Lannett Company Inc (LCI) 2011 Q2 法說會逐字稿

(Operator instructions) I would now like to turn the call over to Robert Jaffe, Investor Relations for Lannett Company. Mr. Jaffe, you may begin.

Thanks operator. Good afternoon everyone, and thank you for joining us today to discuss Lannett Company's fiscal 2011 second quarter financial results. On the call today are Arthur Bedrosian, President and CEO, and Keith Ruck, Chief Financial Officer.

Please be advised that this conference call is being broadcast live on the internet at www.Lannett.com. A play back of this call will be available for 3 months, and may be accessed on the internet at Lannett's website.

I would also like to make the cautionary statement and remind everyone that all of the information discussed on the call today is covered under the Safe Harbor Provisions of the Litigation Reform Act. The Company's discussion today will include forward-looking information reflecting management's current forecast of certain aspects of the Company's future, and our actual results could differ materially from those stated or implied. This afternoon, Arthur will review the Company's business highlights, then Keith will discuss the financial results for the quarter in more detail, followed by Arthur's concluding remarks. We will then open up the call for questions. With that said let me turn the call over to Arthur Bedrosian. Arthur?

Thank you Robert and good afternoon, everyone. We are certainly pleased with our overall financial performance in the quarter. The increase to our bottom line was driven by higher sales of certain key products and lower operating expenses. We continue to be impacted by a lack of product approvals, due to a backlog at the FDA. We believe, however, that several of our drug applications, including our NDA for Morphine Sulfate Oral Solution will soon be approved, following a positive inspection by the FDA of our manufacturing facility.

We have notified the FDA that we are ready for the inspection and expect it to occur shortly. Last week, we announced the promotion of Bill Schreck to Chief Operating Officer. Bill joined Lannett more than 8 years ago and brings broad experience to his new role. His initial responsibilities will include overseeing operations, sales, and certain administrative functions. With that, I would now like to turn the call over to Keith for an overview of our financial results.

Thank you, Arthur and good afternoon, everyone. For the fiscal 2011 second quarter ended December 31, 2010, net sales increased to $30.0 million from $28.7 million, for the second quarter of fiscal 2010. The increase was primarily due to higher sales of certain key products, including Oxycodone Solution, Levothyroxine, and OB-Natal One.

Gross profit climbed to $8.4 million from $8.1 million for the same period in the prior year. Included in gross profit for the recently completed quarter, were 2 items I would like to highlight. First, due to the delay in the FDA's approval of our Morphine Sulfate Oral Solution NDA, we recorded approximately $1.5 million of additional inventory reserves specific to the Morphine Sulfate inventory. And second, during the quarter, we settled outstanding litigation, which resulted in reversing approximately $618,000 of previously expensed royalties. Research and development expenses decreased to $1.7 million from $2.7 million in the fiscal 2010 second quarter.

Selling, general, and administrative expenses declined to $2.9 million, from $4.0 million in the same quarter of the prior year. The decrease primarily reflects the reversal of accrued employee bonuses from the fiscal year 2010, the payment of which was tied to the timely approval of the Morphine Sulfate Oral Solution NDA. Due to the delay in receiving this approval, these bonuses will not be paid. Operating income nearly tripled to $3.8 million from $1.3 million in the same quarter last year. Net income was $2.4 million, or $0.09 per diluted share, compared to $55,000 or break even on a per share basis for the prior year second quarter.

Turning briefly to our results for the first 6 months of fiscal 2011. Net sales were $55.4 million, compared with $60.2 million for the comparable period of fiscal 2010. Gross profit was $14.3 million, compared with $19.6 million for the same period in the prior year. R&D expenses decreased to $3.7 million from $5.8 million in the first half of fiscal 2010. SG&A expenses decreased to $7.5 million from $7.8 million in the same period of the prior year. Net income was $1.9 million or $0.08 per diluted share, compared with $2.9 million or $0.12 per diluted share for the first half of the prior year.

Turning to the balance sheet, in December we completed a secondary offering of common stock for a total of 3,250,000 shares; net proceeds of the offering were approximately $14.9 million. As of December 31, 2010, cash, cash equivalents, and short-term investment securities available for sale were approximately $23.4 million. And long-term debt, including the current portion, decreased to approximately $3.1 million at December 31, 2010, from $7.7 million at September 30, 2010. We paid off the $4.5 million PIDC Torresdale Avenue facility loan in December, and we expect to replace it with a $3.8 million mortgage on that same property in the current quarter. With that brief financial overview, I'll now turn the call back over to Arthur. Arthur?

