Catalent Inc (CTLT) 2018 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Second Quarter Fiscal Year 2018 Catalent Earnings Conference Call. (Operator Instructions)

And now I'd like to turn the conference over to Tom Castellano, Vice President, Investor Relations and Treasurer. Please go ahead.

Thank you, Candace. Good morning, everyone, and thank you for joining us today to review Catalent's Second Quarter Fiscal Year 2018 Financial Results. Please see our agenda on Slide 2 of our accompanying presentation, which is available on our Investor Relations website. Speaking today for Catalent are John Chiminski and Matt Walsh, whom you all know well.

During our call today, management will make forward-looking statements and refer to non-GAAP financial measures. It is possible that actual results could differ from management's expectations. We 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 conditions.

Now I'd like to turn the call over to John Chiminski.

Thanks, Tom, and welcome everyone to our earnings call. We're very pleased with our second quarter and year-to-date results for fiscal year 2018, which position us well as we enter the second half of our fiscal year. For the second quarter, we recorded strong revenue growth and double-digit adjusted EBITDA growth in constant currency across all 3 of our reporting segments.

As you can see on Slide 6, our revenue for the second quarter increased 25% as reported and increased 22% in constant currency to $606.3 million with 8% of the 22% being organic and with all reporting segments contributing to the growth. Our adjusted EBITDA of $139.3 million was above the second quarter of fiscal year 2017 on a constant currency basis by 39%, of which 15% was organic, again, with all segments contributing to year-over-year EBITDA growth. Our adjusted net income was $60.7 million or $0.45 per diluted share for the second quarter, an increase of $0.18 per share versus the prior year.

Additionally, through the first 6 months of fiscal year 2018, we've recorded revenue growth of 24% as reported and 22% in constant currency with 11% of the 22% being organic, which is significantly above our long-term outlook of 4% to 6% top line growth. As discussed previously, we continue to work internally on our annual update to our strategic plan and assessing the future impact of the Cook Pharmica acquisition on our long-term outlook. We anticipate being in a position to update our analysts and investors of any change to our long-term guidance on our Q3 FY '18 earnings call.

Now moving to our key accomplishments. First, during the quarter, we closed the acquisition of Cook Pharmica, a biologics-focused contract development and manufacturing organization based in Bloomington, Indiana. 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 acquired company operates a world-class 875,000 square-foot development and manufacturing facility at Bloomington and employs more than 750 people.

The combination of Catalent and Cook Pharmica significantly strengthens our position as the leader in biologics development and manufacturing. Together, we will provide customers a single partner, providing cell line development, large molecule analytical services, drug substance manufacturing and drug product manufacturing to accelerate biologic drug development programs for customers and bring better treatments to patients worldwide through a comprehensive portfolio of integrated solutions. The integration is well underway, progressing slightly ahead of our expectations and already creating value for the company, our customers and our shareholders.

As reminder, we took our pro forma net leverage ratio up to 5x to fund the acquisition, but as of December 31, we've already reduced our pro forma net leverage ratio to 4.4x, which was a faster deleveraging path than expected as a result of the strong Q2 EBITDA performance across the business.

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 have recently completed engineering runs. We expect to have the new capacity officially cleared for use during the third quarter, with utilization expected to ramp up during the fourth quarter. As mentioned on previous earnings calls, we've already signed a number of customer contracts for the third train, 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.

Next, I'm pleased to announce the appointment of Wetteny Joseph to the position of Senior Vice President and Chief Financial Officer effective tomorrow, succeeding Matt Walsh, who has announced his desire to leave the company to assume the position of Chief Financial Officer of Allergan. We're excited to have Wetteny move into this new role within the company. His leadership as President of our Clinical Supply Services business for the last 2 years, together with his deep experience in finance and controllership, developed both here at the company and throughout his career, will make him a key asset to all of our strategic and financial initiatives. We look forward to his continued success as a member of our executive leadership team. Wetteny is in the room here with us today.

I'd also like to thank Matt for his nearly 10 years of service and for what he has done to help us and our shareholders. He has been an important part of the Catalent story from its inception as a stand-alone business through its initial public offering and its maturation as a public company. We wish him well -- we wish him all the best in his new endeavor.

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

Now I'd like to turn the call over to Matt, who will take you through our second quarter fiscal year 2018 financial results as well as provide our revised outlook for fiscal year 2018.

Thank you, John. Let me acknowledge -- let me begin by acknowledging John's gracious words. It has been my sincere pleasure to be CFO of Catalent and to work for you and with you, John, and be part of Catalent's transformation to the great company it is today. While I look forward to starting my new job, I'm also happy to note that I leave Catalent in a strong financial position and with a tenured successor and overall financial team that I admire and respect. And I expect the transition to be seamless between myself and Wetteny.

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 in constant currency.

Softgel revenue of $228.1 million grew 9% during the quarter with EBITDA growing at 13%, which is 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. We acquired the business during the third quarter of fiscal year 2017.

