior to the transaction, including lyophilization, vial filling and cartridges as well as adding U.S.-based sterile formulation and prefilled syringe to our already strong sterile capabilities.

The acquisition of Cook Pharmica significantly accelerates the already strong growth of our existing biologics business by expanding biomanufacturing capacity for clinical and commercial manufacturing across the network. As a reminder, biologics comprised approximately 14% of Catalent's consolidated revenue in fiscal year 2017 and the acquisition of Cook Pharmica is expected to increase our biologics percentage to 21% of the combined entities pro forma revenue. Please see the Form 8-K that we filed with the SEC on October 24 for important information concerning how we calculate pro forma revenue.

The oral delivery portion of the Drug Delivery Solutions business had another strong quarter, with favorable end market demand for high-margin offerings within our U.S. controlled release business.

Our blow-fill-seal offering recorded results during the first quarter that were below the prior year period due to lower volume and operational challenges, resulting from us taking steps to proactively improve our quality and manufacturing protocols and processes at the site, which we expect to continue over the next several quarters.

Strategically, market fundamentals continued to remain attractive for this key sterile fill technology. This segment also experienced declines in high-margin product participation revenue during the quarter, which had a negative effect on the segment's EBITDA margins. You will recall we highlighted this dynamic as a fiscal year 2018 headwind during last quarter's call when we provided guidance. We expect these declines to carry into future quarters, which we anticipated in our guidance communications today.

The acquisition of Pharmatek, which we completed during the first quarter of the prior year, modestly contributed to the segment's revenue and EBITDA growth. Excluding the impact of the acquisition, the DDS segment posted organic revenue growth of 13% and organic EBITDA growth of 10%.

In order to put to provide additional insight into our long-cycle business, which includes both Softgel Technologies and Drug Delivery Solutions, we're disclosing our long-cycle development revenue and the number of new product introductions, or NPIs, as well as revenue from NPIs. As a reminder, these metrics are only directional indicators of our business since we do not control the sales or marketing of these products, nor can we predict the ultimate commercial success of them.

For the quarter ended September 30, 2017, we recorded development revenue of $33 million, which is in line with the development revenue recorded in the same period of the prior fiscal year. In addition, during the quarter, we introduced 53 new products, which contributed $10.5 million of revenue, which is 19% lower than the revenue contribution of NPIs launched in the first quarter of the prior fiscal year. This is aligned with our plan and based on timing of launches in this fiscal year. We expect fiscal year 2018 NPIs launches and their revenue contribution to be in line with our long-term outlook.

As a reminder, the number of NPIs and the corresponding revenue contribution in any given period depends on the type and timing of our customers product launches, which are often driven by regulatory approvals or otherwise at the discretion of our customers unless these figures will continue to vary quarter-to-quarter.

Now, as shown on Slide 9, our Clinical Supply Services segment posted revenue of $109.7 million, which was up 46% compared to the first quarter of the prior year, driven by increased customer project activity across all of our core offerings, storage and distribution and manufacturing and packaging. Low-margin comparator sourcing activity contributed approximately 1/4 of the segment's revenue growth. Segment EBITDA increased 58% compared to the first quarter of the prior year, primarily driven by the revenue growth in our core offering and improved capacity utilization across the network.

Given the low margin of the comparator sourcing activity, it contributed modestly to the segment's first quarter EBITDA growth. All of the revenue and EBITDA growth recorded within the Clinical Supply Services segment was organic.

As of September 30, 2017, our backlog for the CSS segment was $333 million or 1% sequential decrease. The segment recorded net new business wins of $99 million during the first quarter, representing an 8% increase year-over-year. The segment's trailing 12-month book-to-bill ratio was 1.1. These indicators continue to support our expectation that this business should continue to grow revenues towards the high end of our consolidated long-term outlook.

The next slide contains reference information since we've already discussed the segment results shown on the consolidating income statement by reporting segment on Slide 10.

Slide 11 provides a reconciliation to the last 12 months EBITDA from the most approximate GAAP measure, which is earnings from continuing operations. This bridge will assist in tying out the reported figures to our computation of adjusted EBITDA, which is detailed on the next slide.

So moving to adjusted EBITDA on Slide 12. First quarter adjusted EBITDA increased 21% to $90.9 million. On a constant currency basis, our first quarter adjusted EBITDA increased 22%, of which 13% was organic, driven by strong performance across our Drug Delivery Solutions and Clinical Supply Services segments.