Thank you, Keith. Early in our fiscal 2011 second quarter, we launched Fluphenazine Hydrochloride tablets USP, the generic equivalent of Prolixin in 1 milligram, 2.5 milligram, 5 milligram, and 10 milligram dosages, one of the ANDAs we've purchased previously. For the 12 months ended September 2010, Fluphenazine Hydrochloride tablets USP, 1, 2.5, 5, and 10 milligram had US sales of approximately $28 million at average wholesale price according to Walter's core data.

As Keith mentioned during the second quarter, we completed a stock offering, including the over allotment. We intend to use the proceeds of the offering to accelerate the growth of Cody Laboratories, our pain management division, and enhance our margins. We are implementing plans to expand our pain management business by adding APIs, and investing in infrastructure to head capacity. We are also assessing a number of business opportunities, including acquisitions, purchasing ANDAs, and/or licensing complimentary products through a transaction, although there is none imminent at this time.

Looking ahead, as I said earlier, we expect to receive FDA approval for our new drug application for Morphine Sulfate Oral Solution in the near term, shortly and to relaunch the drug shortly thereafter. We also expect to receive approval of some of our ANDAs pending at the FDA over a similar time frame.

Moreover, we continue to invest in product development. Currently we have 18 product applications pending at the FDA, one of which we believe is a first time generic. We have an additional 60 product candidates in various stages of development. With the time available, we would now like to address any questions you may have. Operator?

(Operator Instructions) Marco Rodriguez, Stonegate Securities. Please go ahead.

Was wondering if you can first talk about the SG&A level in the prepared remarks you mentioned there was a reversal of bonus. Can you kind of quantify that?

On the SG&A line total bonus that was reversed was about $1.3 million, $1.3 million to $1.4 million. $1 million of it was on the SG&A line.

Okay. And so, given that, and given the level that you are at right now, I'm assuming sustainability at the $2.9 million to $3 million level is not, not logical, I guess?

Correct. Obviously you have a $1 million of bonus reversal, which is a one time event, so that would bring it back up to say, $3.9 million. And the only, I'll call non-baseline activity that was going on, more so in the 6 months, versus just the quarter, was the FDA litigation that we're in. In this quarter, was only about $50,000. The previous quarter was over $400,000.

Then, can you talk a little about R&D. That kind of ticked down a little bit more than I was expecting and kind of looks like it's a little bit lower than it could be. Can you talk a little bit about that?

Yes. We tend to project our R&D expenditures based on our forward-looking annual operating plan. If we believe for any reason our annual operating plan objectives are not going to be met, we tend to cut back on the expenditures that we planned for the year, whether they be capital expenditures or they be bio equivalency studies. In this particular fiscal year, as you know the first quarter we had a setback where we manufactured product and had to meet prices from a competitor. When we met those prices we incurred a floor stock adjustment that was rather significant. And as a result, for the remainder of the year, of this fiscal year, we decided to reduce some of the expenditures we had previously planned.

So, while we generally plan each year to spend a certain amount in R&D, that number is a flexible amount and it is spent if we think that the year will support it. And if there is any kind of a setback during the year, or any change in our operating plan, we tend to cut back. So it is really something we are managing as we manage our business.

Okay. So given obviously you had some setbacks at the beginning of your fiscal year here, is this new level of spending where we're at now, the $1.7 million kind of a baseline that we should be thinking about?

Well no, as I said this year, we generally spend probably in the neighborhood of between 7% and 10% of our annual sales volume in R&D. So, we would think we would stay in that same level, unless again, we have a setback. So each annual year, each July, we tend to think what we are going to spend. We certainly have developed projects that we could spend the money on.

And all we do is delay some of those expenditures. For example, we'll postpone some bio equivalency studies and push them off into the following year. The delay with the backlog at the agency we are not getting the revenue from some of the products we already filed with them, and it is difficult to continue to keep sending applications down there and never receiving any approvals to launch, so we have to monitor that. If we were getting the level of approvals we previously got, then our R&D activities would remain the same. So those 2 things really drive the level of expenditures for us.

Okay. Just kind of rephrasing what I had actually meant to kind of say I guess then, the second half of the year, given that you did have some setbacks in the beginning of the year, it kind of sounds like now that that should basically tick back up to that 7% to 10% range, rather than down to where we're at right now where it's about 5.5% of sales.

No it wouldn't kick up that much. It probably will kick up a little bit because a lot has to do with the timing of some of the studies that we have on the way. I would certainly say that beginning July, and our new fiscal year you'll see the level of expenditures be the same as they have been historically, roughly between 7% and 10% of our annual sales. But for the remainder of this fiscal year, we'll probably, because we've already cut back some of the expenditures, I don't think you'll see that level of climb back up for the remainder of the year. But in July, we'll start the new year with the same amount of expenditures we planned previously.

