Catalent - Earnings Call - Q4 2019

Transcript

Operator (participant)

Good day, ladies and gentlemen. Welcome to the Catalent fourth quarter fiscal year 2019 earnings conference call. At this time, all participants are in a listen-only mode. Later, there will be a question-and-answer session, and instructions will follow at that time. If you require any assistance during today's call, please press star, then zero on your touchtone telephone. As a reminder, today's conference is being recorded. I would now like to turn the conference over to Tom Castellano, Vice President of Investor Relations and Treasurer. Sir, you may begin.

Thomas Castellano (VP of Investor Relations)

Thank you, Shannon. Good morning, everyone, and thank you for joining us today to review Catalent's fourth quarter fiscal year 2019 financial results. Please see our agenda on slide two of our company presentation, which is available on our Investor Relations website. Speaking today for Catalent are myself, John Chiminski, and Wetteny Joseph. 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 three for more detail. Slides three, four, and five discuss the non-GAAP measures, and our just-issued earnings release provides reconciliations to the nearest GAAP measures. Catalent's Form 10-K, to be filed with the SEC later today, has additional information on the risks and uncertainties that may bear on our operating results, performance, and financial condition. Now, I'd like to turn the call over to John Chiminski.

John Chiminski (CEO)

Thanks, Tom, and welcome everyone to our earnings call. We're pleased with our fourth quarter financial results, which position us well heading into fiscal year 2020. As you can see on slide six, our revenue for the fourth quarter increased 6% as reported, or 8% in constant currency, to $726 million. The growth in revenue was driven by our Biologics and Specialty Drug Delivery, Oral Drug Delivery, and Softgel Technologies segments, and was partially offset by the ASC 606 revenue recognition change, which affected how we report comparator sourcing activity within our Clinical Supply Services segment. Excluding the impact of this revenue recognition change, revenue would have increased 11% in constant currency compared to the prior year.

Organic revenue grew 4% year over year during the quarter in constant currency and was led by a strong recovery within our Softgel and Oral Drug Delivery segments, with Biologics and Specialty Drug Delivery also contributing. Our adjusted EBITDA of $199 million was a record quarter for the company and above the fourth quarter of fiscal year 2018 on a constant currency basis by 11%. Our adjusted net income for the fourth quarter was $102.9 million, or $0.70 per diluted share, which is $0.03 above the same figure from the prior fiscal year. The strong results at the profitability line were led by our Oral Drug Delivery and Softgel Technologies segments, but all segments reported profitability above prior year levels.

Additionally, for fiscal year 2019, we've recorded revenue growth of 2% as reported and 5% in constant currency, while recording adjusted EBITDA growth of 9% as reported and 11% in constant currency. As a reminder, fiscal year 2019 revenue was negatively impacted by the ASC 606 revenue recognition change. Excluding the impact of this change, revenue grew 9% compared to the prior year. Now, moving on to our operational update. First, we continue to make great strides on our biologics strategy. The business continues to grow, and I'm pleased to announce that the Bloomington site recently received approval for its 21st commercial product, which is up from the 12 it was producing at the time of the acquisition. We continue to manage a robust funnel of late-stage clinical opportunities across Bloomington and Madison that will continue to drive strong growth in fiscal year 2020.

Additionally, the $200 million investment in biologics spanning both Bloomington and Madison is well underway and progressing according to plan. This investment will add more drug substance manufacturing and drug product fill-finish capacity to meet projected growth among existing and future customers. Further adding to our biologics portfolio, on May 17th, we completed the acquisition of Paragon Bioservices, a leading viral vector development and manufacturing partner for gene therapies. Paragon provides us new expertise and capabilities in one of the fastest-growing therapeutic areas in healthcare, reinforcing Catalent's leadership position across biologics and positioning us for accelerated long-term growth. Paragon brings deep expertise in adeno-associated viral vectors, the most commonly used delivery system for gene therapy, as well as a platform for development of an expanded offering of vectors, enabling entry into other adjacent technology categories to support the development and manufacturing of gene and cell therapies.

This expertise, combined with Paragon's manufacturing capabilities and world-class facilities, positions us well to capitalize on substantial industry tailwinds in gene therapy. Paragon's leading position in vector manufacturing and blue-chip customer base, and its expanding commercial footprint makes it an ideal strategic fit for our business. The business is performing well out of the gate, and the expected positive impact of Paragon on our future revenue and EBITDA profile will deliver highly compelling value to shareholders, as evidenced by our recently announced increase in our expected long-term revenue growth outlook from 4-6% to 6-8%. We supplemented the capabilities we gained with the Paragon acquisition by acquiring two nearby manufacturing facilities and other related assets and capabilities from Novavax. The agreement gives us immediate access to state-of-the-art manufacturing equipment, people, and space to accelerate the growth of our gene therapy development and manufacturing business.

As a reminder, Catalent Biologics, including Paragon, Bloomington, and our pre-existing biologics businesses, can provide integrated solutions from drug substance manufacturing and analytical services through clinical and commercial supply and fill-finish in a variety of finished dose forms, including vials, cartridges, and syringes. Biologics comprised approximately 14% of Catalent's consolidated revenue in fiscal year 2017 and represents more than 32% of the company's revenues today. The combination of organic and inorganic investments we're making in biologics continues to create significant value for the company, our customers, and our shareholders. Second, the European Early Development Center of Excellence we acquired as a part of the Juniper Pharmaceuticals transaction in the first quarter of fiscal year 2019 continues to advance our strategic goal to be the most comprehensive partner for pharmaceutical innovators, helping our customers to unlock the full potential of their molecules and provide better treatments to patients faster.

The integration of the Nottingham U.K. site and its nearly 150 employees into the Catalent network is tracking according to our expectations, and the acquisition continues to contribute strong financial results to our Oral Drug Delivery segment. Third, in June, we announced our agreement to purchase Bristol-Myers Squibb oral solid, biologics, and sterile product manufacturing and packaging facility in Anagni, Italy. This transaction will enhance our global network and provide us drug product sterile fill-finish capacity and oral solid dose manufacturing in Europe, along with an agreement to continue to manufacture BMS's current product portfolio at the site. The addition of the Anagni facility provides our European customers with great biologics and oral dose capabilities to accelerate their development programs and improve commercial supply. We anticipate completing the transaction by the end of the calendar year.