On Slide 13, you can see that first quarter adjusted net income was $27.1 million or $0.21 per diluted share compared to adjusted net income of $19.6 million or $0.16 per diluted share in the first quarter a year ago. This slide also includes the reconciliation of earnings from operations to non-GAAP adjusted net income in a summarized format. A more detailed version of this reconciliation is included in the supplemental information section at the end of the slide deck and shows essentially the same add-backs as seen on the adjusted EBITDA reconciliation slide.

Slide 14 shows our capitalization table and capital allocation priorities. Our total net leverage ratio on a reported basis is unusually favorable at 3.2x since the cash balance as of September 30 reflects the receipt of cash proceeds from the primary stock offering completed during the quarter in connection with the Cook Pharmica acquisition, which was completed after the quarter-end. However, if we calculate our leverage ratio on a pro forma basis as if the Cook Pharmica acquisition had occurred at the beginning of the period, our total net leverage ratio would be approximately 4.8, which is above the 4.0 ratio as of June 30, 2017, due to incremental debt added to fund the Cook Pharmica acquisition.

We believe that given the strong free cash flow generating ability of the combined entity, Catalent plus Cook Pharmica, we will be able to delever back down to pre-transaction levels within 24 months.

As John mentioned, we successfully accessed the capital markets in September and October. At the end of September, we issued 7.4 million new shares of our common stock at $39.10 per share and in mid-October issued $450 million aggregate principal amount of 8-year U.S. dollar-denominated senior notes at a very attractive coupon of 4 7/8%.

The proceeds from the debt and equity issuances along with cash on hand were used to fund the upfront portion of the purchase price for the Cook Pharmica acquisition, which closed on October 23.

Concurrently with the debt issuance, we completed an amendment to our senior secured credit facilities to lower the interest rates on our U.S. dollar-denominated and euro-denominated term loans as well as extend the maturity of the term loans 3 years to 2024. The new applicable rate for our U.S. dollar-denominated term loans is LIBOR, subject to a floor of 1%, plus 2.25%, which is 50 basis points lower than the previous rate and the new applicable rate for our euro-denominated term loans is Euribor, also subject to a floor of 1%, plus 1.75% and this is 75 basis points lower than the previous rate. The annualized interest expense savings for the repricing of the term loans is approximately $9 million per year.

Finally, our capital allocation priorities remain unchanged and focus first and foremost on organic growth.

I'll now provide our updated financial outlook for fiscal year 2018, which reflects the recently completed acquisition of Cook Pharmica. As seen on Slide 15, we expect full year revenue in the range of $2.31 billion to $2.41 billion. We expect full year adjusted EBITDA in the range of $521 million to $547 million and full year adjusted net income in the range of $198 million to $224 million. We expect in the range of $152 million to $165 million for capital expenditures, and we expect that our fully diluted share count on a weighted average basis for the fiscal year ending June 30, 2018 will be in the range of 133 million to 135 million shares. The share count increase reflects the stock offering of 7.4 million shares that I previously mentioned, which occurred near the very end of the first quarter.

In addition to the guidance we just provided on revenue, adjusted EBITDA and adjusted net income, we also wanted to provide some clarity on a few components of the P&L that will change in fiscal year 2018 as a result of the Cook Pharmica acquisition.

First, we expect depreciation expense to be between $123 million and $128 million. Next, we expect our consolidated effective tax rate to be between 29% and 30%. Last, we expect our total interest expense to be between $113 million and $114 million as a result of the new debt, partially offset by the repricing of the senior term loans.

Slide 16 shows the walk from our prior FY '18 guidance to our revised FY '18 guidance. The first set of bars shows that there's no net change from a base business perspective. Within the base business, there are puts and takes that are offsetting. I'd highlight that the Accucaps acquisition continues to perform above our expectations and that strength is offsetting declines related to product participation revenue.

The second set of bars shows the expected contribution of the Cook Pharmica acquisition from the closing date of October 23 through the end of our fiscal year 2018.

And the last set of bars brackets the additional positive FX translation impact to revenue and adjusted EBITDA that we're seeing as a result of continued strengthening of the euro and pound sterling in relation to the U.S. dollar.