Okay. Perfect. And then I was wondering if you could provide a little bit more color in regard to Levo and Digoxin, what the level of sales were in the quarter and any kind of general trends you saw in the quarter and what you're seeing thus far?

Levo and Digoxin are still our number 1 and number 2 products. Sales of Levo were 43% of our revenue. And Digoxin was again about 12%. BACC, ends usually being number 4. And the number 3 slot, depending on what's happening for the quarter, has varied. This quarter, it will be Oxycodone Solution will be the number 3 product for us in the pain management area.

And any kind of general trends, have you seen a return to sanity, if you will, from the pricing environment? Or still more pressure there in regard to Levo and Digoxin?

We always expect the pricing pressure, so there's really never any return to sanity. Unfortunately, your competitor doesn't have the customer that we have. And the only way they think they can get it is by lowering the prices. That generally doesn't work, but it certainly does ruin margins for everybody. So I don't think we'll see any change in that.

We are in a commodity business and anytime somebody wants to lower a price, we have a choice to make. Walk away from the customer and the business, or match the price and keep the customer and keep the business. I don't see that changing. It is still very competitive out there. And we still encounter it occasionally.

But overall, I would say the trend is not as bad as it was previously. But we still, I wouldn't take comfort in that. The business, the reason we are vertically integrating is to eliminate this problem in our business. Where the competition is quoting lower prices dictates my margins.

Then I was wondering if you could confirm here, with the capital raise that you recently did in December. The cash balance on your balance sheet as of December 31 is inclusive of that $14.9 million, is that correct?

That is correct. I also stated on the earnings call that we used cash at the beginning, or mid December before the offering to pay $4.5 million of a loan down. It came due at that time, and we expect to, in effect, refinance it here in this third quarter.

Okay. If I did my math right there then, it looks like if I take out that noise, the capital raise and the paying down of debt, cash would have been roughly $13 million versus $17 million from Q1. Can you kind of walk me through what might have gone on from the cash from operations or any other burn area?

I'm going to do it a little differently.

Okay.

I'll take the cash balance as of September. Hold on a minute. Cash balance in September, I'm going to use cash and investments. The 604. So we had $22.5 million at the end of September. We added to that $14.9 million. And we, hold on. So we had $22.5 million. You add to that $14.9 million, and then you subtract $4.5 million on the debt repayment.

Should have $32.9 million.

Yes. Hold on. If you would have been at -- I did this the other day. But we had some CapEx during the quarter. Or during the year. Yes, what we did was we had CapEx, which offset the cash generated by operations.

There was a positive cash flow from operations in the quarter?

Generally there always is, yes. We have a positive EBITDA, and we did this quarter. And a lot of it was used for CapEx. I'd have to rerun the numbers, I thought I had done it the other day.

Okay. Then lastly, I was wondering if you might be able to talk a little bit more in regard to how you're looking at your business over the next 12 months. Kind of going through any key drivers you are looking at and key risks?

For the next 12 months? We look forward to the next 5, let's say, well the remainder of this fiscal year, because we don't know when these approvals will come and the impact are. We are not going to give much hope to the remainder of the year. We have said it would be profitable previously, we still believe the fiscal year will be profitable, but the quarters are choppy because we don't know when those approvals will come. But next fiscal year beginning July 1, we are looking at a strong year, because we'll certainly enter that year with 3 possibly 4 approvals that will help our margins and it will restore the sales volume for Cody as well, where we are experiencing idle opportunities, you might say. So over the course of 12 months, counting the months we are in now, I would say it's going to remain a little bit weak, and then certainly start to pick up as we hit June 30.

Okay. Great. Thanks, guys.

Sure. Thank you.

(Operator instructions) Gregg Hillman, First Wilshire Securities.

Hey, first of all, I don't know if I caught this. But what were the narcotics sales in the quarter overall as a percentage of sales? Or dollar number?

What we call pain management, we are about $18 million, sorry 18% or $5.5 million.

$5.5 million? Okay thank you. And then Arthur, can you just review what is going on with Hydromorphone and C-Topical, please?

Hydromorphone is doing well. We are really running at capacity. 3 shifts at Cody, manufacturing the API. And we are not getting all that we need from Cody, ourselves. But we are not back ordering the product at the moment. We are supplying the marketplace for the tablet.

And on the C-Topical, the same issue there. We have been supplying the market. The market sales have picked up a little bit, and we are starting to see some additional opportunities there. We also plan to put some marketing effort behind that product. So I think we'll see a continued growth in the C-Topical market and the same with the Hydromorphone market.

