Pharmaceutical Product Development 10-K 2008
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended December 31, 2007
For the transition period from to
Commission file number 0-27570
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC.
(Exact name of registrant as specified in its charter)
Registrants telephone number, including area code: (910) 251-0081
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x
The aggregate market value of the common stock held by non-affiliates of the registrant was approximately $4.1 billion as of June 30, 2007, based on the closing price of the Common Stock on that date on the Nasdaq Global Select Market. Shares of common stock held by each executive officer and director and by each person who owns 10% or more of the outstanding common stock have been excluded in that such person might be deemed to be an affiliate. This determination of affiliate status might not be conclusive for other purposes.
As of February 15, 2008, there were 119,342,146 shares of the registrants common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
The Companys definitive Proxy Statement for its 2008 Annual Meeting of Stockholders (certain parts, as indicated in Part III).
Statements in this Report that are not descriptions of historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements reflect managements current view with respect to future events and financial performance, but are subject to risks and uncertainties. Actual results could differ materially from those currently anticipated due to a number of factors, including those set forth herein and in our other SEC filings, and including, in particular, the factors discussed in Item 1A, Risk Factors.
We are a leading global contract research organization providing drug discovery and development services, post-approval expertise and compound partnering programs. Our clients and partners include pharmaceutical, biotechnology, medical device, academic and government organizations. Our corporate mission is to help clients and partners maximize returns on their research and development investments and accelerate the delivery of safe and effective therapeutics to patients.
We have been in the drug development business for more than 22 years. Our development services include preclinical programs and Phase I to Phase IV clinical development services as well as bioanalytical product testing and clinical laboratory services. We have extensive clinical trial experience, including regional, national and global studies across a multitude of therapeutic areas and in various parts of the world. In addition, for marketed drugs, biologics and devices, we offer support such as product launch services, medical information, patient compliance programs, patient and disease registry programs, product safety and pharmacovigilance, Phase IV monitored studies and prescription-to-over-the-counter, or Rx to OTC, programs.
With offices in 30 countries, operations in 40 countries and more than 10,000 professionals worldwide, we have provided services to 45 of the top 50 pharmaceutical companies in the world as ranked by 2006 healthcare research and development spending. We also work with leading biotechnology and medical device companies and government organizations that sponsor clinical research. We are one of the worlds largest providers of drug development services to pharmaceutical, biotechnology and medical device companies and government organizations based on 2007 annual net revenue generated from contract research organizations.
Building on our outsourcing relationship with pharmaceutical and biotechnology clients, we established our discovery sciences business in 1997. This business primarily focuses on preclinical evaluations of anticancer therapies, biomarker discovery and patient sample analysis services, and compound development and commercialization collaborations. We have developed a risk-sharing research and development model to help pharmaceutical and biotechnology clients develop compounds. Through collaborative arrangements based on this model, we assist our clients by sharing the risks and potential rewards of the development and commercialization of drugs at various stages of development.
Our integrated drug discovery and development services offer our clients a way to identify and develop drug candidates more quickly and cost-effectively. In addition, with global infrastructure, we are able to accommodate the multinational drug discovery and development needs of our clients. As a result of having core areas of expertise in discovery and development, we provide integrated services across the drug development spectrum. We use our proprietary informatics technology to support these services.
Discovering and developing new drugs is an extremely expensive, high-risk and time-consuming process. Multiple industry sources estimate the fully capitalized cost of developing and commercializing a new pharmaceutical product ranges from $800 million to over $1 billion. In addition, it generally takes between 10 and 15 years to develop a new prescription drug and obtain approval to market it in the United States.
The drug development services industry provides independent product development services to pharmaceutical, biotechnology and medical device companies, and government organizations. This industry has evolved from providing limited clinical trial services in the 1970s to a full-service industry today characterized by broader relationships with clients and by service offerings that encompass the entire drug development process, including preclinical evaluations, study design, clinical trial management, data collection, biostatistical analyses, regulatory consulting, clinical laboratory and diagnostic services, pre- and post-approval safety analysis, product registration and post-approval support.
Over the past 22 years, technological advances, as well as the emergence of the biotechnology industry, have dramatically changed the drug discovery process. New and improved technologies have evolved such as ultra high-throughput screening, new in vitro and in vivo preclinical profiling techniques, biomarker research and the gene-based drug research commonly referred to as genomics. The objective of these innovations is to find more drug targets and to screen against targets much more quickly, with literally millions of chemical compounds possible. This process is expected to produce many more molecules having the ability to affect biological activity. These molecules then need to be tested quickly and economically to determine their viability as potentially safe and effective drug candidates. Moreover, many industry participants, including pharmaceutical, biotechnology and contract research companies, have broadened their efforts to collaborate technically and financially to optimize their drug pipelines.
The Drug Discovery and Development Process
Drug discovery and development is the process of creating drugs for the treatment of human disease. The drug discovery process aims to generate safe and effective drug candidates, while the drug development process involves the testing of these drug candidates for safety and efficacy in animals and humans and to meet regulatory requirements.
The Drug Discovery Process
Targets. Historically, scientists have used classical cellular and molecular biology techniques to map biological pathways in cells to provide a cellular basis for understanding disease processes. Based on this information, scientists are now using genomics to pinpoint genes responsible for cellular disease functions. Once genes are identified, they are tested in cellular assays or animals to identify which genes seem to have a causal link between cellular function and occurrence of disease. The preferred genes encode proteins that are used as drug targets in chemical screens.
Screening. After identifying a potential drug target, researchers develop tests, or assays, to screen chemicals for their ability to alter the functional activity of the target. Ones that do so are called hits. Thousands of chemicals can be quickly evaluated when these assays are incorporated into high-throughput screening processes. Hits that have good potency and selectivity are called leads and are then tested for their potential as drug candidates.
Lead Generation. Scientists now also design compound libraries to provide a starting point to identify leads in the drug discovery process and to better understand the biochemistry and therapeutic relevance of targets. High quality libraries contain compounds of known purity, structure and weight, and also have diverse structural variations. Once a hit is identified in a functional assay, the compound is profiled for drug characteristics such as solubility, metabolism, stability and feasibility for commercial production.
Lead Optimization. The process of lead optimization involves refining the chemical structure of a lead to improve its drug characteristics, with the goal of producing a preclinical drug candidate. Lead optimization typically combines empirical and rational drug design. In empirical design procedures, large numbers of related compounds are screened for selected chemical characteristics. In rational drug design, chemicals are optimized based on the three-dimensional structure of the target. A lead that has been optimized to meet particular drug candidate criteria and is ready for toxicity testing is called a preclinical candidate.
Process Research and Development. Compounds created for screening in lead generation and lead optimization are made in relatively small, milligram quantities. Before a drug candidate can be taken into preclinical and clinical trials, larger quantities must be produced. The goal of process research is to improve the ease with which compounds can be produced in these larger quantities, typically by minimizing the number of production steps, and to determine how to reduce the time and cost of production. Process development refers to the production scale-up and further refinement required for clinical trials and commercial manufacturing.
The Drug Development Process
The drug development process consists of two stages: preclinical and clinical. In the preclinical stage, the new drug is tested in vitro, or in a test tube, and in vivo, or in animals, generally over a one- to three-year period. After successful preclinical testing, the new drug can be advanced to the clinical development stage, which involves testing in humans. The following discussion describes the role of the Food and Drug Administration, or FDA, in the clinical drug development process in the United States. Similar regulatory processes exist in other countries.
Prior to commencing human clinical trials in the United States, a company must file with the FDA an investigational new drug application, or IND, containing details for at least one study protocol and outlines of other planned studies. The company must provide available manufacturing data, preclinical data, information about any use of the drug in humans for other purposes and a detailed plan for the proposed clinical trials. The design of these trials, also referred to as the study protocols, is essential to the success of the drug development effort. The protocols must correctly anticipate the nature of the data to be generated and results that the FDA will require before approving the drug. If the FDA does not comment within 30 days after an IND filing, human clinical trials may begin.
The clinical stage is the most time-consuming and expensive part of the drug development process. The drug undergoes a series of tests in humans, including healthy volunteers as well as patients with the targeted disease or condition. Human trials usually start on a small scale to assess safety and then expand to larger trials to test efficacy. These trials are usually grouped into the following three phases, with multiple trials generally conducted within each phase:
After the successful completion of all clinical phases, a company submits to the FDA a new drug application, or NDA, for a drug, or a biologic license application, or BLA, for a biologic, requesting that the product be approved for marketing. The NDA/BLA is a comprehensive, multivolume filing that includes, among other things, the results of all preclinical and clinical studies. The FDAs review can last from a few months to several years, depending on the drug and the disease state that is being treated. Drugs that successfully complete this review may be marketed in the United States. As a condition to its approval of a drug, the FDA might require additional clinical trials following receipt of approval, in order to monitor long-term risks and benefits, to study different dosage levels or to evaluate different safety and efficacy parameters in target populations. In recent years, the FDA has increased its reliance on these trials, and with the passage of the Food and Drug Administration Amendments Act, or FDA Act, in late 2007, the FDA is expected to require sponsors to run more post-approved trials in the future.