Additionally, let me remind everyone of the seasonality in our business and highlight our expected quarterly progression through the year. As discussed for several years now, the first quarter of any fiscal year is generally our lightest quarter for the year by far, with the fourth quarter of any fiscal year generally being our strongest by far. And this will continue to be the case in fiscal year 2018, where we expect to realize approximately 40% of our adjusted EBITDA in the first half of the year and 60% of our adjusted EBITDA in the second half of the fiscal year.

Operator, we'd now like to open the call for questions.

(Operator Instructions) Our first question comes from Tycho Peterson with JPMorgan.

This is Tejas on for Tycho. Just trying to get a sense here of any timing-related impacts in the first quarter. I know you said in softgel timing was a little bit of a headwind, but expect the business to pick up for the remainder of the year and then in the rest of the business, were there any sort of timing-related benefits in the quarter that you'd like to call out? Just trying to get a sense of the base business momentum, it seems very healthy in 1Q and the fact that sort of the uptick in the base business guidance seems a little bit low relative to our expectations.

That's a good question, Tejas. I think we saw -- in addition to what we called out in the softgel business, I think we saw some timing-related favorability in the DDS business. I wouldn't say it's significant, but it was enough front-loaded that it did impact our thinking about not changing guidance for the base business, excluding the Cook acquisition. There was no timing-related issues of any magnitude in the CSS segment.

Got it. And then just a couple of questions here on Cook. Would you be able to give us a sense of what the Cook impact would have looked like if the acquisition had closed on the 1st of July, just ballpark, just trying to get a sense here of momentum in the Cook business over the last couple of quarters in terms of constant currency, organic growth and EBITDA margins? And is there anything different you want to call out regarding lumpiness or seasonality over the next 12 months for that business?

I believe that the Cook business would exhibit similar seasonality to the Catalent business, so we don't expect the addition of Cook to change the seasonal dynamic that Catalent has exhibited over many years now, with first quarter being the lightest by far, fourth quarter being the strongest by far. In terms of the impact of Cook Pharmica, we're -- I think, Tejas, what you might want to think about doing is just making an estimate of the first quarter that we did not own the business. The company's not going to make a public position on accounting that we weren't responsible for. So it wouldn't be a bad idea to just annualize off of the 9 months' worth of numbers that we're providing here and that will give you at the end -- maybe back off that a little bit because the Cook business itself is growing throughout the year. That should give you a pretty good estimate of the full year impact on a pro forma basis.

Got it. That's helpful, Matt. And just final one here. There seems to have been a little bit of a pickup in terms of the impact from biosimilars that some of your branded biologics customers have been calling out this quarter and perhaps over the last couple of quarters. Is the impact there for a CMO like Catalent very similar to the small molecule side where branded to generic conversion doesn't really move the needle for you?

Biosimilars is certainly a positive driver of activity for us. So that is -- that will be additive to our growth in terms of a long-term outlook. We view biosimilars and the role that Catalent can play very positively.

Our next question comes from Tim Evans with Wells Fargo.

So in the Clinical Supplies segment, this will be the third quarter that you have materially outgrown the market here and I'm just trying to get a better sense to what's going on here. Is there -- do you feel like you're taking some share? Is there something else going on? Just trying to get a better understanding for that really high growth that you've seen for the past few quarters.

Sure. I think a couple of things are at play there, Tim. First, I would say we don't necessarily see any significant shift in the competitive landscape. We just see the pie as growing, and the customers that we are doing business with in the CSS business just happens to be running hot on molecules that they're taking into clinical trials. So I think that is one driver that is a real net positive. The company has also been making efforts in our -- what we have branded our FastChain initiative to help our customers minimize wasted materials and the resulting added expense from undertaking trials and this has been a positive driver of activity and results in the business. And I would say 2 as you look at the prior year period, it's a bit of a favorable comparison point because we were just in the early throes in the first quarter and will see this in the second quarter likely as well of upgrading our ERP system for our U.S.-based operation in Philadelphia. And that slowed down our ability to perform in the prior year period. So we've got some favorable comparison points for this quarter and for next quarter on that basis. So I'd highlight those 3 things.

Okay. And then you called out some softness in consumer health and prescription in APAC. It's hard to imagine pill counts being down in that region. So what's kind of behind the softness in that business?

I think a lot of our Asia-Pacific volumes were headed into China on an import basis. And some of those import regulations in China have been changing for the products that we were manufacturing on our customers' behalf. And so sourcing of those materials into China has been changing and that has not been favorable for our performance in the region.

Our next question comes from Dave Windley with Jefferies.