We are trying to get Cody. Cody did receive enough quota for the manufacture of API, so that should improve. But since they are at capacity with 3 shifts, the only way we'll be able to increase the market for them would be to go to another process that we haven't received a patent on; the to 2 step process, they are currently using a 3 step process, which will expedite the manufacturing opportunities and that is part of what is going on at Cody there. We are trying to use the money we raised to help Cody increase the production of their facilities for us, for those APIs that we buy from them. So everything we plan to do there is going well along our plans.

And for the Hydromorphone, how much goes into your own tableting, versus how much API you are selling to other parties?

It is about 50-50. We sell roughly half of what have we produce to another company and half goes to Lannett.

Okay.

And both companies have a bigger demand on Cody as well. In other words, the other company is not getting all that they would like, neither is Lannett. But we have been treating them fairly, by sharing the resources, you might say.

Okay. And then, so basically, in fiscal year 2012, it seems like you'll have a really much stronger base earnings in pain management, that will be sustainable for a long time.

That assumes that Morphine Sulfate is approved and back up in production, yes.

Okay. And the bit about that reversal, when your SG&A was down significantly, and presumably, if you get, the Morphine Sulfate Oral Solution approval, that that will get reversed, but it will be more than made up for with Morphine Sulfate Oral Solution sales, is that correct?

No. The bonus has been cancelled for good. That's why it, from an accounting point of view, you can reverse it. So even if Morphine Sulfate does come back, there will still not be a payment of the bonus.

Okay. So it was just like a special one time bonus to get the thing approved by a certain date?

No, it was a bonus left over from the fiscal year 2010, and at year end, part of it was determined, we only paid part of the bonus. And the remaining part that was on our balance sheet up until the end of this quarter was contingent, we didn't feel it was appropriate to pay unless we got the timely approval on the Morphine Sulfate. We knew if we didn't get a timely approval, it would impact inventory reserves and the marketability of what is currently in inventory.

Okay. So in other words, before you get to the -- you could have another bumpy quarter, due to, from the bottom line perspective, you could have another, the next quarter, for example, could be a weak quarter, and well, certainly will be a weak quarter, but it's a question but the June quarter is more of a question mark whether it will be weak or not, is that correct?

I would agree with those comments that June, sorry, this third quarter that we are currently in, will be a weaker quarter. Because you still do not have Morphine Sulfate.

Right.

But you know, let's assume we can get up and running again on Morphine Sulfate n the fourth quarter. If we do, the more time we have in that quarter with Morphine Sulfate, the better off we will be.

Okay. And the total number of narcotic ANDAs you have right now is what?

The total number we have at the agency?

Yes, or in the pipeline.

I don't have that number off the top of my head. I don't want to guess at it. Of the 18, I don't believe, I don't believe there's many narcotics down. Maybe just 2 or 3 of the 18 at the current time. Those have been down at the agency for some time. So previously, we weren't, we didn't have enough raw material from Cody. We still don't have enough raw material from Cody to make those applications worth while. But the plan is Cody has to make the API, in order for me to use their raw material on my applications. There's lots of applications that went down, they're using other people's raw material. But out of the 18, I would guess it is probably around 3 products down there. And I'm not talking about the Morphine Sulfate now, besides the Morphine Sulfate. As we go forward, more will be filed using Cody's API.

Okay. Okay. That's interesting. Will that occur more in like fiscal 2013 or will that occur in fiscal 2012?

Well, starting in 2012 and throughout the future, we'll be starting to use more of Cody's material in our applications.

Okay. Great. Thank you.

Thank you.

Tom Harenberg, Carl M Henning Company.

The bonus question was answered. But was Cody profitable in the prior quarter?

In the December quarter, no.

Right. No? Okay.

Yes and primarily, they are not producing any and did not produce anything in that quarter in the way of Morphine Sulfate.

Okay. Thank you.

Rasvidi Bariera.

Of the generic drug that you have on the market right now, is there a way to get the timetable for when their brand name equivalent comes off patent?

The products that we already have on the market, there is no patents on any of those drugs that we are currently selling.

So they are not?

No, there is not. All the patents have expired on the drugs we sell. And of the applications that are in the queue, let's say, there is probably only a couple where there is a patent challenge involved, maybe 3 that might have patent challenges.

Okay. So there is no upcoming patent expiration for any of the name brand equivalents?

That's correct.

And second question. Is there any credence to the possibility of you being acquired?

No there isn't.

All right. Thank you very much.

You are welcome.

Our next question comes from George Gaspar.

Arthur, can you just highlight again this FDA clearance requirement that you're holding on, to get back in this Morphine Sulfate area? Is that a check that you have to go through for both Cody and Philadelphia? Or can you explain that?

No it's just the, well that is the peculiarity here, on the Morphine Sulfate, just so we're clear, Cody manufactures that dosage form, however the inspection causing the delay is an inspection here at Lannett. Back a year ago we had an inspection in January, it was completed in February. We responded to the 483s within 7 days. We contacted the agency monthly to make sure that they didn't need any additional information.