Trends Affecting the Drug Discovery and Development Industry
The drug discovery and development services industry has been and will continue to be affected by, among others, the following trends:
Rapid Technological Change and Increased Data. Scientific and technological advancements are rapidly changing the drug discovery and development processes, requiring industry participants to make significant investments to keep pace with competition. The technology to understand gene function, known as functional genomics, is dramatically increasing the number of identified potential drug targets within the human body. Many pharmaceuticals on the market today have historically targeted no more than an estimated 500 human gene products. With an estimated 20,000 to 25,000 human protein-coding genes, an enormous number of targets for therapeutic intervention remain untapped. This number of targets increases the need for companies to use state-of-the-art technologies to effectively validate and optimize promising targets and lead candidates. Industry participants are also looking to applications such as biomarker technology to save development time and costs, as well as enable more precise diagnosis and personalized treatment of disease. These evolving technologies and the expertise to manage them are costly and involve significant investments in expertise, capital, intellectual property and sophisticated instrumentation. Thus, drug discovery and development service firms that have the capability and expertise to provide early stage research and development services offer the potential to offset some of these investments and potentially reduce the financial risk of drug discovery efforts.
Changes in the Regulatory Environment. The drug discovery and development process is heavily regulated by the FDA and its Center for Drug Evaluation and Research, or CDER. The war on terror, the risk of global vaccine shortages and the threat of new potential pandemics have elevated the FDAs focus on research in the areas of bioterrorism and vaccine development. In addition, recent product safety concerns, increases in drug and general healthcare costs and the emergence of importation issues have placed the FDA and other regulatory agencies under increased scrutiny. As a result of these and other events, drug safety, cost and availability are under intense monitoring and review by Congress, the FDA and other government agencies. In September 2007, primarily in response to the FDAs handling of postmarket data and recent drug safety concerns, the FDA Act, was signed into law. In addition to reauthorizing and amending various provisions that were scheduled to expire, this Act provides the FDA with new regulatory authority to require drug sponsors to run postapproval clinical trials and develop and implement risk evaluation and mitigation strategies. The FDA Act and continued drug safety issues could have a lasting and pronounced impact on the drug discovery and development industry.
Government-Sponsored Drug Research and Development. Government agencies continue to be a significant source of funding for new drug and vaccine research and development. The total budget of the National Institutes of Health, or NIH, for the fiscal year 2007 and 2008 is approximately $29 billion and includes significant appropriations for drug research and development initiatives in the areas of cancer, vaccines, AIDS and chronic diseases such as diabetes. As a result, drug research and development service providers and contractors, including CROs, should continue to benefit from government-sponsored research and development initiatives.
Increase in Potential New Drug Candidates. The number of drug compounds in various stages of development has increased steadily over the past five years, with particularly strong growth in the number of compounds in early stages of development. While research and development spending and the number of drug candidates are increasing, the time and cost required to develop a new drug candidate also have increased. Many pharmaceutical and biotechnology companies do not have sufficient internal resources to pursue development of all of these new drug candidates on their own. Consequently, these companies are looking to the drug discovery and development services industry for cost-effective, innovative and rapid means of developing new drugs.
Research and Development Productivity. While the total number of compounds in clinical development has increased in the last several years, thereby increasing the aggregate spending on research and development programs associated with new drug candidates, the number of novel new drugs approved for marketing remained relatively flat or even declined in recent years. Pharmaceutical and biotechnology companies have responded by focusing on efforts to extend the value of existing products, improve clinical success rates, restructure and re-engineer business processes and business units and lower clinical study costs. Furthermore, many pharmaceutical and biotechnology companies have also responded to the productivity challenge by increasing their focus on licensing and collaborative arrangements to improve new drug pipelines and gain financing for future development and marketing programs.
Biotechnology Industry Growth. The U.S. biotechnology industry has grown rapidly over the last decade and has emerged as a key client segment for the drug development services industry. While the biotechnology industry accounts for a smaller percentage of total industry R&D expenditure, the rate of biotechnology companies spending is higher than traditional pharmaceutical companies. This industry is generating significant numbers of new drug candidates that will require development and regulatory approval. Many of these new drug candidates are now moving into clinical development, with over 1,000 products in Phase II/III clinical development. Many biotechnology companies do not have the necessary staff, operating procedures, experience or expertise to conduct clinical trials on their own. Because of the time and cost involved, these companies rely heavily on contract research organizations to conduct clinical research for their drug candidates. The ability of small and mid-sized biotech companies to attract the funding needed to sustain operations and advance clinical candidates to subsequent stages in the development process can affect the growth of the development services industry. Over the past several years, venture capital funding for small and mid-sized biotech companies has continued to grow, averaging over $1 billion per quarter over the last several quarters.
Globalization of Clinical Trials. Clinical trials have become increasingly global as sponsors seek to accelerate patient recruitment, broaden access to trained investigators, reduce costs and gain access to new sources of market expertise. Moreover, pharmaceutical and biotechnology companies are increasingly seeking to file drug registration packages in multiple countries and regulatory jurisdictions to extend drug product markets. More clinical study work is being conducted in Eastern Europe, Asia and Latin America, as well as other geographic regions. The clinical studies to support these registration packages frequently include a combination of multinational and domestic trials. This trend puts an emphasis on global experience and coordination throughout the development process, including the collection, analysis, integration and reporting of clinical trial data. Among the major global drug development service providers, approximately 40% of the net revenue generated in 2007 was derived from outside of the United States.
Cost Pressures of Introducing New Drugs. Market forces and governmental safety initiatives place significant pressures on pharmaceutical and biotechnology companies to reduce drug prices. In addition, increased competition as a result of patent expiration, market acceptance of generic drugs, and governmental and private managed care organization efforts to reduce healthcare costs have added to drug pricing pressures. The industry is responding by consolidating, streamlining operations, decentralizing internal discovery and development processes, and minimizing fixed costs. In addition, increased pressures to differentiate products and justify drug pricing are resulting in an increased focus on healthcare economics, safety monitoring and commercialization services. Moreover, pharmaceutical and biotechnology companies are attempting to increase the speed and efficiency of internal new drug discovery and development processes.
We address the needs of the pharmaceutical, biotechnology and medical device industries, as well as academic and government organizations, for drug discovery and development by providing integrated services to help our clients maximize the return on their research and development investments. Our application of innovative technologies, therapeutic expertise and commitment to quality throughout the drug discovery and development process offers our clients a way to identify and develop successful drugs and devices more quickly and cost-effectively. We have obtained significant drug development expertise from more than 22 years of operation, and in 2003 we expanded into the medical device industry. We use our proprietary informatics technology across our discovery and development services to support and help accelerate the process. Finally, with global infrastructure and expertise in key regions throughout the world, we are able to accommodate the multinational discovery and development needs of our clients.
Our corporate mission is to help clients maximize the return on their research and development investments and accelerate the delivery of safe and effective therapeutics to patients. The key parts of our strategy to accomplish this mission include the following:
We provide services designed to increase efficiency, reduce time and save costs through our global infrastructure, integrated research and development technologies experience, and client-focused communications. We operate in two segments: Discovery Sciences and Development. See our consolidated statements of operations included elsewhere in this report for segment information regarding revenue and see Note 16 in the Notes to Consolidated Financial Statements for segment information regarding total assets and a measure of profit or loss.
Our Discovery Sciences Group
Our Discovery Sciences Group focuses on the discovery research segment of the biopharmaceutical research and development outsourcing market.
Preclinical Service. Our preclinical biology group integrates pharmacology, metabolism, pharmacokinetic and toxicology expertise to provide preclinical program design and project management services. We provide a broad range of preclinical services including:
Once a potential drug candidate is identified, we offer services that enable our clients to make decisions about whether to advance the drug candidate into a preclinical program both faster and with a greater probability of success. Our experts can provide full preclinical development services and integrate other development services internally.
We offer preclinical consulting as well as a full range of preclinical efficacy, pharmacokinetic, pharmacodynamic and mechanism models for anticancer therapeutic candidates. Our experienced preclinical staff designs and manages the studies needed to identify, profile and optimize lead compounds across all therapeutic areas.