So quick follow up on the last one from Tim. Is that -- those import regulation changes, do you expect those to persist for some time? Or is that a fairly short-term transient issue?

I would say we certainly see it for the remainder of this fiscal year and probably into next fiscal year, Dave, that's about as far as we're looking. We're working on some things to improve our positioning in the supply chain, but I think it's something that we'll see certainly for the rest of this fiscal year and then into next.

Okay. Maybe question for John around biologic strategy. How do you envision bringing Madison and Cook Bloomington together kind of merging sales force, streamlining operations, things like that? Or will they continue to operate somewhat independently?

First of all, I would say that the operations are highly complementary. What we got with the Cook Pharmica acquisition was a business that was extremely strong on the drug product side. So this is the finished dosage form in vial syringe lyophilized form, which we really did not have and our customers were asking us to develop through Madison. So highly complementary nature. And I'd also say that our drug substance business in Madison really is leadership, where on the Cook side, I would say they have some standard offerings with 2 by 2,500 stainless steel reactors. So the combination of the 2 assets really creates a very strong integrated end-to-end offering, where we see many of our Madison customers now wanting to go beyond drug substance and go into the drug product, which we can fulfill out of Cook Pharmica. And we're also -- as the one thing to be very clear about, this is a fast-growing expanding market. So for us, it's about continuing to add additional capacity and we'll probably continue on in Madison going beyond the third train that we've completed and moving on to a fourth and fifth train, but then the capacity that we have in Cook, with the large part of an unused roof overhead could be used for further drug substance manufacturing and moving towards the single-use bioreactors, which we've really kind of pioneered in Madison. We've just brought the sales teams together actually last week, as you know as soon as the acquisition just closed, and there's tremendous opportunity. The Cook business had a relatively small, very small sales force where their strategy was fundamentally to continue to grow with existing customers, which is very different from Catalent's model of really expanding our customer base and bringing as many high-value molecules as we can into the business. So we see that evolving positively on a go-forward basis. Really, really pleased with the acquisition and the potential to take us, where right now, we're at -- 21% of our revenues are now going to come from biologics-related activity. With the acquisition of Cook Pharmica, we have a stated goal of 20% to 25% and as we kind of round out our strat plans early next year, we'll probably be pushing that towards 25% to potentially 30% of overall revenues. So the combination of 2 assets should really keep the strong biologics growth momentum continuing for us.

Just one follow-up and I'll drop. They had -- so Cook, you've talked in, I think, the prior call about the transaction that their utilization levels of their facility are relatively low, certainly for biologic assets in the industry. And I think I understand that they have built out some fairly substantial capacity fairly recently. And so curious about what they anticipated coming into that space? Are there -- is there a line of sight to commercial products production in the relative near term and then kind of going back to the sales and your comments around Madison and bioreactor, et cetera, how -- essentially, how do you fill that space?

Yes. So first of all, they were very aggressive in creating a biologics-focused business and currently, today, I'll say that they are already doing a commercial product there on the drug product side. They have 6 already up and running and a very robust funnel and with the capacity they have installed, which is, I think, being utilized at about 40%, we envision being able to get up to basically about $300 million of revenues without substantial new CapEx investment. With the funnel that they -- funnel and -- the CapEx that they have already invested, they will require about $8 million to $10 million of annual maintenance CapEx. But as we look at their funnel and the potential on the drug product and drug substance side, we'll be looking at their CapEx requests in business cases and putting up those up against the rest of the company and we do see over our strat plan period that we will be -- continue to be disproportionately investing our growth CapEx on that front. So we got a long runway, I would say, in terms of both pipeline, expanded access to the market with our business development team, the CapEx they have installed to really get to some pretty significant number, pretty much doubling their current revenues and then there's the opportunity for additional CapEx investment. It's a huge facility of which literally half of it is currently not built out. So that's going to give us a run rate for a very long time and it's going to be unique asset from the standpoint that you're going to be able to have such a large amount of activity under a single roof, which, as you know, in Catalent, we do have 35 different sites, whereas this site is going to end up being really a marquee site that will, again, be able to contribute significantly to the company over a long period of time.

Our next question comes from Derik De Bruin with Bank of America.

This is [Juan] for Derik. My first question is given that Cook is accretive to your top line growth, does this acquisition bring you closer to formally increasing your long-term organic growth guidance of 4% to 6%? What are your current thoughts about this?