Fourth, last month, we announced that we have significantly expanded our global spray drying capacity through an agreement with Sanofi Active Ingredient Solutions, under which we have gained access to commercial-scale spray dry manufacturing services for Catalent customers at Sanofi's Haverhill U.K. facility. The agreement not only gives us access to spray drying capabilities and state-of-the-art equipment, but also to an experienced and skilled team at the site with expertise in commercial-scale spray dry dispersions, which are frequently used to overcome the solubility challenges with many new medicines. This instant-on capacity, along with the investment that we're making at our Winchester, Kentucky facility, enables the transfer and scale-up of spray drying programs from our specialized early-stage clinical development sites in San Diego, California, and Nottingham, U.K.

I'm also pleased to report that we've already signed our first program into the new capacity at Haverhill and are in discussions with several other potential customers. Finally, we remain positioned increasingly well in an attractive, robust, growing market and have the strongest development pipeline since Catalent's inception, with more than 1,100 active projects. Now, I'll turn the call over to Wetteny Joseph, our Chief Financial Officer, who will take you through our fourth quarter fiscal year 2019 financial results, as well as provide our outlook for fiscal year 2020.

Wetteny Joseph (CFO)

Thanks, John. As John briefly mentioned earlier, the company adopted the ASC 606, the new accounting standard concerning revenue from contracts with customers, as of July 1st, 2018, using the modified retrospective method. The reported results for the three months and fiscal year ended June 30th, 2019, reflect the application of the new standard, while the reported results for the three months and fiscal year ended June 30th, 2018, were prepared under the guidance of the prior standard, ASC 605. This is especially important as I discuss the results related to our Clinical Supply Services segment, where adoption of the new standard changed the treatment of our comparator sourcing activities, which are now reported on a net basis compared to a gross basis in the prior year. Now, please turn to slide seven for more detailed discussion on segment performance, beginning with our softgel business.

As in past earnings calls, my commentary around segment growth will be in constant currency. Softgel revenue of $244.7 million increased 5% during the quarter, with segment EBITDA increasing 14% due to strong growth for prescription and consumer health volumes in North America and Europe, partly due to the stabilization of ibuprofen supply. As we anticipated, we saw a recovery in the fourth quarter as we experienced strong production levels for ibuprofen products given API supply availability, which helped partially offset the headwind we experienced through the first nine months of the fiscal year. Additionally, the strong EBITDA performance was driven by the improved capacity utilization in favor of a product mix across the network.

It is also worth noting that the fiscal 2019 revenue growth for the segment would have been nearly 2% after normalizing for the Asia-Pacific divestitures completed late in fiscal 2018 and the impact of the ibuprofen shortage, which is aligned with the segment's historical revenue growth rate. Slide eight shows that our Biologics and Specialty Drug Delivery segment recorded revenue of $231.1 million in the quarter, which is up 19% versus the comparable prior year period, with segment EBITDA growing 2% during the quarter. However, most of the segment's revenue growth and all of the segment's EBITDA growth was inorganic and driven by the Paragon acquisition, which contributed 15 percentage points to the segment's revenue growth and 17 percentage points to the segment's EBITDA growth. Excluding Paragon, the segment recorded organic revenue growth of 4% in the quarter, but an EBITDA decline of 15%.

Recent investment in our biologics business continued to translate into growth during the fourth quarter as we recorded strong growth in drug products and drug substance volumes across the U.S., but the pre-existing business experienced revenue declines in Europe, along with unfavorable product mix, partially due to the timing of the annual maintenance shutdown at one of our facilities, which negatively impacted segment's bottom line. Additionally, the business was impacted by the completion of a limited duration customer contract for non-cell line clinical manufacturing services in our U.S. drug substance platform as the customer completed the build-out of its own capacity. We expect this to be a headwind for our drug substance business over the next few quarters as we work to onboard new customers and continue to increase our utilization levels. However, we continue to believe that our biologics business is positioned well to drive future growth.

The results for the respiratory and ophthalmic business were in line with the prior year period, and the fundamentals remain attractive for these key sterile fill technology platforms. Slide nine shows that our Oral Drug Delivery segment recorded revenue of $174.1 million in the quarter, which is up 16% versus the comparable prior year period, with segment EBITDA increasing 30% during the quarter, partly attributable to the Juniper Pharmaceuticals acquisition, which contributed 10 percentage points to the segment's revenue growth and 13 percentage points to the segment's EBITDA growth during the quarter. The organic revenue growth of 6% and EBITDA growth of 17% was driven by increased demand and favorable product mix within our commercial oral delivery business, as well as higher volume related to analytical and development services across the U.S. and Europe.

Additionally, the segment continues to have one of our strongest development pipelines, including several late-stage spray drying development programs, and we expect to see accelerating growth in the near to midterm. In order to provide additional insight into our long-cycle businesses, which include Softgel Technologies, Biologics and Specialty Drug Delivery, and Oral Drug Delivery, we are 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 fiscal year ended June 30th, 2019, we recorded development revenue across both small and large molecules of $646 million, which is more than 20% above the development revenue recorded in the prior fiscal year.

Additional disclosure on our development revenue, which is now calculated in accordance with ASC 606, is included in our Form 10-K to be filed today with the SEC. In addition, we introduced 193 new products, which contributed approximately $103 million of revenue in the fiscal year, which is nearly 70% more than the revenue contribution of NPIs launched in the prior fiscal year. Now, as shown on slide 10, our Clinical Supply Services segment posted revenue of $85.1 million, which is now 19% compared to the fourth quarter of the prior year, driven by ASC 606 treatment of comparator sourcing activity.

Excluding the impact of ASC 606, segment revenue declined 3% compared to the prior year period, but segment EBITDA increased 10% compared to the fourth quarter of the prior year, driven by favorable product mix to manufacturing and packaging services, improved comparator margins, and increased capacity utilization across the network. All of the segment EBITDA growth recorded within CSS was organic. As of June 30th, 2019, our backlog for the CSS segment was $366 million, a 6% sequential increase. The segment recorded net new business wins of $94 million during the fourth quarter, which is a decrease of 6% compared to the net new business wins recorded in the fourth quarter of the prior year. The segment's trailing 12-month book-to-bill ratio remained at 1.2 times.