Supported by our board-certified toxicologists, we develop and implement preclinical toxicology programs. To support the clinical development program, we write the toxicology study protocols, identify qualified good laboratory practice, or GLP, testing facilities, manage the placement and conduct of studies, and prepare and review pharmacology, toxicology, absorption and metabolism data for regulatory submissions.
We provide non-GLP bioanalytical services in our laboratory located in Middleton, Wisconsin. Our bioanalytical laboratory analyzes biological fluid samples from preclinical animal studies and conducts in vitro discovery/early development experiments to test potential drug candidates.
Our technical writers, alongside our board-certified toxicologists, prepare pharmacology and toxicology summaries for regulatory submissions. They also work with regulatory authorities to develop preclinical plans. We offer a full range of regulatory support services, including document preparation, review and submission for all preclinical regulatory filings required by regulatory agencies, as well as facilitation of meetings with regulatory agencies to ensure successful outcomes.
Biomarker Discovery Sciences. We provide biomarker discovery and patient sample analysis at our Menlo Park, California, biomarker discovery sciences laboratory. Biomarkers are components of bodily fluids that indicate the progression or presence of a disease. Our laboratory is equipped with advanced technologies to carry out identification of the different types of proteins, naturally occurring peptides and metabolites, as well as of blood cell populations from a variety of biological samples. Our proprietary mass spectrometry platform that is used for proteomic, peptidomic and metabolomic quantification is at the center of our process. Our technology allows clients to analyze patient samples for novel or known biomarkers in the presence or absence of a drug. The changes in the
biomarker profile of a patient can assist in the evaluation of the efficacy of a drug. We were issued a U.S. patent covering our proprietary MassView software in 2005. The MassView software helps scientists identify individual components of a biological sample and the amount of each component in the sample.
Compound Collaboration Programs. With increased capacity to screen and develop early lead compounds and candidates, pharmaceutical companies now find themselves lacking the capacity to develop all of these compounds and take them to market within a reasonable time. Many biotechnology companies have promising drug development candidates but lack the financial resources or the infrastructure to develop them further. These situations provide attractive opportunities for us to use our extensive experience in strategic, global drug development to selectively in-license and develop compounds or jointly develop drug candidates in collaborative arrangements. Our compound collaborative efforts have created a pipeline of products that leverages our resources, creates new opportunities for growth, and allows us to share the risks and rewards of drug development with our clients and partners.
We entered into our first compound partnering arrangement in 1998 when we acquired an exclusive license, as part of a development collaboration with Eli Lilly and Company, to develop and commercialize the compound dapoxetine for genitourinary indications, including premature ejaculation, or PE. We developed the compound through Phase II proof-of-concept and, in January 2001, out-licensed it to ALZA Corporation which was subsequently acquired by Johnson and Johnson. Under the terms of the agreement, we granted Johnson and Johnson worldwide rights to develop and commercialize dapoxetine and Johnson and Johnson is responsible for all clinical, regulatory, manufacturing, sales and marketing costs associated with the compound. In exchange, we received an upfront payment and are entitled to receive further payments if regulatory milestones are achieved. In addition, we are entitled to receive royalty payments based on sales of dapoxetine, as well as milestone payments when specified sales levels are reached. In December 2003, we acquired Lillys patents and remaining rights to develop and commercialize dapoxetine in the field of genitourinary disorders in return for a cash payment of $65.0 million. We also agreed to pay Lilly a royalty of 5% on annual sales of dapoxetine, if any, in excess of $800 million. In December 2004, Johnson and Johnson submitted an NDA to the FDA for dapoxetine. The FDA accepted the NDA for filing in February 2005, which triggered a $10.0 million milestone payment from ALZA to us. In October 2005, Johnson and Johnson received a not approvable letter from the FDA, but continued its global development program. In December 2007, Johnson and Johnson submitted a marketing authorization application for dapoxetine to regulatory authorities in seven countries in the European Union. Although these regulatory applications have been submitted, we do not know if or when Johnson and Johnson will submit applications for or obtain regulatory approval for dapoxetine in the United States or any other country.
In 2003, we made an equity investment in Syrrx, Inc., a privately held drug discovery company, and entered into a collaboration agreement to develop Syrrxs orally active dipeptidyl peptidase IV, or DPP-4, inhibitors to treat type 2 diabetes and other major human diseases. In March 2005, Takeda Pharmaceutical Company Limited acquired Syrrx. In July 2005, Takeda acquired the development and commercialization rights to all DPP-4 inhibitors previously granted to us under the collaboration agreement between PPD and Syrrx. Under the new agreement, Takeda paid us a $15.0 million upfront payment in the third quarter of 2005. We will also be entitled to receive potential milestone payments and royalties associated with the future development and commercialization of specified DPP-4 inhibitors and will serve as the sole provider of clinical and bioanalytical services to Takeda for Phase II and Phase III trials of DPP-4 inhibitors conducted in the United States and Europe. As a result of this agreement, we will have no further material expense associated with the development and commercialization of these DPP-4 inhibitors. In January 2006, Takeda commenced Phase III trials for the lead DPP-4 inhibitor, alogliptin, and as a result, paid us a $15.0 million milestone payment. In December 2007, Takeda submitted an NDA for alogliptin to the FDA. If the FDA accepts the NDA for filing, we will earn a $15.0 million milestone payment from Takeda. In addition, if the FDA approves the NDA for alogliptin, we will earn a $25.0 million milestone payment from Takeda.
In 2004, we purchased shares of Accentia Biopharmaceuticals, Inc. Series E convertible preferred stock for $5.0 million. Accentia is a specialty biopharmaceutical company focused on the development and commercialization of late-stage clinical products in the areas of respiratory disease and oncology. In 2004, we also entered into a royalty stream purchase agreement with Accentia under which we purchased for $2.5 million a royalty stream equal to 7% of net sales of specified products. We subsequently amended that agreement and agreed to
provide specified clinical development services, up to a maximum dollar limitation, to Accentia in connection with a Phase III trial for SinuNase®, Accentias proprietary compound that it is developing for the treatment of chronic sinusitis. In exchange for providing these services, Accentia agreed to pay us an additional royalty equal to 7% of the net sales of specified SinuNase products if approved for sale by the FDA. Under the amended agreement, either party had the option to terminate the provisions of the agreement related to our obligation to provide clinical development services at any time on or before December 31, 2006. Accentia exercised this option and terminated these provisions of the agreement effective December 28, 2006. Accentia recently announced that it completed enrollment in the SinuNase Phase III program and expects to announce top-line results in the first quarter of 2008.
In early 2007, we exercised our option to acquire an exclusive worldwide license from Ranbaxy Laboratories, Ltd. to develop, manufacture and market its novel statin for the treatment of dyslipidemia. The preclinical toxicology, drug metabolism and pharmacokinetic data suggest that the statin has the potential to offer an improved safety profile over currently marketed statins. Under the terms of the agreement, Ranbaxy will be entitled to receive milestone payments upon the occurrence of specified clinical events. In the event of approval to market a drug product, Ranbaxy will be entitled to receive royalties on sales of the drug and sales-based milestones. We will be responsible for all costs and expenses associated with the development and commercialization of the compound, including preclinical and clinical studies. Ranbaxy has retained co-marketing rights to the compound in India. We filed an investigational new drug application with the U.S. FDA in March 2007 and completed a Phase I single dose study in humans in July 2007, and the compound was safe and well tolerated at all doses in this trial. We also completed a first-in-patient study, and a drug-drug interaction study to evaluate the interaction between our statin and gemfibrozil, a fibrate commonly used to lower triglycerides. We are currently conducting additional trials to further evaluate the safety and efficacy of this statin. We have preliminary results from the first part of a high dose comparator trial. These preliminary results suggest that our statin was well-tolerated in the first part of this trial based on adverse event and clinical laboratory data and compared favorably to the comparator statins with respect to lipid lowering. The second part of the study is in progress and final results could vary materially from the preliminary results. We anticipate having final results from this high dose comparator study in the first quarter of 2008 and plan to decide upon a course of action related to this statin program after evaluating the full and complete results from these trials.
Our Development Group
We have designed our various global services to be flexible and integrated in order to assist our clients in optimizing their research and development spending through the clinical stages of the development process. We provide a broad range of development services, either individually or as an integrated package, to meet clients needs.
Phase I Clinical Testing. Having conducted Phase I studies for more than 20 years, we are one of the industrys most experienced Phase I trial providers. Our 300-bed Phase I clinic in Austin, Texas capitalizes on our strengths in conducting first-in-man studies, cardiac monitoring and large, complex, procedure-intensive Phase I trials. Our professional physician and nursing staff administer general Phase I safety tests, special population studies and bioavailability and bioequivalence testing. Bioavailability and bioequivalence testing involves administration of test compounds and obtaining biological fluids sequentially over time to measure absorption, distribution, metabolism and excretion of the drug. Our Phase I unit also includes a dental research clinic to evaluate the safety and effectiveness of new analgesic compounds in molar extraction models. Our Phase I services can also be integrated with other services that we provide, such as bioanalytical, data management, pharmacokinetic and biostatistical services.