This is a good question, [Juan]. It's something that we're taking under advisement. We're not going to be making a statement on our long-term outlook today, but we are looking at it. We've got our normal annual cycle of strategic planning coming up here within the next couple of months. We also have to process the impact of the new revenue guidance, which we are required to adopt as of our FY '19 fiscal year. We have to factor that into the equation as well and that's underway. So we will be looking at it carefully for next quarter Q2 or Q3 communication.

And regarding your margins, your biologics mix is going up, product participation revenues are coming down. Can you walk us through the product mix trends by segments and implications to the gross margin? And how should we think about the gross margin opportunity for Catalent in the long term?

Okay. We continue to see margin accretion potential in the business. That comes from a combination of mix, but also operating leverage over the assets. So very quickly, by segment, softgel, we generally will perceive that to be steady in terms of its margins. The addition of Accucaps is, just given the nature of their product slate, modestly dilutive to the segment margins. But through operating leverage and other Lean Six Sigma activities we can undertake in the segment, we see softgel basically holding steady. The CSS business stands some of the best potential, actually for margin accretion. It comes back to what I was saying about the revenue recognition standard that we have to adopt as of July 1 of FY '19. And how we account for comparator sourcing revenue may be changing. Right now, we have to account for that on a gross basis. We have to gross up those sales. And there's the potential, as we move to the new rev rec standard, that we would actually then record those on a net basis and that would be a significant margin enhancement in terms of the EBITDA margin in the CSS business. In the DDS segment, there's also very attractive margin enhancement opportunities here mainly because of the shift in biologics, but also just the growth of our oral solids business, specifically in the controlled release area and some potential that we have for new avenues for the Zydis technology. So we continue to believe that the business can margin up 200 to 300 basis points over the term of any strat plan that we do and that's sort of how we think about margin expansion available to us.

And lastly, I mean going back to the biopharma supply chain questions before, have you seen any customer-related destocking? Or are the lower volumes that you're seeing in Asia-Pacific particularly with the over-the-counter products, is that besides the importation comment that you brought up about China? Is that an overall industry phenomenon? Or is it just a few customers?

So what we're experiencing with the supply chains in China is broadly experienced across the pharma space. So it's not just Catalent that is seeing that. But in terms of our particular customer slate in Asia-Pacific and that part of the volume decline, I would say that's really just Catalent.

Also, if you think that another comment of that is really driven by VMS products, which I would say are our lowest-margin products, which if you recall back 2 and 3 years ago, we were trying to leverage some unused capacity in our softgel network to increase volumes, if you will. So we've garnered some additional business going into China. There were some regulatory changes that muted that, but we've then gone past that -- those capacity utilization opportunities in softgel and continue to be focused, I would say, more heavily on the Rx and OTC business segments within that business unit.

Our next question comes from John Kreger with William Blair.

John, just a follow-up question on biologics. Has your thinking changed at all about sort of what sort of scale of business you're going to be competing for? And can you remind us what sort of customer overlap you have between the Madison book of business and what Cook has been doing?

Sure. So our thinking has not changed in terms of scale. I would say the biologic supply space has really barbelled between the very big suppliers where they'll still have opportunities, I would say, on potential biosimilars that come to market and a few blockbusters in the biosimilar -- or I'm sorry, in the biologics area, which would be really the kind of the Lonza, BI and other large capacity manufacturers. And even WuXi, I think, may be moving towards some larger capacity for the -- a biosimilar opportunity in China. But there's a huge portion of these molecules that are in small and midsize companies where the volumes, as we've talked about, we believe that of the molecules that are currently in the pipeline from the analysis that we've done with our strategic advisory board, our own experts and outside consults say that 70% of what's currently in the pipeline is going to require a 5,000 liter or less bioreactor. So we really like that space. It has aggressive growth for us. It allows us to be reasonable in terms of the CapEx requirements. We're spending in the tens of millions of dollars versus the hundreds of millions of dollars for big capacity and it allows us to use that single-use bioreactor technology, which really improves cycle times and the potential for contamination and so forth. So our business case and our approach towards where we want to put capacity in for biologics for me remains the same. With regard to the 2 businesses, we were actually very pleased with the lack of overlap that we have between the 2 businesses. They had many. Once the customer names and products were unblinded to us during due diligence, these were marquee names. Now there are several large customers that are customers of ours, but we hadn't tapped into from a biologics standpoint. So overall, everything about this deal continues to be on the favorable side of the equation.