They didn't ask for any additional information, until December, when they said that they weren't going to approve the Morphine Sulfate until they did a PAI, that is a pre-approval inspection. We questioned that because there's really not been any outstanding issues, and we have been inspected considerably, considering the national average for inspections. And they said well, the other inspection wasn't closed out. We pointed out to them that that's not our doing, that we offered to supply anything more you wanted, and we called every month for 12 months. What more can we give you? Tell me what you want, we'll give it to you so you can approve the application.

They also indicated 2 other applications were also being held up. And they wanted to do another GMP inspection. They agreed to do that rather quickly at our meeting in January 28, which we put out in the press release, and they are also wanting to do another PAI inspection on the Morphine Sulfate. We have inquired with them; we presume that inspection is here at Lannett, and that seems to be confirmed. So what they are going to do the PAI, they are typically looking at the application itself, so we are comfortable we'll pass the physical plant inspection as well as the PAI inspection for the Morphine Sulfate.

We are not concerned about either 1 of them. The question is how quickly they will come in. They have had said they'll be here shortly. Again we don't know what shortly means to them and to you and I but we do expect it to be quickly. You know we don't expect it to be months from now.

Okay.

As soon as that inspection is over, which could take about a week, we would probably get a closeout of the January inspection from last year and they would then give the okay for Washington to approve our applications. So it happens relatively quickly then.

I see. Well, it's an interesting explanation. Secondly, in the use of cash, how much has -- Since, including this past quarter, what is the build up in terms of cost into the facilities, if any? Can you highlight either Philadelphia and Cody individually as to what was spent in the quarter? And probably post your offering? And maybe what you are looking at in the current quarter, and maybe by mid-year?

Well, I can tell you that I can talk in total. I don't have the breakdown between Cody and Lannett. But through the first 6 months of, to end of December 31, 2010, we had spent $4.1 million in CapEx.

Okay.

And more are of it came, you break that down into quarters, more of it occurred in the first quarter, about $2.5 million occurred in the first quarter.

Okay. And.

But Cody, Cody was given an additional $5 million to spend, because in their annual operating plant they wanted originally $6.25 million. We approved $1.25 million, again, because we had the setback of the first quarter. And after the offering, we restored the other $5 million to Cody. That will be spent over the course of the next let's say 8 or 9 months or 12 months. And what they'll be doing with that is equipping additional areas of facility to make additional API.

So it's going to be infrastructure, rooms dedicated to making certain products, and the production of those products. And hopefully, if we look back 12 to 18 months from now, let's say from December of 2010, they will have some Drug Master Files filed with the agency as well. So that the expenditures we are talking about will allow them to manufacture API, start selling it to Lannett and other companies, so they can recover those expenses for the capital expenditures. So most of what we are planning at the moment is with Cody. Internally at Lannett, here in Philly, as you know, we did move our warehouse from the Torresdale facility, and that 28,000 square feet will be fit out for manufacturing space. We are looking at equipment and we are planning to fit up that space.

Again, we'll spend less this year because our income is not going to be good enough to support a large expenditure, and then the following fiscal year, starting July 1, we'll probably expand the capital expenditures for that facility. We may spend a little bit more than we planned this year because of the offering. So that we can have certain manufacturing capabilities, because as these products start to get approval for the agency, we'll need that additional manufacturing capability. Our manufacturing processes are growing. Our distribution is lessening. In other words we are doing more business where we manufacture the dosage forms directly versus distributing a product made by our partners.

I see. Okay now one question Arthur, follow-up on Cody. How many production rooms do you have out there now? And what would be your objectives 6 months and a year from now?

In terms of rooms, they have I believe four rooms now and quite frankly, they never really talked to me in terms of how many rooms they would have, because what they are trying to do is put together some dual purpose rooms so that you have a room with HVAC, in other words a GMP environment suite, let's call it. And then they want to have the ability to move reactors in and out so that they could use those suites for multiple products.

For example they'll make one drug in it, then remove the equipment, bring in other equipment and make another drug in that same area. So it isn't the quantity of rooms you have per se, it is the flexibility within those rooms. Previously for example, the Hydromorphone area is dedicated to making Hydromorphone. I mean we run it 24/7 in 3 shifts, so it's busy. But they're looking to expand, to put a secondary area in that would not only make Hydromorphone, but it also would allow them to make other products. So when they go to the 2 step process, they won't have 2 dedicated rooms and only need 1.

I see. All right, that is a good explanation. I have a question also on the shareholder offering that recently accomplished. Can you highlight where that stock went? How many institutions were involved? How many potential shareholders did you pick up in it? Can you give us any color on that?