In the second quarter of the current fiscal year, the business continued to perform well above our expectations and contributed 12 percentage points to the segment's revenue growth and 9 percentage points to the segment EBITDA growth. Excluding the acquisition, our softgel business declined 3% organically at the revenue line, but increased 4% at the EBITDA line, driven by a historical contract settlement recorded in the quarter.

Slower organic revenues within the business was due to a decrease in product participation revenue and lower consumer health volumes in Asia Pacific. Our softgel North American and Latin American businesses performed modestly about prior year levels. It's important to note that we continue to expect the softgel business, excluding the Accucaps acquisition, to perform at revenue and EBITDA levels that are in line with the prior year during the second half of this fiscal year.

The update for Drug Delivery Solutions segment is shown on Slide 8. The DDS segment recorded revenue of $285.4 million, which was up 30% versus the prior year with EBITDA growing 58% during the quarter. A sizable portion of this segment's revenue and EBITDA growth was driven by the Cook Pharmica acquisition, which closed in October 2017, and this contributed 21 percentage points to the revenue growth and 40 percentage points to the EBITDA growth. In its first quarter as part of the Catalent's family, the site is off to a fast start. We continue to feel good about the immediate and long-term growth prospects of this business.

The acquisition of Cook Pharmica and its Bloomington site strengthen our position as a leader in biologics development, analytical services and finished product supply. The combined business of Catalent Biologics and Bloomington 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.

As we're seeing in the numbers, the acquisition of the Bloomington site significantly accelerates the already strong growth of our existing biologics business by extending bio manufacturing capacity for clinical and commercial manufacturing across the network. As a reminder, biologics comprised approximately 14% of Catalent's consolidated revenues 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, 2017, for important information concerning how we calculate pro forma revenue.

Recent organic investments in our legacy biologics business continued to translate into growth during the second quarter, and it remains the fastest-growing business within Catalent. We recorded strong revenue and EBITDA growth in our Madison facility, driven by the completion of project milestones and larger clinical programs. We continue to believe that our biologics business is positioned well to drive future growth as indicated by business development signings of Roche, Moderna Therapeutics, Triphase Accelerator, Therachon AG and Grid Therapeutics.

The oral delivery portion of the DDS business had another strong quarter with favorable end-market demand for high-margin offerings within our U.S. controlled release business. Our European prefilled syringe business also had a strong quarter, but a significant portion of the strength was timing-related. This was driven by the normal maintenance shutdown of the Brussels facility, which occurred in the second quarter of fiscal year 2017 being moved to the third quarter of this fiscal year.

Our blow-fill-seal offering recorded results during the second quarter that were below the prior year period due to lower volumes and operational challenges, resulting from us taking steps to enhance our quality and manufacturing protocols and processes at the site, which we expect to continue throughout the remainder of this fiscal year. Strategically, market fundamentals continued to remain attractive for this key sterile fill technology.

The segment also experienced declines in high-margin product participation revenue during the quarter. You will recall we highlighted this dynamic as a fiscal year 2018 headwind during the start of the fiscal year. We expect these declines to carry into remaining quarters of this year, which has already been incorporated into our guidance communications.

In order 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 6 months ended December 31, 2017, we recorded development revenue of $70 million, which is in line with the development revenue recorded in the same period of the prior fiscal year. In addition, during the first 6 months of the fiscal year, we introduced 100 new products, which are expected to contribute $33 million of revenue, which is 20% lower than the revenue contribution of NPIs launched in the first 6 months of last year. This is aligned with our plan and based on timing of launches this year.

We expect the fiscal year 2018 NPIs launches and their revenue contribution to be in line with our long-term growth 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 at the discretion of our customers and thus, these figures will continue to vary quarter-to-quarter.

Now as shown on Slide 9, our Clinical Supply Services segment posted revenue of $108.7 million, which was up 36% compared to the second quarter of the prior year driven by increased customer-project activity across our core storage and distribution services business. Lower margin comparator-sourcing activity contributed approximately half of the segment's revenue growth.

Segment EBITDA increased 55% compared to the second quarter of the prior year, primarily driven by the revenue growth in our core storage and distribution services business and improved capacity utilization across the network. Given the low margin of the comparator-sourcing activity, it contributed modestly to the segment's second quarter EBITDA growth. All of the revenue and EBITDA growth recorded within the CSS segment was organic.

As of December 31, 2017, our backlog for the CSS segment was $306 million, an 8% sequential decrease. The segment recorded net new business wins of $80 million during the second quarter, representing a 26% decrease year-over-year. The segment's trailing 12-month book-to-bill ratio was 0.9. These indicators are below recent historical trends due to a faster-than-expected burn of the backlog in the first half of the fiscal year, as evidenced by the higher levels of organic growth recorded during the first and second quarters.

Additionally, in the second half of the fiscal year -- this fiscal year, we expect more tempered year-over-year revenue growth given the strong results posted in the comparable prior-year period as well as the first 2 quarters of this fiscal year.

The next slide contains reference information. We've already discussed the segment results shown on the consolidating income statement by reporting segment, which is on Slide 10.