It is important to note that the backlog and net new business wins figures that I just disclosed have been adjusted for the ASC 606 change in revenue accounting and now include comparator revenue on a net basis. The next slide contains reference information. We have already discussed the segment results shown on the consolidated income statement by reporting segment on slide 11. Slide 12 shows, in precisely the same presentation format as slide 11, the fiscal 2019 performance of our operating segments, both as reported and in constant currency. I won't cover the variance drivers in detail since the main themes are consistent with what we discussed throughout the fiscal year.

The key EBITDA growth drivers are the Paragon and Juniper acquisitions, strong growth within our biologics, drug products, and drug substance offerings, favorable product mix within Oral Drug Delivery related to licensing activities, and higher storage and distribution revenue, and improved capacity utilization within Clinical Supply Services, which are partially offset by the impact on our softgel segment of the worldwide ibuprofen shortage during the first nine months of fiscal 2019, and solid revenue declines due to certain high-margin products, and the end of a limited duration customer contract that impacted our U.S. drug substance business. Slide 13 provides a reconciliation of the last 12 months of EBITDA from operations from the most proximate GAAP measure, which is net earnings or loss. This bridge will assist in tying out the reported figures to a computation of adjusted EBITDA, which is detailed on the next slide.

Moving to adjusted EBITDA on slide 14, fourth quarter adjusted EBITDA increased 10% to $199.4 million. On a constant currency basis, our fourth quarter adjusted EBITDA increased 11%, most of which was inorganic and driven by the Paragon and Juniper acquisitions, coupled with organic growth within our softgel, OSD, and CSS segments. Note that slide 14 contains a revised presentation of the reconciliation of net earnings to adjusted EBITDA. We have revised the presentation so that you can see the effect on our LTM adjusted EBITDA for each of the four quarters of fiscal 2019 of our removal of an adjustment of $15.1 million previously made solely in the first quarter of fiscal 2019.

The adjustment related principally to a payment made by a customer that was fixed and determinable in the first quarter following termination of a contract with us, and that due to the company's adoption of ASC 606 as of July 1st, 2018, is in the modified retrospective method, was not reflected in GAAP revenue in that quarter, and instead was part of a transitional adjustment to retained earnings recorded as of the opening of the quarter. Removal of that adjustment reduced adjusted EBITDA in the first quarter of fiscal 2019 by $15.1 million to $99.9 million, resulting in full-year adjusted EBITDA for fiscal 2019 of $599.6 million. On slide 15, you can see that fourth quarter adjusted net income was $102.9 million or $0.70 per diluted share, compared to adjusted net income of $90 million or $0.67 per diluted share in the fourth quarter a year ago.

This slide also includes the reconciliation of net earnings or loss to non-GAAP adjusted net income in the same revised format used for the previous adjusted EBITDA reconciliation slide, showing essentially the same add-backs. Slide 16 shows our debt-related ratios and our capital allocation priorities. Our total net leverage ratio as of June 30th was 4.4 times, which is more than a full turn above where the ratio stood at the end of the prior quarter. The ratio increased as a result of incremental debt added to fund the Paragon acquisition. Pro forma for the Paragon acquisition, our total net leverage ratio was 4.2 times, which is an improvement of 3/10 of a turn compared to the ratio at the time we announced the transaction.

Additionally, given the free cash flow generation of the company, it is growing adjusted EBITDA, the company naturally delivers between one-half and three-quarters of a turn per year. Finally, our capital allocation priorities remain unchanged and focus first and foremost on organic growth, followed by strategic M&A. Turning to our financial outlook for fiscal year 2020 on slide 17, we expect full-year revenue in the range of $2.78-$2.88 billion. We expect full-year adjusted EBITDA in the range of $700-$730 million, and full-year adjusted net income in the range of $300-$330 million.

We expect that our fully diluted share count on weighted average basis for the fiscal year ended June 30th will be in the range of 159-160 million shares, counting the preferred shares we issued in May to fund part of the Paragon acquisition as if they all were converted to common shares in accordance with their terms. In addition to the guidance we just provided on revenue, adjusted EBITDA, and adjusted net income, we also wanted to highlight our expectations related to our consolidated effective tax rate, which we expect to be between 24%-26% in the fiscal year. We also expect interest expense in fiscal 2020 to increase as a result of the incremental debt added to fund the Paragon acquisition and be between $130-$134 million during the fiscal year.

Lastly, continued investments in biologics, including gene therapy, are expected to increase our fiscal year 2020 capital expenditures to approximately 11%-12% of net revenue. Slide 18 walks through some of the moving pieces that we considered when determining our fiscal 2020 full-year revenue under adjusted EBITDA guidance. The first set of bars, brackets, the changes that we expect to see in our base business performance, which aligns with our constant currency long-term outlook at the revenue line, but are much stronger from an EBITDA perspective. Organic revenue growth is expected to range between 4% at the low end and 7% at the high end of the range. Organic EBITDA growth is expected to be between 9% at the low end and 12% at the high end of the range as a result of favorable mix trend across the business.

The second set of bars suggests FY20 for the full-year impact of the Paragon acquisition that was completed in May 2019, so there are approximately three and a half quarters of incremental contribution in fiscal 2020 included in that adjustment. The third set of bars highlights the impact of the sale of our softgel facility in Braeside, Australia, which primarily makes vitamin, mineral, and supplement products to one of our customers, Blackmores. As you may recall, we announced the sale of the facility in April 2018 and have been working to move certain non-Blackmores products to other sites within our network. The transition is well underway, and the anticipated transaction is expected to close in October 2019. The revenue and EBITDA impact highlighted is net of the product transfers that will remain within the Catalent softgel portfolio.