Laboratory Services. We offer the following laboratory services:
Austin Central Laboratory. Our Austin central laboratory is located in our Phase I unit and primarily supports the Phase I operations there. This laboratory performs clinical chemistry assays on volunteer specimens to ensure each subject qualifies for the study and is not adversely affected by a drug. Having our laboratory in the same facility as the volunteers speeds our response time to assess unexpected outcomes. This laboratory also serves as a central laboratory for U.S. small to medium size Phase II through IV multicenter safety studies.
Global Central Laboratories. Based in Highland Heights, Kentucky, and Brussels, Belgium, our global central laboratories provide highly standardized efficacy and safety testing services with customized results databases for pharmaceutical and biotechnology companies engaged in clinical drug development, as well as government-funded studies. We focus on providing long-term, large-scale studies where laboratory measurement of clinically relevant endpoints is critical. Our global central laboratories can provide these services worldwide within 24 to 48 hours from the time a patients blood is drawn. In addition, in the first quarter of 2008, we established a collaboration with Peking Union Lawke for central laboratory services in China.
Bioanalytical Laboratories. We provide bioanalytical services through GLP-compliant laboratories in Richmond, Virginia, and Middleton, Wisconsin. Our bioanalytical laboratories analyze biological fluid samples from animal and human clinical studies. The latter studies include those conducted by our Phase I unit as well as those conducted on behalf of our clients from Phase I to IV for drug and metabolite content and concentration. We currently have more than 2,250 validated assays available for our clients use in conducting laboratory analyses. Our laboratories also process fluid samples for preclinical studies. Our bioanalytical methods include liquid chromatography/mass spectrometry (LC/MS), high performance liquid chromatography (HPLC), radioimmunoassay (RIA) and enzyme-linked immunosorbent assay (ELISA). Support services include handling HIV-positive samples, managing data for pharmacokinetic studies from multicenter trials, and archiving samples and data. In early 2008, our service offerings expanded to include complex immunologic assays for the vaccine industry.
cGMP Laboratory. We provide product analysis laboratory services through our cGMP-compliant laboratory in Middleton, Wisconsin. Our product analysis services include inhalation, biopharmaceutics, dissolution, stability and microbiology studies. These studies are necessary to characterize dosage form release patterns and stability under various environmental conditions in the intended package for marketing. These evaluations must be carried out from preclinical testing through Phase IV and the resulting data maintained over the commercial life of a product. New formulations, as well as generics and prescription products going to over-the counter status such that they no longer require physician prescription for consumer use, all require the same set of studies as the original dosage form.
We are one of a few full service companies able to offer our clients the advantages of bioanalytical, biomarker, product analysis and global central laboratory services, as well as Phase I clinical testing.
Phases II IV Clinical Trial Management. The core of our development business is a comprehensive package of services for Phases II IV clinical trials which, in conjunction with our other services, allows us to offer our clients an integrated package of clinical management services. We have significant clinical trials experience in the areas of:
We provide our clients with one or more of the following Phase II IV clinical trial management services:
Study Protocol and Case Report Form Design. The protocol defines the medical issue the study seeks to examine and the statistical methods that will be used. Accordingly, the protocol specifies the frequency and type of laboratory and clinical measures that are to be tracked and analyzed, the number of patients required to produce a statistically valid result, the period of time over which they must be tracked, and the frequency and dosage of drug administration. To be successful and for the product to make it to market, the protocol must fulfill requirements of regulatory authorities. Once the study protocol has been finalized, the case report form, or CRF, must be developed. The CRF is the critical document for investigative sites to record the necessary clinical data as dictated by the study protocol. If necessary, the protocol and CRF change at different stages of a trial. A CRF for one patient in a given study may consist of 100 or more pages. We serve our clients in the critical area of study design by applying our experience in the preparation of study protocols and case report forms and providing the associated study specific training.
Site and Investigator Recruitment. Third-party physicians, referred to as investigators, administer the compound under investigation to patients at hospitals, clinics or other locations, referred to as sites. Investigators implement or test medical devices in similar settings. A significant portion of a trials success depends on the successful identification and recruitment of experienced investigators with an adequate base of patients who satisfy the requirements of the study protocol. We recruit these investigators to participate in clinical trials and have access to several thousand investigators who have conducted clinical trials for us in the past. We work closely with clients to identify investigator sites with a proven record in managing and overseeing clinical studies. We are continually looking for new investigator sites around the world, with the ability to recruit patients in the therapeutic area of trial, complying with GCPs and meeting our quality expectations.
Patient Enrollment. The investigators, with our assistance, find and enroll patients suitable for the study. The speed with which trials can be completed is significantly affected by the rate at which patients are enrolled. Prospective patients are required to review information about the drug or device and its possible side effects, and sign an informed consent form to record their knowledge and acceptance of potential side effects. Patients also undergo a medical examination to determine whether they meet the requirements of the study protocol. Patients then receive the compound and are examined by the investigator as specified by the study protocol.
Study Monitoring and Data Collection. As patients are examined and tests are conducted in accordance with the study protocol, data are recorded on CRFs. Specially trained persons known as monitors visit sites regularly to ensure that CRFs are completed correctly and to verify that the study has been conducted in compliance with the protocol and GCP. We offer electronic data capture, or EDC, technologies, which can significantly enhance both the quality and timeliness of clinical data collection while achieving real time data assessment of trial progress. Our study monitoring and data collection services are designed to comply with the FDAs and other relevant regulatory agencies safety reporting guidelines as well as provide timely reviews for independent data monitoring safety committees. With significant experience conducting large global clinical trials, we have monitored thousands of clinical trials, including many large international trials with hundreds of sites and thousands of patients per trial. Our project management services are key to providing leadership and direction, across our global team, utilizing systems and processes to assure quality, effective delivery and accuracy throughout the project. Our global risk management process addresses potential obstacles, provides strategic intervention solutions and determines escalation pathways for further discussion, if needed.
We monitor our clinical trials in compliance with government regulations and guidelines. We have adopted global standard operating procedures intended not only to satisfy regulatory requirements in the United States and in many foreign countries, but also to serve as a tool for controlling and enhancing the quality of our clinical trials. All of our standard operating procedures comply with good clinical practices, or GCP, requirements and the International Conference on Harmonisation, or ICH, standards. The FDA has adopted these standards in its guidance documents and the members of the European community and Japan have codified these standards into their clinical research regulations. We compile, analyze, interpret and submit data generated during clinical trials to the FDA or other relevant regulatory agencies for purposes of assisting our clients in obtaining regulatory approval. We also provide consulting on the conduct of clinical trials for simultaneous regulatory submissions to multiple countries.
Government Services. We have an extensive history of working with the National Institutes of Health, particularly with the National Institute of Allergy and Infectious Diseases, or NIAID. We have more than 15 years experience working as the clinical site monitoring group for the Division of AIDS, or DAIDS, at NIAID. The initial contract requirements were for monitoring services at domestic sites; however, this has been expanded to include both domestic and international sites as well as GCP training for the sites, laboratory audits and GLP training and quality management. Approximately 80 full-time professional and administrative staff, including registered nurses with experience in monitoring HIV/AIDS therapeutic trials, provide training, quality management and clinical monitoring services to the NIAID, Division of AIDS. Currently this program provides services through more than 700 sites in 43 countries. In connection with our work with NIAID, since 2000, we have conducted nearly 12,500 interim site visits, which involved chart review, pharmacy assessments, site operation assessments, laboratory audits and regulatory file reviews for approximately 900 protocols.
Data Management and Biostatistical Analysis. We provide clients with design input from product development plans, protocol design, CRF design and database development. In addition, we have in-depth experience with EDC systems and our database structures comply with industry established standards and government regulations. We prepare statistical and safety summaries for interim and final analyses, data safety monitoring committees, endpoint adjudication committees and regulatory submissions (including NDAs, BLAs and PMAs).
Medical Writing and Regulatory Services. We provide planning services for product development including preclinical review, consulting and clinical protocol development. These activities are complemented by report writing, program management and other regulatory services designed to reduce overall development time.
Safety/Pharmacovigilance. We provide both pre-approval and post-approval pharmacovigilance services to the pharmaceutical and biotechnology industry. For example, we are now processing an average of more than 3,500 reports per month globally on adverse events that are serious or non-serious events of special interest. We specialize in the real-time processing of event reports necessary for non-biased, independent third-party adjudication, and have managed adjudicated safety studies of up to 25,000 patients.