Slide 11 shows in precisely the same format as on Slide 10, the 6-month year-to-date performance of our operating segments, both as reported and in constant currency. I won't cover the variance drivers in detail since our year-to-date results parallel our second quarter results and show constant currency revenue growth and similar EBITDA performance across all 3 reporting segments. The year-to-date 22% constant currency revenue growth or 11% growth on an organic basis compared to the same period a year ago was nicely above our long-term objective of 4% to 6% organic revenue growth per year.

Slide 12 provides a reconciliation of 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 13, second quarter adjusted EBITDA increased 42% to $139.3 million. On a constant currency basis, our second quarter adjusted EBITDA increased 39%, of which 15% was organic driven by strong performance across Drug Delivery Solutions and Clinical Supply Services segments.

On Slide 14, you can see that second quarter adjusted net income was $60.7 million or $0.45 per diluted share, compared to adjusted net income of $34.7 million or $0.27 per diluted share in the second 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.

One important item I want to draw your attention to is the tax add-back, which is higher than in prior periods. During the second quarter, we recorded a onetime net charge of $46 million within our income tax provision as an estimate of the net accounting impact of recent U.S. tax legislation. We expect less than 1/4 of this charge to be paid in cash after considering the use of certain NOLs. The payment will be made over an 8-year period and will be funded with U.S.-generated cash. Due to the significant complexity of the provisional estimate we've recorded during the quarter, it's important to note that it may require adjustment over the next 12 months. I'll provide more color on the impact of tax reform on our forward-looking effective tax rate during the FY '18 guidance section of these prepared remarks.

Slide 15 shows our capitalization table and capital allocation priorities. Our total net leverage ratio on a reported basis as of December 31 was 4.8x due to the incremental debt added during the quarter to partially fund the Cook Pharmica acquisition. However, as John mentioned earlier, we calculate our leverage ratio on a pro forma basis for the Cook Pharmica acquisition, which would include a full 12 months of earnings, rather than only for the 2 months that we own the business.

Our total net leverage ratio would be 4.4x, which is nicely below the pro forma total net leverage ratio of 4.8x we've recorded during the prior quarter and the 5.0x discussed at the time of the acquisition announcement. We continue to believe that given the strong key 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 faster than the 24 months we previously communicated.

As a reminder, we also successfully refinanced the company during the quarter. In mid-October, we issued $450 million aggregate principal amount of 8-year U.S. dollar-denominated senior notes, a very attractive coupon of 4 7/8%. The proceeds from the debt issuance, along with the cash on hand and the proceeds from the September equity issuance, were used to fund the upfront portion of the purchase price for the Cook 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 rate 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 plus 2.25%, which is 50 basis points lower than the previous rate, and the new applicable rate for our euro-denominated term loan is Euribor, subject to a floor of 1% plus 1.75%, which 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. We also lowered the interest rate and extended the maturity of our revolver, although we currently have nothing drawn on it. 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 continued underlying strength in the business. As seen on Slide 16, we expect full year revenue in the range of $2.42 billion to $2.48 billion. We expect full year adjusted EBITDA in the range of $537 million to $557 million and full year adjusted net income in the range of $212 million to $232 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.

In addition to the guidance we just provided on revenue, adjusted EBITDA and adjusted net income, we also wanted to provide some clarity on our consolidated effective tax rate, given the tax legislation signed at the end of calendar year 2017. As a result of the U.S. corporate tax rate decreasing to 21%, we expect our FY '18 consolidated effective tax rate to be between 27.5% and 28.5% due to the partial-year impact of the rate change. As we enter FY '19 and beyond, we expect our consolidated effective tax rate to be between 26% and 28%.

Slide 17 shows the walk from our prior FY '18 guidance to our revised FY '18 guidance. The first set of bars shows the net change from a base business perspective. Within the base business, we continue to see strength across 4 major areas: the Accucaps business acquired in the third quarter of FY '17; our core Madison Biologics business; our U.S. controlled release business; and the Cook Pharmica acquisition, which as we mentioned is out-of-the-gate strong.

The second set of bars shows the impact to revenue from the increasing volume in our lower-margin comparator business within our CSS segment. However, the revenue increase we expect should have an immaterial impact on our consolidated adjusted EBITDA, given the low-margin nature of this business.

The last set of bars brackets the additional positive FX translation impact to revenue and adjusted EBITDA we're seeing as the result of the 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 of 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 42% of our adjusted EBITDA in the first half of the year and 58% 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) And our first question comes from Tycho Peterson of JPMorgan.

I want to start out with the Cook performance in the quarter, it was a little bit better than we've been modeling. Any onetime items to call out there? And maybe can you talk about your confidence in the sustainability of the strength you saw here?

The strength of the Cook acquisition that we saw was mainly mix-related as well as timing-related. We were expecting that the business would have a normal maintenance turnaround in the second quarter. And just due to the underlying strength in the business, we decided to postpone that turnaround to the third quarter, Tycho, so more timing-related, but we did see overall good strength and mix in the business.

Okay. And then, Matt, can you comment a little bit more on the blow-fill-seal operational inefficiencies you called out and kind of plans to remedy that?