Great. And then just one quick follow-up. Matt, now that Cook is closed, can you update us on your free cash flow goal for fiscal '18?

So we had communicated at the beginning of the year that we would -- that we were targeting free cash flow in the range 65% to 75% of adjusted net income. And while that would be expected to go up with the addition of Cook, we're not changing the outlook because of the CapEx that we're likely to continue to invest in the Cook's site.

Okay. So just to clarify, on a dollar basis, your free cash flow outlook for '18 really doesn't change?

Correct.

Our next question comes from Matthew Mishan with KeyBanc.

I know it's going to take some time to delever here, but long term, are there other biologic CMO assets of similar size? And do you see yourself as potentially making another large acquisition in this space in -- over the next couple of years?

So there are other acquisition targets in the biologic CDMO space. I would say that we're certainly open to that kind of growth in the future. We're, obviously, aggressively growing organically, and there may be opportunities that present themselves. So we're certainly not taking ourselves out of contention for growth through merger and acquisition activity. I think it will be a while, though, before we see a deal that presents the same kind of attractive return profile that the Cook Pharmica acquisition did.

Okay. And then just shifting gears to Accucaps, why is that performing well above expectations? And why should we not be thinking to use kind of similar conservative numbers around Cook?

Well -- so in the Accucaps business, they had seen very strong performance on a volume basis across the board, but they've also seen favorable mix to some of the generic products that they manufacture, better than we were expecting. Matt, with respect to the Cook piece of it, we've got a forecast in for the business for the remainder of the year that we think is -- we have a high degree of confidence that they will hit that forecast.

(Operator Instructions) Our next question comes from Kevin Caliendo with Needham & Company.

Thanks very much for the bridge to your fiscal '18 guidance, that is a really helpful slide. I just want to talk a little bit about taxes. I think the tax rate guidance you came in is a little bit higher. Can I just assume that's because of the increased revenues from Cook?

That's correct.

Okay. And another tax question, now that the initial sort of, the first wave of tax reform bills are out, have you guys taken a look at it? And can you talk a little bit about what you might think there -- what kind of opportunity there might be for the company from a potential tax reform bill?

So I would caveat my answer to that question, Kevin, with saying that things are still moving quite a bit. And even the things that have been communicated still require a significant amount of definition around them so that we can do our detailed calculations to really give a precise answer to that question. But at a high level, we've run some numbers based on what we think we know. And our reading of this says that this will be a net neutral, maybe modestly positive development for Catalent in the way the House bill is currently being described.

Okay. Is that just some of the importation stuff? Or -- I mean, most people are expecting this to be a little bit more positive. Is it just sort of your mix and how much you're bringing in from overseas?

We're really just looking at the net impact of the lower tax rate, the loss of depreciation deduction and probably most of our interest expense deductions, but that being offset by immediate expensing of CapEx and it's really those things that will be the drivers for Catalent in terms of where our rate will ultimately go. The import-export components of the plan are pretty ill-defined right now. That -- that's an area that requires a lot more specificity before we can accurately predict what the impact will be.

Got you. And one quick one. Just the -- we were sort of way off on the unallocated costs in the quarter. Can you just go a little bit more into that? What was in the number there?

That number tends to be swung by noncash unrealized foreign currency translation impacts, both on intercompany debt and also on the euro component of our long-term external debt.

(Operator Instructions) And I'm currently showing no further questions at this time. I'd like to turn the call back over to John Chiminski for closing remarks.

Okay. Thank you, operator, and thanks, everyone, for your questions and for taking the time to join our call. I'd like to close by reminding you of a few of our key priorities for fiscal year 2018. First, we're confident and committed to delivering FY '18 results consistent with our financial guidance. Second, we're committed to building a world-class biologics business for our customers and for patients and look forward to another year of double-digit revenue and EBITDA growth from our core biologics offering. The successful and efficient integration of Cook Pharmica into the Catalent portfolio is a top priority for the management team, as we look to swiftly capitalize from the benefits of having both drug substance and drug product capability under one roof. Last, operations, quality and regulatory excellence are at the heart of how we run our business and remain a constant focus and priority. We support every customer project with deep scientific expertise and a commitment to putting the patient first in all we do. Thank you.

Ladies and gentlemen, this concludes today's conference. Thank you for your participation. Have a wonderful day.