I don't have numbers I can rattle off the top of my head but we did speak to upwards of 50 companies. The reception, I would have to tell you, was extremely good. There certainly was a good demand for stock.

The real issues were, unfortunately, I have to be frank with everyone. I ended up having a kidney stone, I don't mean to get into details, but I was unable to actually visit all the people that were lined up to see us, because I was restricted from flying, thank God I passed the kidney stone well enough, but it was a little awkward trying to do a road show while you are dealing with that issue. So as a result, it could have been a little bit better, let's say, but I was able to conclude the job and get the job done. We did, certainly, solve the liquidity problem.

As you can see, our stock is trading in very large numbers now, which was one of the main goals for the company and one of the main reasons the farmers agreed to join us in the sale of some shares, and I believe the response from all of the people who bought shares was very warm. Because they did see opportunities for this company in terms of the projected sales increases, and the business model we are talking about with the vertical integration, where they believe there is a potential for Lannett and they realized Lannett did need money and additional shares had to be sold.

Essentially we are now more of a real public company than a privately held one, because we no longer have a majority owner, and the majority owner is now a major shareholder but not majority and that also helped the liquidity issue. The liquidity issue kept our stock handicapped. As you know, during the course of the road show, our stock moved, which was a little bit unusual during road shows for the stock to move up. It did. Then there was a day when it collapsed. We are not sure exactly what happened there but overall, we were expecting a certain level of reception and we achieved all that.

So I would say that between lost capital and Oppenheimer and our own efforts in the Company, we got the job done. I believe that there is an expectation now, okay, you got the money, now what are you going to do with it? And of course that is up to Lannett now to prove they are capable of using that money wisely. We certainly did make the point that the major investment would be made in Cody. Because the vertical integration was the most intriguing part of this opportunity for Lannett and certainly the one where our margins would improve as a result of it as well.

I believe the road show was very successful. Could we have sold more shares? Probably if we were able to meet more people, but as you know it was around the holidays and it was difficult to get to see everyone. But it was a successful one. That much I can say. I'm grateful for the new shareholders, that joined the Lannett Company. They shouldn't be disappointed. And they won't be.

Okay. Thank you very much for that.

You are welcome.

Raymond Myers, Benchmark Company.

I want to ask you about the results of the Cody investments. Could you give us a little more detail about how much you are going to spend there? And how much increased API those investments will produce? How fast that new production will come online, and if there is any metrics around the return on investment that you can apply? Those will be interesting to know.

I agree with you, but I don't know that I could do all those off the top of my head. I will tell you that the plan is for them to spend roughly $6.25 million. They've started, previously we authorized back in July for the annual operating plan $1.25 million. We now increase that by $5 million. It will probably take them roughly a year to spend that additional $5 million. At the end of the year to 18 months as they said earlier, we'll probably have 5 or 6 new APIs that they'll be manufacturing and probably about that many Drug Master Files with the agency.

The ROIC on those kinds of investments, obviously can't answer the questions off the top of your head. But I can give you an example in our industry. When you get an application approved or you have a Drug Master File that people are using, the return on that investment doesn't have any expiration date. To give you a typical example that I gave the shareholders during the road show, we have one drug that Lannett paid on the dosage form now $100,000 to file and get that ANDA 30 years ago, I'm still selling that drug 30 years later and last year I believe we did about $5 million in sales on that drug.

Now Cody on the API, it is somewhat the same story. You get a license. Not a license, but a Drug Master File is filed with the agency. The companies can reference it, they can use your raw material and so long as you keep that customer, you are continuing to get a return on that investment. It doesn't end, there's no expiration dates on that. Most of these narcotics have been used for a millennium. We continue to see them being used. And what makes me more optimistic is you are now realizing that the government, because they are dealing with the RIMS and the abuse of these narcotic drugs, is creating a market for brand drugs to be created that have abuse deterrent features to them. Where we didn't expect that market.

Right now, 90% of all narcotics is filled with generics. So now you are going to see a growth in the brand market in the narcotic field. So from our perspective, everything Cody is spending money on will be returning money on that investment for a very long period of time. I will try to get a more specific answer in terms of product by product. But I have to wait until they actually make the product and look back as to what they spent in facilitating the manufacture of that. So I could say well this drug cost X, this one cost Y, and this is what we are selling of it. Otherwise, it's just talk right now. But I believe what I'm telling you is fairly close to accurate, in terms of what you'll realize in the future.

Once you invest the full $5 million and spend their $5 million in the coming fiscal year, to expand their production, will they, at that point, be fully meeting the demand for API from both Lannett and your partners? Or is there still a backlog at that point?