Sure, sure. We have, within Catalent, a rigorous internal audit of process of our quality and operational processes. That turned up several issues at Woodstock some months ago that we needed to attend to, and that's exactly what we've been doing. We have -- so we have been directing company time, managerial resources to the site to do a bit of a reset and make sure that the way that we're operating is rigorously adhering to all of our own internal SOPs, Tycho. So this is self-imposed and completely discretionary on the company's part. But the -- one of the consequences there, we have -- we had slowed down our throughput and cycle times on the various factions that we're doing. And that -- so that's showing up in the financials. And as we look at the time line of the activities that we're undertaking, we see this as a fiscal year 2018 issue. So we will see it going into the second half, and we'll be steadily recovering during that time with most of that and with the expectation being that we'll be back at full run rate by the end of the fiscal year.

Okay. And then just last one on guidance. EBITDA guidance is only coming up around $30 million at the midpoint. Obviously, you've had a nice top line each in both the first and second quarter. Maybe can you just talk a little bit on the puts and takes around EBITDA? Is it just incremental investment around Cook that's maybe limiting the EBITDA expansion here?

So we talked about the areas that we're seeing strength, which is in our biologics business, both our legacy business as well as the Cook business. And we're seeing strength in our U.S. controlled release business. But where we've got some either flatness or maybe some timing-related issues, where we might see declines in the second half of the year, would be in our softgel business; blow-fill seal, as we've talked about; and the CSS business, which we mentioned will be up against some pretty tough year-on-year comparisons in Q3 and Q4.

Okay. And congrats on your new job, Matt. It has been great working with you here.

Thank you, Tycho. Likewise.

And our next question comes from Ricky Goldwasser of Morgan Stanley.

Matt, congratulations on the new opportunity. So just a couple of questions here. When we think about the Madison facility, can you just give us a little bit more color on the -- on where you stand in capacity? And then also just some more color -- we've seen obviously a lot of M&A activity in the past 6 months and in the space, companies being taken private or merging. If you can just -- how are you thinking about the competitive dynamics in the space as a result of these transactions?

Yes. So Ricky, I'll start off with that -- the answer to that part of the question. First of all, it remains a highly dynamic space where, honestly, the way I've been describing it is that I think we're in a probably a 10- to 15-year secular growth trend. And what's really happened is between the Lonza acquisition of Capsugel, the Thermo Fisher acquisition of Patheon and now, Catalent is kind of the last-standing premier CDMO, we're seeing a lot more business, I guess, I would say accruing to the bigger players because our customers are really looking for these CDMO partners that have the ability to invest in the quality of operations and then the investments required from a capacity standpoint. So I think the larger players are going to continue to accrue more of the benefits from what I think is a long-term secular 10- to 15-year trend. From a competitive dynamic standpoint, I would say that we haven't seen any significant changes or increases to competitiveness based upon those larger acquisitions or even in the situation of AMRI being taken private, which we really didn't have any head-to-head type of competition with them. But I can tell you that there seems to be more stability from a competitiveness standpoint, which it exists, but it hasn't changed dramatically. And as we've said, I think there's really kind of a 10- to 15-year secular growth trend as these larger CDMO, of which, again, Catalent is the last-standing premier pharmaceutical services business. I think you're just going to continue to see the pharma and biotech businesses that have now become very comfortable partnering with these larger groups, and this is why they want fewer, bigger, better providers. From an overall M&A standpoint, certainly Catalent has been part of the M&A story, I would say, over the last decade. In fact, over the last 2 decades, which is how Catalent really came together, and we continue to be very active in this space with the underlying comment that our primary capital allocation is for organic growth drivers with M&A, following in behind that. We really see organic growth as the fundamental driver with M&A being used to fill in our strategic priorities or accelerate our strategic plans.

And Ricky, it's Matt. The first part of your question related to Madison capacity. So at the present time, Madison is operating at very high rates of capacity utilization. We have known for some time that we would get to this point, which is why we greenlighted the third-train capacity, which construction has completed. And we're doing engineering validations run now -- runs now, and we will see recordable revenue ramping up small amounts in the third quarter and increasing into the fourth quarter. So we will be able to continue the rate of revenue growth at Madison that -- the high rate of revenue growth that we have enjoyed there in recent quarters.

And our next question comes from Dave Windley of Jefferies.

I wanted to follow up on that last question, Matt. You talked about small amounts of recordable revenue in the third quarter. Beyond that, do you have -- are you able to contract with clients at this point for ramp? In other words, do you have visibility to that? Or are kind of signings of contracts contingent on the engineering runs and things like that? I'm just curious about the timing of kind of gaining that visibility.