The last set of bars, brackets, the negative FX translation impact of revenue on adjusted EBITDA year on year, principally driven by the recent strengthening of the U.S. dollar in relation to the euro and pound sterling. In fiscal 2019, the average euro rate was 1.14, and the average pound sterling was 1.29. In light of recent activity in the foreign exchange markets, we assumed a euro conversion rate of 1.12 and a pound sterling rate of 1.22 in our fiscal 2020 financial guidance, resulting in a modest FX headwind. As you can see on the slide, these drivers yield an anticipated adjusted EBITDA margin expansion of approximately 150 basis points, assuming the midpoint of our guidance range. Lastly, 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 by far, with the fourth quarter of any fiscal year generally being our strongest by far. This will continue to be the case in fiscal 2020, where we expect to realize approximately 40% of our adjusted EBITDA in the first half of the year and 60% of our adjusted EBITDA in the second half of the fiscal year. Operator, we would now like to open the call for questions.

Operator (participant)

Thank you, ladies and gentlemen. If you wish to ask a question at this time, please press star then one on your touch-tone telephone. If your question has been answered or you wish to move yourself in the queue, please press the pound key.

To prevent any background noise, we ask that you please place your line on mute once your question has been stated. Our first question comes from Tycho Peterson with J.P. Morgan. Your line is open.

Tejas Savant (Analyst)

Good morning, guys. This is Tejas Savant for Tycho. Thanks for taking the question here. So, John and Wetteny, I mean, looks like Paragon drove about a $30 million contribution from roughly about half a quarter since the deal closed. Just wanted to get your take on, was that in line or sort of materially ahead of your expectations here? And then any early color that you can share in terms of customer response, if anything has surprised you there?

Then as a quick follow-up to that, you've spoken about sort of Paragon having a pretty well-diversified pipeline of programs across 30-plus customers, but obviously in the near term, there is a degree of customer concentration here. So is there anything to point out, Wetteny, in terms of the cadence of revenue from these customers in fiscal 2020 or some unique seasonality in this portion of the business that we should keep in mind as we model the contribution?

Wetteny Joseph (CFO)

Yeah. Tejas, I'll take the first part of this before we get into the financial question that you asked early on. I'd say, first of all, on the customer response, it's been extremely positive with regards to Catalent acquiring Paragon.

I've been in dialog or met with a majority of the top customers along with my team, and I would say that we really got Paragon at a point where they needed to have a company, if you will, that would be able to continue to, I would say, invest in their growth as well as bring in the processes necessary for the strong growth that they have. So it's been received very well by Paragon, now Catalent's customers, as well as by the overall team. In fact, we've had, I guess, near 100% retention of all of the team and have all of them under retention agreements. So we're very happy about that. With regards to, I would say, the robustness of the business, I mean, today they have probably 30-40 early-stage programs with customers, and that's growing almost on a weekly basis.

Paragon has an incredible reputation, and quite frankly, the business development activities result mostly from picking up the phone from referrals or knowledge of Paragon and their capability. From those, I would say, 30-40 early-stage programs, we also have probably about another, I guess, 100 programs that are being run by 30-40 customers with about 100 programs, if you will, being run through Paragon. We do have several large customers there, but I would say that across all of Catalent, I mean, in an individual site, we may have some customer concentration, but in terms of the robustness of the funnel that we have there, it causes no concern. Again, they're growing by leaps and bounds. With that, I'll turn it over to Wetteny with regards to any commentary with regards to their performance in the stub period. Sure.

Tejas, you're roughly right in terms of the contribution from Paragon in the roughly half of a quarter. I would say that that was slightly above our expectations, and certainly are very pleased with the business out of the gates for us. You can see in our guidance the inorganic portion that we are assuming in our guidance as far as the contribution from Paragon for the fiscal year. Of course, that's roughly three and a half quarters' worth of the other half falling in the base business bucket for us.

The one thing I would add, in addition to having the number of programs we have and the customers, we announced in the quarter the addition of two facilities from Novavax, which bring us both capable staff as well as manufacturing and lab space that we should be able to, in the future, attract even more programs to further diversify the slate of customers that we have in the business in the long term.

Tejas Savant (Analyst)

Got it. And then, John, a couple of quick sort of unrelated follow-ups here. Can you just share some quick thoughts on your perspective on the commercial spray drying opportunity? I mean, obviously, you signed the Sanofi agreement here, and I think a little while ago, there was also a $40 million investment in Winchester. So how do you think of that sort of shaping up down the road?

And then in terms of your Bristol agreement here, what exactly is being baked into the guide in the second half? And is there any excess capacity at the site which you could leverage for other clients?

Wetteny Joseph (CFO)

Sure. So with regards to spray drying, I would say that our Oral Drug Delivery team has done a tremendous job building out a strategy that brought in early development capabilities through the acquisition of Pharmatek Nottingham, and we also repositioned our Somerset site. And we have, I would say, a majority within Catalent of spray drying molecules that are available. They're being developed. It's a large slate. Maybe not a majority. I would say maybe 30%-40% of the molecules that are out there, Catalent has them in early development. So we really needed to build out commercial spray drying capability.

Because of the need of our customers, the team had a terrific strategy, which was we knew that the build-out in Winchester was going to take a couple of years, so we needed to have a little instant-on capability, which was the strategy behind doing the partnership with Sanofi to be able to take their facilities and capabilities to have that instant-on capability for the large suite of spray dry molecules that we have within the company. As a matter of fact, as we already noted in our prepared comments, that we've already signed our first spray drying activity in Haverhill. We see this as just another great capability that we've built within Catalent to make sure that we have a full suite of offerings. Spray drying is one of several techniques used for solubility and bioavailability, and it was an area where we were underdeveloped.

And now, through what we built out in our early development capabilities with Pharmatek and Nottingham, the former Juniper site, now we have the ability to take those products commercial. So again, I've always talked about the fact that we have probably our best robust pipeline within OSD as well as a strong strategy, so we feel terrific about that. With regards to Anagni, again, this is a really strategic site acquisition, if you will, that we're doing with BMS. It's going to provide us capabilities within Europe that we really don't have now. It's really a fantastic site. It's going to give us capabilities from biologics to Oral Drug Delivery packaging. And that's going to close at the end of the year. And I'll just also note that we also have, within our purchase agreement from BMS, that we'll be continuing to manufacture their product within the site.