Post-Approval Services and Market Development Support. We provide custom-designed post-approval services as well as programs to help develop markets for products still under development for pharmaceutical, biotechnology and medical device clients. In 2003, we created a dedicated team of clinical, marketing and health outcomes experts to help companies with pre-launch (Phase II through IIIb) and post-approval (Phase IV) programs to develop products as well as the markets for new products and to extend the market value of existing products. The portfolio of services we offer in this area includes health outcomes, large-volume Phase IV monitored studies, registries and observational studies, medical information, professional contact center services, writing and editorial services, risk management services, Rx-to-OTC switch programs, and online marketing and education.
PPD GlobalView, our proprietary web-based EDC system, has provided our post approval studies with a customizable, intuitive system for investigators to fulfill their trial objectives. Applying advanced technologies and
experience, we combine health outcomes such as epidemiology, psychometrics and economics with clinical research to measure and compare risks, benefits and economic and quality-of-life impacts of drug therapies. Our Phase IV monitoring studies can produce valuable safety and efficacy data analyses as well as provide information for patient education programs. Our registries and observational studies collect real-world data on how a product is used in a non-controlled setting. Data can be used to determine actual prescriber use or treatment patterns, to collect potential safety signals for further investigation, and to evaluate effectiveness and patient quality of life. Our patient adherence programs can optimize real-world outcomes and indicate ways to help enhance proper use of a drug by the physician and patient. We also provide Rx-to-OTC switch programs, transitioning prescription products to OTC programs.
Medical Device Market. We support both pre- and post-approval trials for medical device products in a variety of therapeutic areas with particular focus on interventional cardiovascular trials. We provide expert regulatory consulting along with clinical trial execution, project management, monitoring, data management, biostatistics and medical report writing.
eClinical Initiatives. Our eClinical initiatives offer efficiencies, enhanced quality and improved communications with our clients. We utilize a global project milestone and resource management tool that helps project managers provide efficient and cost-effective study management with quality deliverables. We use our clinical trial management system to provide web-based, real-time access to study data from anywhere in the world, across our Phase II-IV studies. The CTMS system has been enhanced to provide ad hoc reporting capabilities and integration with our internal Interactive Voice/Web Response System, or IVRS/IWRS system. We are continuing to develop system interfaces with internal applications, such as remote data capture, or RDC, and client systems for seamless data transfer. We also provide RDC services using Oracle® Clinicals RDC platform, as well as offer our in-house PPD GlobalView EDC system for post approval trials. We also support use of third party EDC vendors in all phases of clinical trial work. Coupled with PPD Patient Profiles and our biostatistical real time analysis, we offer our clients graphical display of real-time study data and blinded statistical tables and listings on an ongoing basis.
Our PPD DirectConnect web portals are now supporting more than 490 client studies across approximately 136 pharmaceutical, biotechnology, clinical laboratory and government clients. We have more than 8,300 external users of PPD DirectConnect and we should complete our 1,000th DirectConnect site in the first half of 2008. This technology has become a core part of how we provide secure, timely access to key study information to our clients. We continue to expand our use of a web-based document management system across the enterprise. This system enables us to utilize resources across disparate locations through the use of workflow automation, electronic signatures and content sharing for global project and departmental teams.
During 2007, we continued enhancing our post-approval EDC system, PPD GlobalView and our event tracking and electronic adjudication system, PPD GlobalView EventNet. Our focus has been on providing new features that allow immediate access to on-line datasets and interactive safety reports, as well as automating our CRF generation tools. PPD Global View systems provide our registries and observational studies group with key study metrics and tracking functionality while providing research investigators a reliable, easy to use data collection system for large post-approval global studies.
Informatics. Our informatics division, known as CSS Informatics, delivers specialized software products and technical consulting services to support many aspects of the pharmaceutical research and development process, including drug discovery, clinical trials, regulatory review and pharmacovigilance. Our informatics clients include international and domestic pharmaceutical and biotechnology companies and government agencies, including the FDA. Our current informatics software products include:
A primary focus of our informatics division is to provide consulting services to help pharmaceutical, biotechnology and medical device companies assess and resolve clinical data management and safety system challenges, such as integrating and customizing systems, migrating clinical and safety data, providing computer systems validation services that include compliance evaluation, and updating or replacing legacy systems to meet regulatory guidance. We provide expertise on the Oracle Life Sciences suite of products with a full range of support services including installation, training, validation, technical support and custom development. Also, leveraging the PPD technical infrastructure, we provide application service provider, or ASP, hosting services for the entire Oracle Life Sciences suite of products.
Clients and Marketing
We provide a broad range of discovery and development services and products to help pharmaceutical, biotechnology and medical device companies as well as academic and government organizations develop compounds, drugs and devices, and gain regulatory approval in the markets in which they plan to sell these products. We believe PPD is recognized among our clients as a leading global contract research organization.
Client Identification and Mix
Our Development Group provides Phase I through Phase IV clinical development and post-approval services. We market these services in the Americas, Europe, Middle East, Africa, and Asia Pacific. The key differentiators that help us win development business from pharmaceutical and biotechnology companies and academic and government organizations include our global infrastructure, quality-driven execution based on ongoing training, quality assurance and control practices, and cross-functional groups with dedicated therapeutic expertise. Through our medical device development group, we offer clinical trial services and regulatory expertise to device companies, including a number of the leading cardiovascular device manufacturers and pharmaceutical companies developing adjunct therapies. In addition, our post-approval services combine clinical, marketing and health outcomes expertise to help pharmaceutical, biotechnology and device companies implement a wide range of strategies to capitalize on the strengths of products and maximize their life cycle.
From a geographic perspective, 63.0% of our Development Groups net revenue in 2007 was derived from the United States, with the balance primarily coming from Europe. For additional information on the geographic distribution of our net revenue, see Note 17 in the Notes to Consolidated Financial Statements included elsewhere in this report.
Our Discovery Sciences Group offers services and technologies to select drug candidates for clinical evaluation. This group primarily targets clients in the pharmaceutical and biotechnology industries. In addition, we perform research on compounds that we own or license through our compound partnering relationships. For the year ended December 31, 2007, all of our Discovery Sciences Group revenue was generated in the United States.
For the year ended December 31, 2007, total net revenue for all of our services was derived from various industries approximately as follows:
For purposes of classifying net revenue, we define pharmaceutical to include companies with the majority of their research and development related to chemical entities, and biotechnology to include companies with the majority of their research and development related to biologically engineered compounds. Other includes companies primarily focused upon medical devices, diagnostics and generic formulations. We refer to the Standard Industry Classification, or SIC, codes for publicly traded companies to determine their classification.
Concentration of business among large clients is not uncommon in our industry. Our diverse client mix, in which no single client in 2007 accounted for more than 10% of our net revenue, limits our exposure to significant risks associated with industry consolidation and major product cancellations. However, we have experienced higher concentration in the past and might experience it in the future. Approximately 39.7% of our 2007 net revenue was derived from clients headquartered outside the United States, in particular in Europe and Japan. Approximately 36.5% of our 2007 net revenue was generated from services provided by our employees located in countries outside the United States. See Note 17 in the Notes to Consolidated Financial Statements included elsewhere in this report for the breakdown of this revenue.
With a primary focus on large pharmaceutical and biotechnology companies, we promote our preclinical services through concentrated business development efforts, scientist-to-scientist communications and centralized corporate marketing programs. In addition, we believe our reputation assists in securing repeat business and new clients for our specialized preclinical oncology lab.
For our development services and products, we use corporate marketing to support the efforts of our centralized business development staff calling on pharmaceutical, biotechnology and device companies. Our sales teams focus on client segments and service areas. In addition, while service area representatives call on particular functional groups within a given biopharmaceutical or device client, our general account managers are responsible for coordinating our provision of services to the client across our portfolio of services.
The top 25 publicly traded pharmaceutical companies ranked by research and development expenses in 2006 accounted for 97% of pharmaceutical research and development spending in 2006 so we concentrate on these companies. The top 50 publicly traded biotechnology companies accounted for nearly 51% of the biotechnology research and development expenditures in 2006. To appropriately focus our sales and marketing efforts among biotechnology companies, we consider additional factors such as the stage of a drugs development and the financial stability of a potential clients business.