Yes, Dave. John Chiminski here. I will say that we're on plan for signed business for what we had in our business case for the first half, which means that we had previously booked on business into that asset, which it will meet -- in our original build-out, there was a lag time between when we build it out and when people had confidence in coming in and placing business. And we don't have any of that business -- this was signed before we even had our engineering validation runs done. So it just shows what is out there from an overall business standpoint. There is a significant demand for the type of work that we can do from a commercial manufacturing standpoint in terms of our 1,000, 2,000 and now 2 by 2,000 meter capability that we're going to have, so very strong. And as I said, we actually have the -- we already have business booked to what was, I would say, a pretty decent plan for the facility for the last half of fiscal year '18 and the businesses booked already completes that business case that we had. So it's terrific news for the company, and again just talks to the level of demand there is out there for flexible biologics manufacturing.

That sounds like it. If I could zoom out from that then, John, on this topic and think about how -- I'd love for you to describe how you envision servicing the demand in that market between your 2 facilities. It seems like one of the real beneficial aspects or assets of Cook is some available space for you to grow into.

Yes.

And just wanted to better understand how you see expanding that space. Is it important to have, say, substance as the Center of Excellence in Madison and drug product in Bloomington and/or vice versa or combined in both? Just curious how you see that build out happening and how that services the market best.

Sure. I will tell you our thinking has evolved quite a bit over those last 3 or 4 months since we've gotten our hands on the Bloomington facility, and we're now positioning it towards having 2 Centers of Excellence towards our drug substance manufacturing. As you know, given the very strong demand that we see over the next 5-plus years, we were -- already had on the books, the potential fourth and fifth train that requires a greenfield build-out at the Madison site. And over the last several months as we stare into our strategic plans that are coming up over the next couple of months, there is just an immediate and readily available space in this world-class facility. Becca was just there a couple of weeks ago. And our thinking now is that we may be able to accelerate that fourth and fifth train through readily available space that's within the facility. Those decisions are made, but it just tells you the quality of this asset that we have and the flexibility, and the fact that we might actually be able to accelerate some of our time lines depending on the route that we go, whether it's from greenfield or just building out within Bloomington. Bloomington will not be a second cousin, with regards to drug substance manufacturing, very different look and feel, actually more of a big pharma feel there in terms of the available space and capability for drug substance. And it's really turning our heads towards thinking about where we're going to place that fourth and fifth train or whether or not we can accelerate it faster than our Madison alone time lines are. So really exciting times. We also think that we're hitting a real sweet spot here. As you know, our strategy is what we call a flexible development in manufacturing within biologics and with our single-use bioreactors. And the bioreactors that we're targeting here, which is the 2,000 meters, just gives us a lot of flexibility, which is bringing a lot of customers. The other part of this is Bloomington has really a terrific mix of high-end pharma customers, in fact, contemplating -- or, complementing our own portfolio, so we're also very conscious of what they're looking for. So we don't expect to have a second cousin here in drug substance. Certainly, they're -- they have a leadership position in drug product. But drug substance, I think, is going to be shared very well across both of those facilities, which are geographically relatively close also, so we're going to be able to get some use across both of those teams.

One last question just for clarification, Matt. You talked on the CSS piece about the difficult comps and more tempered growth. If I also take into account the change in backlog and the lower bookings, should we be thinking growth there? Or should we actually be thinking that, that's going to be down against those difficult comps in the second half of the year?

Our best look right now, David, says that flat is the math for the second half.

And our next question comes from Tim Evans of Wells Fargo Securities.

Matt, could you quantify the onetime contractual settlement in softgel?

It was about $3 million, Tim.

Great. And then can you talk a little bit more about why the APAC consumer is down? Is this temporary? Is this sort of a structural long-term thing? Is it something that will grow again next year? I'm just trying to get a little bit more color on the longer-term outlook there.

Based on the information that we're looking at, Tim, it does seem to be more of a structural long-term issue for our softgel business in the Asia-Pac region. This has always been a product slate that was more geared towards VMS business and -- which had an OTC component to it. For years, we've been trying to push that OTC, high-value OTC component bigger and bigger. It was just more challenging to do. And then with some of the dynamics around changes within how China sources VMS materials, we became -- we've become less optimistic about the ability to grow our softgel franchise in Asia-Pac for the long term.

Okay. And just giving that dynamic, can you give us a sense for the size for APAC softgel?

It's not large, Tim. It's been shrinking, and I will tell you, its profitability contribution is even lower than the sales contribution.

And our next question comes from Derik De Bruin of Bank of America.

So on the backlog in the CSS business, just sort of a question mark. Is the reduction there incorporating the ASC 606 changes in the accounting? And I guess, sort of how does this -- yes, and sir, can you just kindly walk us through that as we sort of get into that new change in the reporting?

Sure. So we'll talk about the technical reporting part of the question first, and then zoom back out and talk about the more strategic implications. On the ASC 606, which is the revenue recognition standard, Catalent adopted that on July 1, so that's the first day of our next fiscal year. This does not have a big impact across most of Catalent but for this certain aspect of revenue recognition within CSS, and that's the comparator business, which is at any point in time, between 20% and 25% of the top line -- current top line of that segment. And we will be recording that on a net basis versus a gross basis starting July 1. So there's nothing, either in our reported results or in our backlog statistics at this point that reflects that. In terms of why, Derik, why the numbers have backed off a bit, we've just been burning the backlog faster than we've historically done. That has contributed to the outsized revenue growth we've seen in the business really for the last 3 or 4 quarters. And so we've got to catch up with our sales efforts and replenish that backlog.