And we are not providing additional financial input with regards to what we have. All I would say is that we clearly have the assumptions of Anagni baked into our year 2020 guidance. No. Got it. Thanks so much. We will, once we close the transaction, we will reflect them at that point. But the guidance we stated earlier does not reflect contributions from Anagni. Thanks, Wetteny. Got it. Got it.

Tejas Savant (Analyst)

Thanks so much, guys.

Operator (participant)

Thank you. Our next question comes from Ricky Goldwasser with Morgan Stanley. Your line is open.

Ricky Goldwasser (Analyst)

Yeah. Hi. Good morning. I have a question on the Bristol-Myers agreement, and more kind of like a bigger picture question.

So when you consider the existing capacity with kind of like some of the large pharma players, do you think that this is the beginning of the trend where we're going to see pharma taking out capacity and just an overall opportunity to do more outsourcing?

Wetteny Joseph (CFO)

Yeah. So Ricky, this is Wetteny here. I would put this as a continuing trend as opposed to the beginning of one. Historically, we have not executed such transactions in terms of bringing on capacity coming out of large pharma. We carefully evaluated this one in the context that John described earlier, which is when you look at our European presence and our footprint in combination with Juniper acquisition to be a full-time CDMO, starting with development capabilities through ability to launch all solid pipelines in Europe.

This is a bit of a gap that we had that this allows us to be able to close and have existing pipeline and customer relationships over time. We expect to take up the capacity utilization at that facility in addition to what John mentioned, which is the contract we have with BMS, whereby we'll be performing work for them at the facility. In addition, given our focus on continuing to grow our biologics in the fast-growing end of the segment, we saw the opportunity to be able to leverage state-of-the-art capability and capacity at the facility for vial filling, which we intend to utilize as well and continue the growth in this very strong market here from a biologics perspective. So it's a combination of those things that led us to execute on this transaction that we will be closing at the end of the calendar year.

But I would describe this as just a continuation of what has been a trend in the overall space in terms of large pharma taking out underutilized capacity and selling those.

Ricky Goldwasser (Analyst)

Okay. And just one follow-up question on your 2020 organic EBITDA growth being just above long-term guidance. So obviously, very early on, and you just provide updated long-term guidance. But do you think that this is something that we could see kind of more given the trends in opportunity to raise that long-term guide over time, or is it just an opportunity or kind of like easing year-over-year comparisons into next year?

Wetteny Joseph (CFO)

So Ricky, after we announced the Paragon acquisition, we took our organic growth, long-term growth expectations from four to six to six to eight. That's with Paragon.

Sitting here, as we've just issued our guidance for fiscal 2020, we're very pleased that we can see our site growing at those ranges and above them from an EBITDA perspective in our base business, which largely excludes Paragon, as three and a half quarters of Paragon would be inorganic in the year. As we've done in the past, we will continue to look at our long-range strategic plans and provide long-term guidance.

And we would only give you guidance on a year-by-year basis as we enter the year, given our visibility into the long-cycle portion of our businesses that are tied to commercial supply agreements with our customers, as well as our visibility, quite frankly, within the shorter-cycle parts of the business that are increasingly exposed to faster growing into the markets in biologics and gene therapy, which afford us the ability to be able to put the guidance that we put out today. But we will do so on a year-by-year basis unless we see a change in our long-term guidance, which we recently did at the time we announced the Paragon acquisition.

Ricky Goldwasser (Analyst)

Thank you.

Operator (participant)

Thank you. Our next question comes from John Kreger with William Blair. Your line is open.

John Kreger (Analyst)

Thanks very much, John, I think in the prepared remarks for biologics, you talk about one customer bringing some capacity in-house and creating a near-term headwind for you. Can you just talk about broadly, are you seeing that as a trend? Where are you seeing customers deciding to strategically have that capability for biologics in-house versus relying upon Catalent or others to do that?

Wetteny Joseph (CFO)

Yeah. So I'll go first and then see if John wants to add anything here. First of all, this was a customer that, from the beginning of the relationship, was building out their own capacity. I would differentiate this from the core of what we do in our drug substance business in that, in our business, we develop cell lines, generally starting with our proprietary GPEx technology. We then used those cell lines in the manufacturing of the drug substance of the biologic itself.

It starts with a cell line. In fact, approximately 70% of the drug substance we manufacture in our drug substance operations start with our cell line. This was a non-cell line product. This is patient-specific production for a customer that is in the realm of messenger RNA-loaded lipid nanoparticles. It's not our core of what we do in the business. And we fully expected this to be a fixed-duration contract, again, knowing that the customer is building out their own capacity in this regard. When I look at the base of the business, we continue to see a market that is growing robustly. We continue to see a ramp-up of our third manufacturing train, which we launched at the end of last fiscal year.

And so I would say the market dynamics, in combination with our capabilities and quality, we expect long-term to continue to see growth in this business. And this particular instance is not an indication that we see of a trend in the business.

John Chiminski (CEO)

Yeah. I'd just say, just to bluntly answer your question, for the main business that we do in medicine, the drug substance manufacturing, that there is no trend to build in-house capabilities, certainly not for the small and mid-sized customers that are a large part of what we're doing there. And again, as Wetteny said, this was a unique situation that was already at the beginning predetermined that they were building capacity and would exit this very deterministic contract.

John Kreger (Analyst)

Very helpful. Thanks. And then a quick follow-up. I think your guidance for the coming year assumes 4%-7% organic revenue growth.

Any extra comments you could add across the four segments where any of these should be well above or below that 4%-7% range?

Wetteny Joseph (CFO)

So what I would say, just go segment by segment without giving full guidance, as you know, on a segment basis, just looking at the trends in the business. Our softgel business in fiscal 2018 had a number of transitory issues, which we're very exiting the year. We're pleased with where the business stands. We've said, historically, this business grows between 2%-4% organically. As a reminder, we will be having the divestiture of the Australia facility in the segment and having largely mitigated the issue with respect to the ibuprofen supply as we exit the year.