Our business development personnel consult with potential pharmaceutical and biotechnology clients early in the project consideration stage in order to determine their requirements. Along with the appropriate operational, technical or scientific personnel, our business development representatives invest significant time to determine the optimal means to design and execute the potential clients program requirements. As an example, recommendations we make to a potential client with respect to a drug development study design and implementation are an integral part of our bid proposal process and an important aspect of the integrated services we offer. Our preliminary efforts relating to the evaluation of a proposed clinical protocol and implementation plan enhance the opportunity for accelerated initiation and overall success of the trial.
Our global marketing initiatives include a mix of advertising, direct response, online promotion, trade events and scientific outreach programs. We integrate client representations and sales materials, a global speakers
bureau, media relations, marketing at professional trade shows and corporate materials to reinforce key messages and selling points. Web-based activities include online advertising, interactive education and information programs delivered by web cast, direct e-mail campaigns and electronic newsletters. In 2007, we enhanced our corporate website, www.ppdi.com, to include an updated design and navigation for our services area, enabling visitors to quickly understand the full spectrum of our offerings. The implementation of a robust, user-friendly video portal allows visitors to hear from us and industry experts, take a virtual tour of a PPD facility and hear the latest in financial webcasts. In addition, we encourage and sponsor the participation of our scientific and technical personnel in a variety of professional endeavors, including the presentation of papers at national and international professional trade meetings and the publication of scientific articles in medical and pharmaceutical journals. Through these presentations and publications, we seek to further our reputation for professional excellence.
Our backlog consists of anticipated net revenue from contracts, letters of intent and verbal commitments that either have not started but are anticipated to begin in the near future, or are in process and have not been completed. Amounts included in backlog represent anticipated future net revenue and exclude net revenue that has been recognized previously in our statement of operations. Net revenue is defined as gross revenue, less fees and associated reimbursements. Once contracted work begins, net revenue is recognized over the life of the contract. Our backlog was $2.7 billion in anticipated net revenue at December 31, 2007, compared to $2.2 billion at December 31, 2006.
Our backlog as of any date is not necessarily a meaningful predictor of future results because backlog can be affected by a number of factors, including the size and duration of contracts, many of which are performed over several years, and the changes in labor utilization that typically occur during a study. Additionally, contracts relating to our clinical development business are subject to early termination by the client and clinical trials can be delayed or canceled for many reasons, including unexpected test results, safety concerns or regulatory developments. Also, the scope of a contract can change significantly during the course of a study. If the scope of a contract is revised, the adjustment to backlog occurs when the revised scope is approved by the client. For these and other reasons, we might not fully realize our entire backlog as net revenue.
Patents, trademarks, copyrights and other proprietary rights are important to our business. We also rely on trade secrets, know-how, continuing technological innovations and licensing opportunities to develop and maintain our competitive position.
We actively seek patent protection both in the United States and abroad. As of December 31, 2007, we owned or co-owned 29 issued U.S. patents and 25 pending U.S. patent applications. Our issued U.S. patents primarily relate to our proprietary antitumor compounds, dapoxetine and methods of its use, and our biomarkers and methods of their use. Our pending U.S. patent applications primarily relate to proprietary biomarker discovery information, chemical compounds, clinical development business methods and software. We have filed or plan to file applications in other countries corresponding to most of our U.S. applications. As of December 31, 2007, we had 53 granted and 40 pending foreign filings.
We also have obtained licenses to other patents from academic institutions and pharmaceutical companies. As of December 31, 2007, we had exclusive license rights to 2 issued U.S. patents and 10 granted foreign filings, as well as 3 pending U.S. patents and 61 pending foreign filing.
Pursuant to the terms of the Uruguay Round Agreements Act, patents issued from applications filed on or after June 8, 1995, have a term of 20 years from the date of filing, no matter how long it takes for the patent to issue. Because patent applications in the pharmaceutical industry often take a long time to issue, this method of patent term calculation can result in a shorter period of patent protection afforded to us compared to the prior method of term calculation, which was 17 years from the date of issue. Under the Drug Price Competition and Patent Term Restoration Act of 1984 and the Generic Animal Drug and Patent Term Restoration Act of 1988, a patent that claims
a product, use or method of manufacture covering drugs may be extended for up to five years to compensate the patent holder for a portion of the time required for FDA review. However, we might not be able to take advantage of the patent term extension provisions of this law.
In addition, we rely on trade secrets and continuing technological innovation, which we try to protect with reasonable business procedures for maintaining trade secrets, including confidentiality agreements with our collaborators, employees and consultants. We also have numerous trademark registration applications pending in the United States and other jurisdictions throughout the world.
The drug and medical device development outsourcing industry is highly competitive and fragmented, consisting of hundreds of smaller, limited-service providers and a number of full-service global development companies. In the past, the industry experienced some consolidation and a group of large, full-service competitors emerged, and consolidations and acquisitions have continued. For example, in 2006, Covance acquired Radiant Research, a multi-site domestic Phase I/IIA business, and PRA International, Inc. acquired Pharma Bio-Research (PBR), a Phase I/IIA clinical development company based in the Netherlands. Also in 2006, Kendle International, Inc. acquired the Phase II-IV clinical business of Charles River Laboratories International, Inc., and PAREXEL International Corporation acquired California Clinical Trials Medical Group, Inc. and Behavioral and Medical Research, adding a broad range of Phase I-IV clinical research services. These consolidations and other transactions, such as the acquisition of PRA International by Genstar Capital, a private equity firm, could potentially increase competition in our industry for clients, experienced clinical personnel, geographic markets and acquisition candidates. Additional business combinations by competitors or clients are possible and could have a significant impact on the competitive landscape of the drug development outsourcing industry.
In addition to competing with a number of other global, full-service companies, our Development Group and Discovery Sciences Group also compete against some medium-sized companies, in-house research and development departments of pharmaceutical and biotechnology companies, universities and teaching hospitals. Newer, smaller entities with specialty focuses, such as those aligned to a specific disease or therapeutic area, compete aggressively against larger companies for clients. Increased competition might lead to price and other forms of competition that could adversely affect our operating results.
Providers of outsourced drug and medical device development services compete on the basis of a number of factors. These factors include:
Over the past few years, our clients have increasingly pursued preferred provider agreements under which development services providers compete for selection as a vendor, with only a limited number of providers being chosen and therefore eligible to win future business from the client. While selection under such agreements is no guarantee of business, larger, established service providers have benefited significantly from these arrangements. In addition, providing clinical development services can be labor-intensive and we compete for a limited pool of professionals to provide these services. Although there can be no assurance that we will continue to do so, we believe we compete favorably in these areas.
Despite recent consolidation, this industry remains highly fragmented, with several hundred smaller, limited-service providers and a small number of full-service companies with global capabilities. Although there are few barriers to entry for smaller, limited-service providers, there are significant barriers to becoming a global provider offering a broad range of services. These barriers include:
For specialty areas such as drug information and post-marketing services, informatics and analytical laboratory services, our Development Group competes in a market that has a myriad of niche providers as well as larger, established firms. For the most part, these niche providers offer specialty services with a focus on a specific geographic region, a particular service or function and/or a specific stage or phase of drug development. By contrast, we provide our services on a global basis across functional areas.
The outsourced preclinical research industry consists of a number of large providers and numerous smaller niche companies. Our Discovery Sciences Group faces significant competition from these companies, as well as competition from research teams funded internally by pharmaceutical and biotechnology companies. Our compound risk-sharing initiatives seek to help our clients increase the return on their research and development investments by sharing development costs and risks as well as potential future revenue streams from successful product launches. Many of these clients search for a collaborative partner through a competitive bidding process, which can include pharmaceutical, biotechnology and discovery platform and services companies, as well as venture capital and private equity firms and financial institutions. As such, there is significant competition for these opportunities and our success will depend on our ability to identify and competitively bid for risk-sharing programs that are likely to be productive.
Our clients are subject to extensive regulations by government agencies. Consequently, the services we provide for these clients must comply with relevant laws and regulations.
Prior to commencing human clinical trials in the United States, a company developing a new drug must file an IND with the FDA. The IND must include information about animal toxicity and distribution studies, manufacturing and control data, stability data and a clinical development plan for the product, and a study protocol for the initial proposed clinical trial of the drug or biologic in humans. If the FDA does not object within 30 days after the IND is filed, human clinical trials may begin. The study protocol must be reviewed and approved by the institutional review board, or IRB, in each institution in which a study is conducted and each IRB may impose additional requirements on the way in which the study is conducted in its institution.