Great. And just a housekeeping question. The bottom moving parts in the capital structure, what sort of is the net interest expense guide for the rest of the year or for the full year?

For the full year basis, we'll be $114 million.

Great. And just, it looks like that the EBITDA performance on Cook was a lot better than expected. Where did that sort of come in?

So there were -- we had better product mix than we thought out of the gate, but there was a significant timing component to this. We expected the business to take its normal maintenance turnaround in Q2. It pushed into Q3. So we'll just be trading that with Q3 performance.

Great. All right, great. And then just one final one, Accucaps, I believe annualizes this quarter. And so what is sort of the inherent organic revenue growth rate of that business as we look out?

So we have always said that softgel should be growing on the lower end of Catalent's 4% to 6% top line expectation. We expect the softgel business in the second half of this fiscal year though to be flat year-on-year.

And our next question comes from John Kreger of William Blair.

I have another biologics question. Can you talk about -- is the demand being driven more from clinical contracts or commercial longer-term mandates? And how should we think about sort of the volatility of the business over the next 2, 3 years given that mix?

Yes, sure. So first of all, on the drug substance front, it's fundamentally, today, for clinical trials. And we do see and are actively pursuing some customers that will be moving us into the commercial range as we exit FY '18 and head into FY '19. And as a matter of fact, some of the contracts -- or some of the customers that we're looking at to fill the new capacity are going to require commercial manufacturing. And we're readying the facility for that transition from an FDA standpoint. From a Cook Pharmica standpoint, they're already very strong from a drug product standpoint for commercial products. They had 12 and then in the last quarter, it had 1 more approval, so they now have 13 products that are in commercial manufacturing, and they have another dozen or so that have the potential, if approved, to go to commercial manufacturing. I think from a longer-term standpoint, clearly, the very strong demand is from the high amount of large molecule -- large molecules that are in the pipeline, and those are growing at a faster rate than small molecules. So we're going to continue to see very strong demand on that clinical front, and then it just depends on whether or not some of these products get approved moving forward. As you know, the FDA appears to be accelerating its drug approvals and had its biggest year ever last year, but again, that's in a piece much different than roughly 12,000, 14,000 molecules that are in the pipeline. So I think clinical will continue to be very strong, and then the hopes are that you continue to have clinical products that may be the ones that get approved.

Great. And then, John, maybe a longer-term one. You've now had over a year with organic revenue growth well above your longer-term targets. And I think you said at the beginning of the call, you're still sort of reassessing your longer-term plan. Can you just maybe talk a bit more about where you see the puts and takes in the business? What parts of the business that maybe cause you to hesitate to think about a longer-term higher trajectory?

Yes. So first of all, we're going to take very seriously any changes to long-term guidance. It's obviously not a quarterly or annual guidance change. So we're going to do this in conjunction with our strategic plans. And we have been growing at rates that are higher than a long-term sort of guidance. And there had been several factors for that, but now we also have the addition of biologics. And I think the factors that will come involved will be a much stronger looking biologics and its mix in the business and how we see that evolving over the next 3 to 5 years. We'll also have to take into effect the change that will happen with -- what we just mentioned with ASC 606 from a clinical trial supply standpoint that'll obviously take out that revenue component from comparator. From there, softgel will continue to grow at the lower end of that 4% to 6% guidance. And then on top of that, we have performance in our oral drug business, which we have some strong potential with regards to an extension of our Zydis product. We have something that is now called Zydis Ultra, and if we can sell into that, combined with continued strong performance out of our Winchester and Kansas City facilities, we've got to put that all into the mix and determine whether or not a long-term outlook change is warranted. The fundamentals of the business are very strong, again, growing at that end top, and it's just whether or not we want to make a fundamental change in that outlook, and we'll do that very purposefully through our strat plan. And we expect that to happen either at our Q3 or Q4 guidance -- Q3 or Q4 earnings reports that will be coming up.

And our next question comes from Sean Wieland of Piper Jaffray.

Matt, congrats on the new gig. Can you give us a sense of what Cook and Accucaps did on an organic basis year-over-year?

So both acquisitions are growing organically very well. On a Cook -- let's talk about Cook first, because we acquired the business when it was really still in its infancy. All the capital had been built out. They spent years laying the groundwork for the sales growth that they're now realizing, which is well into the 20% year-on-year growth rates. And so the business is still -- on a percentage basis, growing very strong off of what was a fairly low base even though it was still close to $200 million. The business has a lot of potential and a lot of capacity to grow. The Accucaps business, also growing double-digits organically, higher at the EBITDA line as we're recognizing operating synergies that we had forecasted as part of the acquisition and just the benefits of asset utilization at Accucaps, which were substantially above what we had forecasted they would be when we were valuing the opportunity in diligence. So the organic growth of those 2 acquired entities has been terrific and above our expectations from the diligence phase of both deals.