We like the trends that we're seeing in the business in addition to some recent product approvals on the prescription side, which we believe will bode well for the business. So again, long-term, I've just given you some of the recent trends. Long-term, we expect the business to be in that 2%-4% growth rate. Looking at our biologics and specialty, we just discussed the drug substance element with respect to the next few quarters' impact from this one contract. But when you look at the drug product and the underlying drug substance business in our core biologics business, we continue to see low double-digit top-line growth rate in the business. Again, the dynamics in the market are favorable and continue to point to a supply and demand imbalance favoring where we sit in terms of our capabilities and quality, etc.

So again, near-term impact from this contract, we're excluding that, particularly on the drug product part of the business. And to a lesser extent, on drug substance, we continue to see tailwind. I think the specialty part of the business is not one we expect to grow at the levels of our core biologics part of this segment. As we've stated previously, that's a business that we would expect to grow in the low single-digit range. And we've seen some variability in that part of the business, partly due to timing of when we've done shutdowns and things of that nature in the business, as well as the work we did in our blow-fill-seal segment last year that ebbed and flowed the capacity in the site. And therefore, our comparables in the fiscal year 2019 would reflect some level of variability in that part of the business as well.

Moving to oral drug, really, you see momentum in the business as we exit fiscal 2019. As we've said, the development pipeline in this business is the strongest that we have. We're very pleased with the number of strategic moves that we've made here, including the pipeline of spray-dried dispersion late-stage programs that we have that we look to capitalize long-term, both with the Haverhill agreement as well as the organic investments we're making in our Winchester facility in the US. And so again, in addition to development in our oral services, which had a strong quarter for us in the fourth quarter. So we would expect to continue to see momentum in the business. And again, long-term, this is a business that's in the mid-single-digit growth rate expectations that we have.

Lastly, our clinical business, we've seen a bit of a longer time to burn revenue in this business. As a reminder, we did, from an ASC 606 versus ASC 605 perspective, change the revenue recognition to a net basis. What that has done is that is the fastest piece to start to burn from a backlog perspective. You don't see that in the overall numbers because it's shown on a net basis. Actually, we've seen that uptick in our comparator, and we've seen that contribution from an EBITDA perspective in the business. We are starting to see the momentum on the revenue side, not in the fourth quarter as we sit here, still early in the fiscal year, from the uptick that we saw in fiscal 2019 in terms of net new business wins throughout the year.

So again, this is a business we would expect to be mid to high single-digit growth long-term. And I've just relayed the trends that we're seeing in the business right now.

John Kreger (Analyst)

Very helpful. Thank you.

Operator (participant)

Thank you. Our next question comes from David Windley with Jefferies. Your line is open.

David Windley (Analyst)

Hi. Thanks for taking my questions. I wanted to drill in on Paragon a little bit. I think in terms of capacity and the cadence of opening new capacity, you had described two sites. There are two suites, I should say, that were opening in the first half, another two suites kind of opening in the second half, and then six more to be opened at BWI over the course of next year. Are the four open now?

I guess I'm just wanting to get a sense for the timing of when those suites are opening and how many suites are contributing to the revenue that you're now expecting in fiscal 2020.

Wetteny Joseph (CFO)

Yeah. So look, the expansion continues to be executed in line with our expectations. Clearly, have reflected in the guidance that we gave, which we broke out into a separate bracket here in terms of what we expect from the Paragon business. We will continue to execute and focus on the integration of the business. And what I would say is that the two initial suites are up and running in the facility, and we continue to work on the next two, which we said would be completed late in the calendar year and proceed from there. Okay.

David Windley (Analyst)

Wetteny, it looks like my math isn't great, but I think I've calculated something in the mid-30s in terms of contribution margin, EBITDA margin from Paragon in the fourth quarter from what you broke out. And then the guidance at the midpoints implies something in the low 30s, which I think is certainly better than the 28 that was discussed at the time of the acquisition. Is my math right? One, is that a level that can continue to expand toward—I think what you've said is that business can expand toward where the core biologics business is performing today. I guess what I'm interested in those things, but also digging for, as you bring on this new capacity, is that a utilization hit that causes margins to step back a little bit when that happens?

Or are the reservation fees and things like that supporting that margin such that that doesn't happen?

Wetteny Joseph (CFO)

So look, I would say, first and foremost, your math is roughly right in terms of where the business is. And what we've said is, long-term, we expect the business to be into the mid-30s EBITDA margins. Look, as we continue to, still early days in the integration of the business, we are very pleased with the contribution in a relatively short timeframe in the quarter. And you can clearly see what we're anticipating in the year given the contract that we have and elements of them that are capacity reservations as well as execution on batches. As we continue to get into years, we will provide guidance accordingly, but we'll cap it there. Okay.

David Windley (Analyst)

And then last question, sticking in BSDD, excluding Paragon, the growth rate there has been a little soft for a couple of quarters in a row. You commented on timing of shutdowns, I think related to that, though I may be confusing that with OSD. But the respiratory and ophthalmic business appears to be a drag there. But you also, in response to an earlier question, called the kind of core biologics business there a low double-digit grower, which is down from what you've historically called mid-teens. And so I do want to understand, in the core BSDD, excluding Paragon, is that core biologics business still, can it still do mid-teens long-term, or have we moderated that and why? Thanks.

Wetteny Joseph (CFO)

So look, our long-term view on the business remains consistent. This is a business we would continue to see delivering into the teens from a top-line growth rate perspective.

What I indicated is that in both the third quarter and the fourth quarter, if you look at our drug substance and our biologics drug product, not all drug products because some drug product is a small molecule, but if you look at the biologics drug product and drug substance, we continue to see low double-digit growth. That's a combination of a mix between drug product growing well into the teens and drug substance being a bit below that as we compared, and we said in the third quarter, to some timing with respect to the prior year. Now, one thing I would remind you of is, in this business, we still have a fair amount of clinical manufacturing operations. We announced recently that today we now have our 21st commercial drug approval for Bloomington by way of example. Bloomington is still working with upwards of 100 programs.