No, well with any luck, hopefully there is still a backlog. That is hard to predict. I would say based on what we are looking at now they would meet the demands for all the products we are talking about because the way they are designing the facility expansion will allow flexibility. So that it won't be a truly dedicated area that has limitations. And as a result, they would be able to maybe go to 2 rooms or 3 rooms, if there is a sudden demand for 1 API, versus another.

They won't have a room sitting idle, because that room is designed to make product A, and the demand is coming for product C. They will be able to manipulate their rooms to be able to keep up with production and demand. Right now, putting in a second room for the Hydromorphone is a reality. The demand is great for that drug, 2 customers of Cody buy it on 1, the other customer is not Lannett, of course, and if our demands continue to outstrip their supply, they will be able to satisfy that demand. If they were able to switch to the 2 step process today, there would be no backlog at all. Excuse me?

About how much dollars of backlog is there now? Or how much more can they produce after these investments than they produce today? Can you quantify that in dollars?

Let's say the demand is about 25% more on the Hydromorphone than they are able to produce.

And they are producing how much?

They are producing at capacity; I'm not sure what the number of kilos is off the top of my head. My guess is probably around 150 kilos.

I'm thinking of dollars.

Well no, I don't know it in dollars. I would be guessing a number off the top of my head right now. Because I don't know what they are producing in the 3 shifts exactly to be able to tell you what they are charging, both of us and then tell you what the dollar amounts would be. I could get back to you with an answer to that question. But I don't want to guess at it.

Okay, thanks. I'll follow-up later. Thank you.

Greg Hillman, First Wilshire Securities.

Yes, again, Keith, that one line on the income statement for product royalties, there was a big reversal, quarter-over-quarter. What was going on there?

We settled some outstanding litigation, and the settlement was less than what we had accrued on our books. So there is about $600,000 that was reversed on that line during this quarter.

Okay. So what would be normal? So the December '09 quarter would be the more normal number?

Well, the settlement.

It is hard to answer that question. Because part of the sales that were involved in December '09 are not necessarily going forward. So I'm not sure; they weren't the same. It is hard to make that comparison. It is an apple and orange type of thing.

Okay. Would you expect product royalties going forward like more than 100,000? No, I would expect them to come down significantly.

Okay. And then, Arthur, and then, if you just look at net sales versus cost of sales, it looks like the margin you went up from 68% to 72%. Why was that? Was that due to Oxycodone? Or what was that about?

Yes, it was due to Oxycodone.

Okay. And then, finally, Arthur, about the FDA, they were talking about cutting its budget? I saw that somewhere in the press recently. I mean, what's kind of going on in the FDA, in terms of the slowness or fastness of the approvals of ANDAs, and also, could they just charge you for the cost of doing the approval?

I'll tell you what I told the agency. When they asked that same question of us; they put together an opportunity for the industry to comment on user fees for generic drugs. And really the example is if you have a child in college and you give them a credit card and he doesn't handle it well, do you give him 2 more credit cards, or do you bring him in and explain how he is supposed to handle the first 1?

We don't want to just give money to an agency when there is a lot of questions. For example, if I give them a user fee for a new application, what happens to the ones that are down there? The ones that I have pending? What happens to my supplements that are down there? Are they going to just expedite my new application? And the old ones are going to sit there? Or are they going to take the money for my new application and deal with the backlog so that my new application gets delayed?

We really have found there are more questions than answers. Giving someone money is not the answer. I need to know how you are going to spend that money and how does it impact me. Because it's my money. And if you are going to ask me for money, then I want to have some control over whether you are going to use it for a new application, my supplements, or my pending applications that are at the agency already. And that is some of the dilemma. As you know, they just put out another opportunity for comment on the user fee. So I'm sure they're not going the kind of answers they want. Or there is still some questions that they are trying to get resolved.

We plan to submit additional information, because we think part of the problem isn't just fees. I think if the agency would meet with the industry, we could probably resolve some of the problems and get some solutions to these backlogs so that everyone is happy. At the end of the day. But trying to do it in a vacuum, or just say someone will give us money and this is what we're going to do with it I don't believe is going to work. Remember the other side of the coin is the agency's uncomfortable expediting applications, because they are complaining well we put some of these drugs on the market so quickly that the industry doesn't do the promised follow-up testing they are supposed to do.

So there is 2 sides to the story. I can understand the FDA's reluctance to just take the money and expedite approvals, because they still want to do their review process. So that's what I'm saying. I think a lot can be done if the agency would actually meet with industry people. I'm not talking about trade groups, I'm talking about meet with companies who might give them some very good suggestions about what they could do to help the industry and help the FDA. We understand we are a regulated business, and we are not against being regulated. I just think we want to work with the regulators a little bit better. It is too adversarial.