Okay, and question on tax reform. So beyond what the rate will be, what you mentioned, how does the new law affect, really, how you're going to plan on running the business, whether it's capital structure, capital allocation, wages, things of that nature?

Right now, Sean, we don't anticipate any material changes to the way that we manage the business as a result of the changes in tax law. Our business shows pretty good balance between U.S. -- now with the acquisition of Cook, we show good balance between U.S. and ex U.S. The overall way that we're running the business, we don't expect to see it substantially change.

And our next question comes from George Hill of RBC Capital.

Matt, I'll add to the list of people wishing you well on the new job. Most of my questions have been hit at this point. I guess, John, I would ask, can you comment on how much of the Madison capacity is already sold through or can already be sold through? And then either Matt or John, I don't know if there's a way to talk about kind of the revenue of the capacity that you guys are bringing online or like the revenue capacity of Madison?

Yes, so I'll just give you a rough number that you won't be able to back into, so sorry. But we've already sold about 10% of the capacity, if you will, through that first quarter, which is really terrific, noting that most pharma assets run at 40%. And we're just bringing this online, and we already got about 10% sold into it. That will be through the first half of -- I'm sorry, the second half of this fiscal year and then obviously, we're going to see that continuing to accelerate. As you know, we were at full capacity, stretching to get one last batch out of the existing Madison facility, and we filled that, probably I would say, at least 2 years in advance of what we thought would happen. So we were -- we really had to dovetail in between maxing out that capacity and bringing on online new capacity, which again just bodes incredibly well. There is overall very strong demand out there, but I'd also say that Catalent's hitting the sweet spot of that demand with our single-use bioreactors for 2,000 and kind of our flexible manufacturing approach. So all in all, it's so far turned out to be a really strong story for the company and bodes well for the future.

The only other thing I would add, George, is when we -- I think we've mentioned this in prior calls. I think I'm just repeating something from the past, but we had forecasted that the addition of the third train could potentially just about double the revenue, potential revenues from the Madison site. And that's just because the third train is relatively large capacity, a 2 by 2,000 liter that can do large clinical, that can do small commercial. So even though it's increasing our number of trains by 1/3, it's the capacity of what we're putting that actually enables us to just about double the revenue at Madison.

Okay, that's helpful. And maybe just kind of a quick follow-up. John, you kind of described a pretty dynamic market as it relates to the competitive environment. Maybe, Matt, just give us a quick reminder of where you need to get leverage back down to, before you guys can be in the M&A market again. And do you -- I guess, do you guys feel capacity constraints because of the size of the Cook acquisition? Or 6, 9 months from now, are we back looking at more assets in the space?

Thanks, George. So in terms of how we're thinking about M&A, we said at the time of the deal, this was a big deployment of capital. We, as an operating team, we're certainly comfortable being levered at 5x. We've been levered well above that in private equity days, but we expect the 5x for -- really, for public market purposes and then issued a small equity stub to keep us at 5x. And we never set a hard-and-fast rule for ourselves that we would have to delever back down to pre-transaction levels before we would do another deal. Because there'd be a chance that we could miss something that would be really attractive. So the good news, since our initial thinking is we delevered faster than our projected trajectory 6 months ago. And so that doesn't -- so because of that, we're not precluding ourselves from looking at deals before we delever all the way back down to the 4x, which is where we were pre-Cook. And I will tell you that the capital markets continue to be accommodative for pharma services companies with good platforms that are looking at attractive growth opportunities through M&A, so capital raising is actually lower down on the list of things that we worry about as we consider future M&A opportunities.

And our next question comes from Dana Flanders of Goldman Sachs.

My first one here, can you just talk a little bit more specifically about the longer-term opportunity in biologics? And just where are we in the supply-demand equilibrium with the capacity you have coming online as well as competitors? I mean, just how long of a runway do we have here before that finds greater balance? And then my second question just following up on M&A, are there any holes now within the biologics business that you still feel like you need to fill? Or might you be more opportunistic across other parts of your business as you look at just opportunities across the space?

Oh, first of all, Dana, welcome to the Catalent name. Great to have you onboard. So first of all, we've done a tremendous amount of work from, I would say, just understanding and analyzing the market for biologics. We have a strong biologics team internally. We've used external consultants. We also have an excellent biologics-focused strategic advisory board, in fact, I just met last week, on Thursday. And all of the data that we have shows that, really, demand should outpace supply over the next 5 years. And that is continuing to hold. The other side of that is we're continuing to see a tremendous amount of capacity being either announced for investment or bringing online. So to date, that hasn't muted any of the opportunities, but we're going to continue to watch that very closely. But it certainly is a very robust marketplace. Pricing continues to be very strong if you have that capacity. And again, we're hitting the sweet spot with our single-use bioreactors and really going up to the 2,000-liter and now be doing 2 by 2,000 liters. So overall, I would say it bodes well. I'll dip a little bit into your second question that was focused around M&A and say that there continues to be opportunities, I think, with the biologics -- or with the Bloomington Biologics facility that we now have. There's a tremendous opportunity for us organically. However, if there are other assets that we think can continue to accelerate what we're doing, and specifically, the drug product area continues to be very robust. There's probably a little bit more that we can do there. And we're also finding that from a biologics standpoint, having that integrated solution, all the way from cell-line development, all the way through finished-drug product and also cartridge manufacturing for some of these auto injectors is a big deal. So we're going to continue to look pretty hard in this space. Our first priority is going to continue to fill things out from a capital standpoint where we see strong organic plays in both our Madison and Bloomington facility but again, active for other pieces that we might be able to fill out.