And so that would tell you that the majority of the programs we're working with, both on drug substance and drug product, are actually in the clinic. And the next important milestone evolution for our drug substance business in Madison is to get it to commercial scale. Until then, we continue to see clinical programs, which can ebb and flow in terms of when the larger later-phase programs you have batches run for them versus other times. So I think some level of variability across the business is something we would expect, albeit the long-term growth rates continue to be what we expect in the business, particularly if you look at it long-term from a CAGR perspective. But from quarter to quarter or half of a year to half a year, you may see this feature given that these are largely clinical stage programs that we have.

David Windley (Analyst)

Great. Thank you. Appreciate it.

Operator (participant)

Thank you. Our next question comes from Dan Brennan with UBS. Your line is open.

Dan Brennan (Analyst)

Great. Thanks. Glad to go back to the question Dave just asked. But if you wouldn't mind, Wetteny, just in the quarter itself, so biologics grew what in the quarter versus specialty delivery?

Wetteny Joseph (CFO)

We've said it's a low double-digit growth if you just look at the core biologics portion of the business. So you can roughly back into what the rest of the business is.

Dan Brennan (Analyst)

Okay. And then back to Paragon. So I think at the time of the deal, you said you had 70 customers at the time of the deal. And I think you said you were, I think, fully booked for fiscal 2019 and fiscal 2020.

So I guess the question is. I forget if you updated it earlier on the prepared remarks, but just give us a sense of. I know, John, you mentioned some earlier comments on the feedback from Paragon from customers. But how do we think about kind of customer activity with Paragon and, to the extent you were to get win new business there, kind of back to date, I think an earlier question on capacity, kind of how much could you potentially provide above and beyond what you've already guided? Is there a capacity to do that?

Wetteny Joseph (CFO)

Yeah. So first of all, I just have to make the comment again that the market for gene therapy work at Paragon is extremely robust. So they're winning and gaining new customers and new programs on a regular basis.

As we've talked about, we currently have two suites up and running, and then we have our phase build-out through the rest of this calendar year and contemplated other build-outs. All I would say is that we have fully contemplated within our capacity models for the build-out those numbers into our guidance. Certainly, getting more capacity faster is something that could improve things over time. But as I said, with the current plans that are meeting our expectations, we have that fully baked into our current guidance.

Dan Brennan (Analyst)

Okay. And then related to CapEx and free cash flow, I believe you guided to an 11%-12% kind of CapEx ratio for fiscal 2020. Maybe can you talk to a little bit of what's implied for free cash flow conversion in 2020? And is that level of CapEx ratio sustainable beyond fiscal 2020?

How do we think about the CapEx needs beyond? I know you're not going to guide for it, but just give us some sense how to think about the need for ongoing capital investment and the impact on free cash. Thank you.

Wetteny Joseph (CFO)

Yeah. Sure. We did say that we expect 11%-12% of net revenue in CapEx. This is a combination of our sort of organic investments in our biologics business, which we announced previously, both across drug product and drug substance, in combination with Paragon as well as others that we mentioned in terms of spray-dry commercial capacity in the U.S. and so on.

So we have said that we expect to see CapEx as a percentage of revenue increase over the next couple of years as we get through these roughly two-year programs across these more significant ones, which we already started to see as we exited this fiscal year 2019 with roughly 9% CapEx as we exited the year. So from a free cash flow conversion perspective, we expect between 30%-45% conversion of adjusted net income to free cash flow given the uptick we've just described from a CapEx perspective. But we are looking to really capitalize on a strong market tailwind, both in biologics and gene therapy, given our position and our capability and quality operations across those businesses.

Dan Brennan (Analyst)

Great. Thank you.

Operator (participant)

Thank you. Our next question comes from Donald Hooker with KeyBanc. Your line is open. Great.

Donald Hooker (Analyst)

Just curious, maybe qualitatively, maybe for Wetteny, when you're setting your guidance for fiscal 2020, how your visibility has changed with all these acquisitions, especially around the gene therapy area, kind of some of the volatility that might be there in terms of visibility to your guidance. Can you qualify that?

Wetteny Joseph (CFO)

So if you look across the business, our long-cycle businesses that are supplying commercial products for our customers continue to have very strong visibility to influence where we guide for the year. We are seeing an increasing amount of revenue contribution from development services across the business. But those increases are coming from the ends of the markets that are growing the fastest, being in the biologics and gene therapy space. So that gives us a certain level of confidence as we enter the year in terms of where we guide to.

And we tend to guide externally to figures that internally we are certainly driving above those. So we certainly have confidence through the midpoint of our guidance as we have in previous years. And I would just reiterate our visibility remains consistent across the long-cycle businesses with the growth on the development side coming from fast-growing ends of the market.

Donald Hooker (Analyst)

Okay. And I guess related to that, it sounded like you were maybe positively surprised from Juniper versus your internal expectations. Can you elaborate on what you think has gone better than expected there?

Wetteny Joseph (CFO)

Juniper has been performing, I would say, slightly above our expectations since we made the acquisition in the first quarter of the fiscal year.

That certainly has remained strong throughout, both with respect to, as we described previously, their Crinone product that we supply in various markets, as well as the development services that we perform for our customers for the development programs. It's a very important strategic element to the business as we look to capture more molecules and feed them through the rest of our network. I think in combination with the upcoming closing of the Anagni facility as well as feeding into the rest of our oral solids network, we're very pleased with the contribution of the business so far and its performance.

Donald Hooker (Analyst)

Thank you.

Operator (participant)

Thank you. Our next question comes from Juan Avendano with Bank of America. Your line is open. Juan, your line is open. Please check your mute button.

Juan Avendano (Analyst)

Hi. Thank you. My first question is on the Clinical Supply Services segment.

I believe that for fiscal year 2019, even excluding the negative impact from the adoption of ASC 606, I believe that organic growth was probably flattish, maybe a little bit negative, a decline. In response to an earlier question, you also said that at the long-term, organic growth rate of the segment is in the mid to high single digits. And so given the dynamics of this low and backlog conversion in CSS, I was wondering if you could just give us a little bit more color on how you expect to re-accelerate organic growth in this segment and what's baked into your long-term guidance of mid to high single digit growth.

Wetteny Joseph (CFO)

Yeah. So Juan, looking at the clinical business, we've certainly seen a slower burn to the backlog, the healthy backlog we've built in this business.