Human trials usually start on a small scale to assess safety and then expand to larger trials to test both efficacy and safety in the target population. The trials are generally conducted in three phases, which sometimes overlap, although the FDA may require a fourth phase as a condition of approval. After the successful completion of the first three clinical phases, a company requests approval for marketing its product by submitting an NDA for a drug or a BLA for a biologic. The NDA/BLA is a comprehensive, multivolume filing that includes, among other things, the results of all preclinical and clinical studies, information about how the product will be manufactured and tested, additional stability data and proposed labeling. The FDAs review can last from several months to multiple years, with the median approval time lasting approximately 13 months. Once the NDA/BLA is approved, the product may be marketed in the United States subject to any conditions imposed by the FDA as part of its approval. In addition, pursuant to the FDA Act that was signed into law in September 2007, the FDA can require drug companies to conduct post-approval clinical trials and implement risk evaluation and mitigation strategies.
Laboratories such as ours that provide information included in IND applications and NDAs must conform to regulatory requirements that are designed to ensure the quality and integrity of the testing process. For example, our bioanalytical laboratories in Richmond, Virginia, and Middleton, Wisconsin, follow the FDAs GLPs. These GLPs have also been adopted by the Ministry of Health in the United Kingdom and by similar regulatory authorities in other countries. Our product analysis lab in Middleton, Wisconsin, also follows the FDAs cGMPs. Both GLPs and cGMPs require standardization procedures for all equipment, processes and analytical tests, for recording and reporting data, and for retaining appropriate records. To help ensure compliance with GLPs and cGMPs, we have established quality assurance at our laboratory facilities to audit test data and we conduct regular inspections of testing procedures and our laboratory facilities.
In addition, laboratories that analyze human blood or other biological samples for the diagnosis and treatment of study subjects must comply with the Clinical Laboratory Improvement Act, or CLIA. CLIA requires laboratories to meet staffing, proficiency and quality standards. The laboratory in our Austin, Texas, facility and our central laboratory located in Kentucky are CLIA-certified. Both of these laboratories and our central laboratory in Europe are accredited by the College of American Pathologists.
The industry standard for the conduct of clinical research is embodied in the FDAs regulations for IRBs, investigators and sponsor/monitors, which collectively are termed good clinical practices, or GCPs, by industry and the GCP guidelines issued by ICH, which have been agreed upon by industry and regulatory representatives from the United States, EU and Japan. Our global standard operating procedures are written in accordance with all FDA and ICH requirements. This enables our work to be conducted locally, regionally and globally to standards that meet all currently applicable regulatory requirements.
In the past several years, both the U.S. and foreign governments have become more concerned about the disclosure of confidential personal data. The EU prohibits the disclosure of personal confidential information, including medical information, to any entity that does not comply with certain security safeguards. Companies in the United States can satisfy these requirements by filing for safe harbor status according to a self-certification procedure agreed to by the EU and the United States. We registered for and have obtained this safe harbor status.
We are also subject to regulations enforced by the following agencies, among others:
We also must comply with other related international, federal, state and local regulations that govern the use, handling, disposal, packaging, shipment and receipt of certain drugs or unknown compounds, chemicals and chemical waste, toxic substances, bloodborne pathogens and bloodborne pathogen waste, and radioactive materials and radioactive waste. In order to comply with these regulations, we have provided procedures, necessary equipment and ongoing training for our employees involved in these activities. To date, we have had no citations or fines from the above agencies.
The failure on our part to comply with applicable regulations could result in the termination of ongoing research or the disqualification of data for submission to regulatory authorities. Furthermore, the issuance of a notice of finding by a governmental authority against either us or our clients, based upon a material violation by us of any applicable regulation, could materially and adversely affect our business.
At December 31, 2007, we employed approximately 10,200 professionals, of whom approximately 9,950 were in the Development Group, approximately 100 were in the Discovery Sciences Group and the remainder served in corporate operations functions. Of our staff, approximately 630 hold Ph.D., M.D., Pharm.D. or D.V.M. degrees and approximately 1,510 hold other masters or other postgraduate degrees. None of our employees are subject to a collective bargaining agreement. We believe that our relations with our employees are good.
We believe that our success is based on the quality and dedication of our employees. We strive to hire the best available people in terms of ability, experience, attitude and fit with our performance philosophy and standard operating procedures. We train new employees extensively and we believe we are an industry leader in the thoroughness of our training programs. In addition, we encourage our employees to continually grow and broaden their skills through internal and external training programs.
Our web site address is www.ppdi.com. Information on our web site is not incorporated by reference herein. We make available free of charge through our web site our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission.
Risks Related to Our Discovery and Development Businesses
Changes in trends in the pharmaceutical and biotechnology industries could adversely affect our operating results.
Industry trends and economic and political factors that affect pharmaceutical, biotechnology and medical device companies and academic and government entities that sponsor clinical research, also affect our business. For example, the practice of many companies in these industries and government organizations has been to hire companies like us to conduct large development projects. If these industries reduce their tendency to outsource those projects, our operations, financial condition and growth rate could be materially and adversely affected. In the past, mergers, product withdrawal and liability lawsuits, and other factors in the pharmaceutical industry appear to have slowed decision-making by pharmaceutical companies and delayed drug development projects. Continuation or increases in these trends could have an adverse effect on our business. In addition, numerous governments have undertaken efforts to control growing healthcare costs through legislation, regulation and voluntary agreements with medical care providers and pharmaceutical companies. If future cost-containment efforts limit the profits that can be derived on new drugs, our clients might reduce their drug discovery and development spending, which could reduce our revenue and have a material adverse effect on our results of operations.
Our revenue depends on a small number of industries and clients.
We provide services to the pharmaceutical, biotechnology and medical device industries and academic and government organizations that sponsor clinical trials, and our revenue is highly dependent on expenditures by these clients. Accordingly, our operations could be materially adversely affected by consolidation in these industries or other factors resulting in a decrease in the number of our potential clients. For example, we experienced longer payment terms in 2007, which increased our days sales outstanding, or DSO, in accounts receivable and unbilled services, net of unearned income. If the number of our potential clients declines even further, they might be able to negotiate price discounts or other terms for our services that are less favorable to us than has historically been the case. We have experienced client concentration in the past and could again in the future. The loss of business from a significant client could have a material adverse effect on our results of operations.
The majority of our clients contracts can be terminated upon short notice.
Most of our contracts for discovery and development services are terminable by the client upon 30 to 90 days notice. Clients terminate or delay their contracts for a variety of reasons, including but not limited to:
The loss or delay of a large contract or multiple smaller contracts could adversely affect our operating results.
We might not be able to recruit and retain the experienced personnel we need to compete in the drug discovery and development industry.
Our future success depends on our ability to attract, retain and motivate highly skilled personnel.
Our future success depends on the personal efforts and abilities of the principal members of our senior management and scientific staff to provide strategic direction, develop business, manage our operations, and maintain a cohesive and stable work environment. For example, we rely on the services of Fredric N. Eshelman, Pharm.D., our chief executive officer. In addition, we hired a number of new senior employees during 2007, including Chief Operating Officer, William Sharbaugh, and Chief Financial Officer, Daniel Darazsdi, so their integration into our company has been and will continue to be critical to our success. Although we have employment agreements with most of our executives, they are generally only for one or two years and do not assure that Dr. Eshelman or any other executive with whom we have an employment agreement will remain with us. We do not have employment agreements with all of our key personnel.
Our ability to maintain, expand or renew existing business with our clients and to get business from new clients, particularly in the drug development sector, depends on our ability to subcontract and retain healthcare providers with the skills necessary to keep pace with continuing changes in drug development technologies. Competition for experienced healthcare providers is intense. We compete with pharmaceutical and biotechnology companies, including our clients and collaborators, other contract research companies, and academic and research institutions, to recruit healthcare providers.
Scientists and Other Technical Professionals
Our ability to maintain, expand or renew existing business with our clients and to get business from new clients in both the drug development and the drug discovery areas also depends on our ability to hire and retain scientists with the skills necessary to keep pace with continuing changes in drug discovery and development technologies. We face the same risks, challenges and competition in attracting and retaining experienced scientists as we do with healthcare providers.
Our inability to hire additional qualified personnel might also require an increase in the workload for both existing and new personnel. We might not be successful in attracting new healthcare providers, scientists or management, or in retaining or motivating our existing personnel. The shortage of experienced healthcare providers and scientists, or other factors, might lead to increased recruiting, relocation and compensation costs for these professionals, which might exceed our forecasts. These increased costs might reduce our profit margins or make hiring new healthcare providers or scientists impracticable. If we are unable to attract and retain any of these personnel, our ability to execute our business plan will be adversely affected.
Our future success depends on our ability to keep pace with rapid technological changes that could make our services less competitive or obsolete.
The biotechnology, pharmaceutical and medical device industries generally and drug discovery and development more specifically are subject to increasingly rapid technological changes. Our competitors or others might develop technologies, services or products that are more effective or commercially attractive than our current or future technologies, services or products, or that render our technologies, services or products less competitive or obsolete. If competitors introduce superior technologies, services or products and we cannot make enhancements to ours to remain competitive, our competitive position, and in turn our business, revenue and financial condition, would be materially and adversely affected.