And our next question comes from Kevin Caliendo of Needham & Company.

A couple of questions for Matt. Just on cash flow looking through the Q, it was a nice bump for the first half of the year. So do we think about operating cash flow first half versus second half being sort of the same ratio as you're predicting for earnings? I know there's a big gain in the receivables this quarter. I'm just trying to gauge what the free cash flow might be for the year.

Yes, so we generally believe that we should be -- on an annual basis, that we should be generating free cash flow that's on the order of 75% of adjusted net income. It's likely going to be higher than that this year because we've had some pretty strong performance on working capital efficiency. Our cash cycle working capital efficiency metrics have really improved as you just noted, Kevin. So that 75% kind of looks low now, and it's just a question of what happens with working capital efficiency in the second half of the year in terms of where we ultimately end up. But hopefully, those guideposts give you some help in terms of modeling us.

Absolutely. And on the tax rate, I understand the corporate rate's 27.5% to 28%, and I think you guided going forward to 26% to 28%. Is -- as well as trying to understand sort of the long-term implications of tax reform, does it make sense -- or is this range that you're getting really based on how much interest you're paying down versus what your CapEx might be and that's really the delta here between the 26% and 28% or is there anything else as we think about tax rate into the fiscal '19 and beyond?

So those 2 things that you highlighted are certainly elements of it. But really, what ends up being the biggest driver of volatility within that 26% to 28% range is going to be our geographic mix of earnings, right. We've got half to more than half of our profitability outside the U.S., where we have been a cash taxpayer for years, and it -- so it really is more dependent on geographic mix than those other items that you mentioned.

One last one. So softgels organically was down 3% in the quarter. Again, was there anything specific about that? I know you're guiding for sort of flattish for the second half of the year. Was there any timing issues or anything? Just not -- ex Accucaps.

So I would say, we alluded to some volume down in the Asia-Pac region as we -- that we've seen in the first half of the year, and we would be likely to see that in the second half of the year as well. Just as a watch-out, we're not quite sure on this item as this is moving in real-time, but there have been some shortages globally of a key raw material, specifically ibuprofen, which is a significant part of our business within softgel. Ibuprofen producers are racing to get material out to customers, and we do see that as a watch-out for the second half of the year. But we -- just to repeat what we said earlier, we do think that ex Accucaps, softgel will be -- the math says it'll be more flat year-on-year than anything else that we can forecast at this point.

Is the ibuprofen shortage a material issue or a demand issue?

This is a supply issue. There's only a few producers of ibuprofen globally, and they've all -- the totality of ibuprofen production has been spotty and not able to satisfy -- not able to fully satisfy demand or if they are, it's just by the skin of their teeth. So that's the situation that we're looking at carefully. We're working with our customers, some of whom have a lot of influence with the ibuprofen producers, and it's just something that we've got our eye on for the second half.

How big is that -- how meaningful is ibuprofen for the softgels business? Excuse my ignorance on this.

This is a little bit hard for me to pin down on this call, Kevin, because our ibuprofen business is global. But it is -- my first estimate, subject to confirmation but I'd have to put some pencil to paper, but I think it's about -- ibuprofen is probably about 10% of the business in all the forms that we manufacture ibuprofen. So there's many different customers, many different brands across the world. There's ibuprofen combos, right, cough-cold, cough-cold-sinus type SKUs that we manufacture, but my initial estimate would be about 10% of global softgel revenues.

I would characterize it more as it's tight versus a regular shortage, and it's -- a large part of it was driven a little bit by the hurricanes that hit specifically to a Texas facility for one of the manufacturers and some additional capacity they've put on line. But we don't expect any of that to be a long-term effect. It's just that the short-term effect, and I think Matt properly characterized it, it's just a watch-out for us. But we do see our way to that kind of flattish second half for softgel.

And that concludes our question-and-answer session for today. I'd like to turn the conference back over to John Chiminski for any closing remarks.

Okay, great. Thanks, 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 important points. First, we're confident and committed to delivering FY '18 results consistent with our updated 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 for our core biologics offering. The successful and efficient integration of Cook Pharmica into the Catalent family 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.

Third, we're aware our business continues to outperform our long-term outlook of 4% to 6% revenue growth. We continue to work internally on our annual update to our strategic plan in assessing the future impact of the Cook Pharmica acquisition on our long-term growth targets.

Next, I'm confident that Wetteny Joseph will flourish in his new role as our CFO, building on the strong foundation established by Matt Walsh and his team.

Last but not least, 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, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day.