As I mentioned earlier, the business, the earliest piece to be executed when we contract for work with our customers is the comparator revenue. And so in past years, we would have seen that uptick earlier because comparator would have been shown on a gross basis. But now it's on a net basis. It's effectively shifted that timing by about a couple of quarters. And so while it's been slower, we've enjoyed the EBITDA growth in the business, which maintained double-digit EBITDA growth throughout the year, which we're very pleased with as we utilize our capacity. And we're seeing that uptick and the benefit of the comparator growth as well. It's just a bit muted at the top line. So while we would have liked to see the burn start earlier, we understand why.

We are starting to see that as we sit here in the early part of FY 2020, we're starting to see that burn of the backlog. And so we continue to be very pleased with the business. And again, long-term, the dynamics in terms of clinical trials and our position with a global footprint to be able to manage and help our customers with their global clinical trials, we continue to be positioned well to have the growth expectations we have long-term.

Juan Avendano (Analyst)

Okay. Going into the BSDD segment, before, I believe the split between biologics and the specialty drug delivery was a 60/40 split. This was before Paragon, given how poorly the specialty part did in fiscal year 2019. And now with the inclusion of Paragon, can you give us an update on the revenue breakdown between Biologics and Specialty Drug Delivery and BSDD?

Wetteny Joseph (CFO)

Juan, look, for fiscal 2019, you can roughly estimate about a $30 million revenue contribution from Paragon. That's not going to materially shift the number for 2019 as you look at the total segment. You can see our assumptions from a fiscal 2020 guidance perspective as far as what the contribution of Paragon is. I don't have the number right in front of me to quote you, but I think you can back into what that is with respect to the contribution. I would just put Paragon into that core biologics definition, if you will, as you do that math. Okay.

Juan Avendano (Analyst)

Lastly, over the last couple of years, you've given us a medium to long-term outlook on the adjusted EBITDA margin expansion, something along the lines of, "We expect X number of hundred basis points of adjusted EBITDA margin expansion over the next two to three years or three to four years." Given now with Paragon and all the investments that are taking place, would you give us a medium to long-term guidance on adjusted EBITDA margin expansion over the next few years?

Wetteny Joseph (CFO)

As we said in our prepared comments, we're seeing about a 150 basis point margin expansion in fiscal 2020 if you assume the midpoint of our guidance. Mid to long-term, we've said we expect to deliver between an increment of 200-300 basis points margin expansion over the next two to three years, which would be inclusive of FY 2020.

Clearly, we're seeing a nice uptick as we guide for 2020. It's not linear in terms of what we've said previously, and we continue to have those expectations.

Juan Avendano (Analyst)

Okay. Thank you.

Operator (participant)

Thank you. Our next question comes from Evan Stover with Robert W. Baird. Your line is open.

Evan Stover (Analyst)

Yeah. Thank you. If I look at the fiscal 2020 guidance bridge and look at Paragon and then add in kind of the stub period that we got in the fourth quarter of 2019, I think the implication is Paragon's going to do about $255-260 million of revenue next year or this year, fiscal 2020. I'm just wondering if you can tell me on a pro forma basis what that growth rate for Paragon looks like.

And the thrust of my question really is to get a better idea of kind of the glide path down from recent 100% growth rates down to 25% plus kind of market growth rates that you've previously given us in that business.

Wetteny Joseph (CFO)

Look, from a Paragon perspective, I would first say that your rough math is about right. Here's what we've said previously. We expected the business. The business did in calendar year 2018 roughly $100 million of revenue. In calendar year 2019, we said we were expecting the business to do $200 million of revenue. Clearly, that's ramping in the back half of calendar 2019. I don't have the exact figure to quote you from a pro forma growth rate perspective, but clearly, this is what I would put in the bucket of hyper growth that we continue to see in this business.

Again, confirming that your rough math is roughly right in terms of the contribution in total for the year, and we've singled out what the inorganic portion of that is.

Okay. Final question for me, a smaller one, the Braeside divestiture. I see it's a little bit of an EBITDA drag this year. That stands in contrast, I think, to the last round of Asia-Pac divestitures you did, which were actually a slight EBITDA benefit, so I'm wondering if you can give me an idea of is that a conservative estimate there with potential for some upside, or does the Braeside divestiture kind of differ maybe from the last round of divestitures you did in Softgel?

Yeah, so this is a little bit of a bigger operation. But as we said, and if you look at that bracket, it's actually EBITDA margin accretive.

As we take out roughly $35 million of revenue with only about a $3 million EBITDA impact, so it's about a 10% number. So it will be EBITDA accretive and part of the 150 basis points margin expansion that we see in the year. So we continue to work diligently to transfer the products from the facility elsewhere in the network. But I would say compared to the other, which were substantially smaller in totality versus this one, the other ones, I think, were roughly flat to slightly negative on EBITDA. This is roughly 3 million, which is a relatively modest EBITDA impact. And again, EBITDA margin accretive.

Evan Stover (Analyst)

All right. Thank you very much.

Operator (participant)

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

John Chiminski (CEO)

Thanks, operator and thanks, everyone, for your questions, for taking the time to join our call. I'd like to close by reminding you of a few important points. First, we're committed to delivering fiscal year 2020 results consistent with our financial guidance and are focused on continuing to drive organic growth across our overall business. Second, we're determined to continue to grow our world-class biologics business, as demonstrated by the $200 million of CapEx being deployed to further build out capacity and capability in our Madison and Bloomington sites and our May acquisition of Paragon, and look forward to continued strong revenue and high-margin EBITDA growth from our biologics offerings. Third, the continued successful and efficient integration of the Paragon business into the Catalent family is a top priority as we look to capitalize swiftly on our recent inorganic investments.

We firmly believe the transaction enhances our biologics offerings, accelerates long-term growth, and will lead to increased shareholder return. Fourth, expanding the adjusted EBITDA margin of our business is a key focus area for the management team as we drive towards 200-300 basis points of further expansion over the next few years. Last, but certainly 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.

Operator (participant)

Thank you. Ladies and gentlemen, this concludes today's conference. Thank you for joining, and everyone, have a wonderful day.