It needs to be more cooperative, and that doesn't mean I pay them to give me an approval, like some people claim; that is not what the agency has done with any of these fees, they do the job they are supposed to do and we don't object to that. I just think we want to try to help them prioritize maybe a little better some of the things that goes on there.

Okay. Thank you, Arthur.

You are welcome.

Sean McMahon, Kennedy Capital.

Just related to the 5 to 60 products that you are hoping to launch out of Cody, how long does that take from when you have the capacity in place actually generating that API or filing that drug that DMF, with the FDA?

Well, the dilemma here, if you get the DMF made tomorrow, and they, let's use the example of Hydromorphone. I have a 2 step process that if I implemented it today, I could take care of both customers of Cody labs, Lannett being 1 of the customers. Trouble is, I have to make a few batches of that product with my finished tablets, assemble the data, submit the data to the agency, and wait for an approval. Now the agency is not approving those supplements. So there is no idea when they are going to get approved.

They normally would have taken 6 months, then they went to 10 months and now the agency is not even looking at supplements, unless they are, there is an expedited review demanded and a justification for it. And that normally, of course is not -- changing suppliers is not a justification. But if they were able to do that promptly, Cody could be solving a shortage tomorrow, from their point of view. And I would be happy not having to wait, a long period of time to switch vendors. This is some of what we want to talk to the agency about.

Just to explain it to you. You remember when I filed a new drug application, they trust my judgement to find the raw material source, use it, make the product, do all the data, submit the data, and there is a lot of data to submit for an application; and then they approve you. Well now all I want to do is switch a raw materials supplier, that they believe I had the qualifications to find originally. Why even have to approve that application? Why not just allow me to submit something annually, that I found the secondary source. I did all my testing, and I'm using that source now. After I did all my testing.

Why have to wait for the application to go to the agency to be approved? That would expedite some work on their behalf, it would eliminate reviewers reviewing things that are unnecessary to be reviewed. And I wouldn't have Cody having to sit there wait for me and the other customer to get approval from the FDA to buy the product commercially. It is a frustration we all feel, all of us in the industry, that hopefully if the FDA were to talk to us, could be eliminated and done very quickly and easily.

So you don't want to file the 5 to 6 now, because you don't have a supplier for that? Or you don't want to deal with the switching of the--?

Precisely. I don't want to deal with the switching. As I said previously, when I was doing a road show, I used an example that Hydrocodone with Acetaminophen, or APAP, or generic Tylenol was used in 18 different combinations. So once Cody made Hydrocodone for Lannett, I could submit 18 ANDAs to the agency, none of those happened to require any bio equivalency testing, so the applications wouldn't have been very expensive.

Now that they removed the Acetaminophen above 325 milligrams, there is probably maybe 7 opportunities to file an ANDA for Hydrocodone with Acetaminophen. But as you can see, if Cody makes one raw material to me, that means multiple applications go to the agency. If I use someone else's raw material, then I've got to supplement every single one of those applications, which is a tremendous duplication of effort and work and ties up the lab needlessly. So it really pays me to wait for Cody to have that raw material ready for me before I do that.

Okay in that $5 million, I guess that is just like physical CapEx building out of Cody labs? Or is there actually, is some of that working capital?

CapEx. It's building and equipment.

Okay. All right. Thank you.

You are welcome.

George Gaspar.

2 years ago or more, the conversation coming from Lannett, Arthur, was on, as you are looking at expanding Philadelphia to do contract manufacturing. In large order basis or the suggestion was there. You have moved this forward here to the point where you are talking more about vertical integration. Where do you stand on seeking out contract manufacturing for others?

Well, I know that I never planned to just do manufacturing because the vertical integration plan dates back to 2005. The purchase of Cody in 2007 was part of that process. We did, and we continue to look for opportunities, and we have had some discussions with a number of companies to make products, some of them even other generic drug companies. But unfortunately, none of those have come to fruition in terms of any orders.

In the meantime though, we have looked at manufacturing some products, and they will be our licenses and joint venturing with marketing firms to sell these products in the brand market such as the C-Topical product, or the OB-Natal One product that we previously were selling. We still look and talk to people about contract manufacturing work but that was never really ever going to be the focus of Lannett. If you understood it that way, my apologies. But contract manufacturing is just from my point of view, another opportunity to keep the plants operating and the people employed. But the vertical integration was always the goal, at least dating back 5 years at this point.

Okay. Thank you.

You are welcome.

We have no further questions at this time. Would you like to make any closing remarks?

Yes. Thank you all for joining us today. If anyone has any further questions, please do not hesitate to contact the investor relations team at Lannett. That concludes our call. Thanks again for joining us today.