Any failure by us to comply with existing regulations could harm our reputation and operating results.
Any failure on our part to comply with existing regulations could result in the termination of ongoing research or the disqualification of data for submission to regulatory authorities. This would harm our reputation, our prospects for future work and our operating results. For example, if we were to fail to verify that informed consent is obtained from patient participants in connection with a particular clinical trial or grant deviations from the inclusion or exclusion criteria in a study protocol, the data collected from that trial could be disqualified and we might be required to conduct the trial again at no further cost to our client, but at a substantial reputational and financial cost to us. Furthermore, the issuance of a notice from the FDA based on a finding of a material violation by us of good clinical practice, good laboratory practice or good manufacturing practice requirements could similarly materially and adversely affect us.
Proposed and future legislation or regulations might increase the cost of our business or limit our service or product offerings.
Federal or state authorities might adopt healthcare legislation or regulations that are more burdensome than existing regulations. For example, recent product safety concerns and the creation of the Drug Safety Oversight Board could change the regulatory environment for drug products, including the process for FDA product approval and post-approval safety surveillance. These and other changes in regulation could increase our expenses or limit our ability to offer some of our services or products. For example, the confidentiality of patient-specific information and the circumstances under which it may be released for inclusion in our databases or used in other aspects of our business are subject to substantial government regulation. Additional legislation or regulation governing the possession, use and dissemination of medical record information and other personal health information might require us to implement new security measures that require substantial expenditures or limit our ability to offer some of our services. These regulations might also increase costs by creating new privacy requirements for our informatics business and mandating additional privacy procedures for our clinical research business.
We might lose business opportunities as a result of healthcare reform.
Numerous governments have undertaken efforts to control growing healthcare costs through legislation, regulation and voluntary agreements with healthcare providers and drug companies. Healthcare reform could reduce demand for our services, including potential drug candidates that are being developed by us or with others under our risk-sharing agreements, and, as a result, our revenue. In recent years, the U.S. Congress has reviewed several comprehensive health care reform proposals. The proposals are intended to expand healthcare coverage for the uninsured and reduce the growth of total healthcare expenditures. The U.S. Congress has also considered and may adopt legislation that could have the effect of putting downward pressure on the prices that pharmaceutical and biotechnology companies can charge for prescription drugs. The Democratic Party having taken control of Congress in 2006 and potentially of the White House in 2008, increases the possibility of healthcare reform. Any such legislation could cause our discovery and development clients to spend less on research and development. If this were to occur, we would have fewer business opportunities for our development and discovery service businesses, which could reduce our earnings, and the development of particular compounds might be discontinued. Similarly, pending or future healthcare reform proposals outside the United States could negatively impact our revenue from our international operations.
The drug discovery and development services industry is highly competitive.
The drug discovery and development services industry is highly competitive. We often compete for business not only with other drug discovery and development companies, but also with internal discovery and development departments within our clients, some of which are large pharmaceutical and biotechnology companies with greater resources than we have. We also compete with universities and teaching hospitals. If we do not compete successfully, our business will suffer. The industry is highly fragmented, with numerous smaller specialized companies and a handful of full-service companies with global capabilities similar to ours. Increased competition might lead to price and other forms of competition that might adversely affect our operating results. As a result of competitive pressures, our industry experienced consolidation, including going private transactions, in recent years. This trend is likely to produce more competition from the resulting larger companies, and ones without the cost pressures of being public, for both clients and acquisition candidates. In addition, there are few barriers to entry for smaller specialized companies considering entering the industry. Because of their size and focus, these companies might compete effectively against larger companies such as us, which could have a material adverse impact on our business.
Our business has experienced substantial expansion in the past and we might not properly manage that expansion in the future.
Our business has expanded substantially in recent years. Rapid expansion could strain our operational, human and financial resources and facilities. If we fail to properly manage our expansion, our results of operations and financial condition might be negatively affected. In order to manage expansion, we must, among other things, do the following:
In addition, we have numerous business groups, subsidiaries and divisions. If we cannot properly manage these groups, subsidiaries or divisions, it will disrupt our operations. We also face additional risks in expanding our foreign operations. Specifically, we might find it difficult to:
Future acquisitions or investments could disrupt our ongoing business, distract our management and employees, increase our expenses and adversely affect our business.
We anticipate that a portion of any future growth of our business might be accomplished by acquiring existing businesses, products or technologies. The success of any acquisition will depend upon, among other things, our ability to integrate acquired personnel, operations, products and technologies into our organization effectively, to retain and motivate key personnel of acquired businesses and to retain their clients. In addition, we might not be able to identify suitable acquisition opportunities or obtain any necessary financing on acceptable terms. We might also spend time and money investigating and negotiating with potential acquisition or investment targets, but not complete the transaction. Any future acquisition could involve other risks, including the assumption of additional liabilities and expenses, issuances of potentially dilutive equity securities or interest-bearing debt, transaction costs, reduction in our stock price as a result of any of these or because of market reaction to a transaction and diversion of managements attention from other business concerns.
We have made and plan to continue to make investments in other companies. In many cases, there is no public market for the securities of these companies and we might not be able to sell these securities on terms acceptable to us, if at all. In addition, if these companies encounter financial difficulties, we might lose all or part of our investment. For example, in 2007 we recorded an impairment of equity investment, totaling $0.7 million to write down the carrying value of our investments for other-than-temporary declines in value. See Note 6 in the Notes to Consolidated Financial Statements included elsewhere in this report for a more detailed discussion of these impairments.
The investment of our cash balance and our investments in marketable debt securities are subject to risks which may cause losses and affect the liquidity of these investments.
At December 31, 2007, we had $171.4 million in cash and cash equivalents and $331.0 million in investments in marketable debt securities. We have historically invested these amounts in U.S. government obligations, guaranteed student loans, municipal notes, corporate notes and bonds, commercial paper, certificates of deposit and money market funds meeting our investment criteria. These investments are subject to general credit, liquidity, market and interest rate risks, which may be exacerbated by the recent U.S. sub-prime mortgage defaults that have affected various sectors of the financial markets and caused credit and liquidity issues. During the year ended December 31, 2007, we determined that any declines in the fair value of our investments were temporary. There may be further declines in the value of these investments, which we may determine to be other-than-temporary. These market risks might have a material adverse effect on our liquidity and financial condition, which could harm our business or our ability to pay dividends or repurchase stock.
At February 22, 2008, we held approximately $238.0 million of municipal notes and student loans as investments. We classified these investments as current assets. These investments have an auction reset feature and are commonly referred to as auction rate securities. This year through February 22, auctions for approximately $123.3 million of our auction rate securities failed, which means that the parties wishing to sell securities were unable to do so. While auctions for some of our other auction rate securities were successful, future auctions might fail. If future auctions fail for any of our investments, our ability to liquidate these investments and fully recover their carrying value in the near term may be limited or non-existent. If the issuers are unable to successfully close future auctions and their credit ratings deteriorate, we may in the future be required to record an impairment charge on these investments. If auctions continue to fail, it could take until the final maturity of the underlying securities (up to 35 years) if we are ever to realize our investments recorded value. These factors might have a material adverse effect on our liquidity and financial condition, which could harm our business or our ability to pay dividends or repurchase stock.
The fixed price nature of our development contracts could hurt our operating results.
The majority of our contracts for the provision of development services are at fixed prices or fixed unit prices, and as such have set limits on the amounts we can charge for our services. As a result, variations in the timing and progress of large contracts can materially affect our operating results. In addition, we bear the risk of cost overruns unless the scope of activity is revised from the contract specifications and we are able to negotiate a contract modification with the client shifting the additional cost to the client. If we fail to adequately price our contracts in total or at the unit level, or if we experience significant cost overruns, our operating results could be materially adversely affected. From time to time, we have had to commit unanticipated resources to complete projects, resulting in lower gross margins on those projects. We might experience similar situations in the future, which could have a material adverse impact on our operating results.
If we are unable to attract suitable willing investigators and volunteers for our clinical trials, our development business might suffer.
The clinical research studies we run in our Development Group rely upon the ready accessibility and willing participation of physician investigators and volunteer subjects. Investigators are typically located at hospitals, clinics or other sites and supervise administration of the study drug to patients during the course of a clinical trial. Volunteer subjects generally include people from the communities in which the studies are conducted, including our Phase I clinic in Austin, Texas, which to date has provided a substantial pool of potential subjects for research studies. Our clinical research development business could be adversely affected if we were unable to attract suitable and willing investigators or volunteers on a consistent basis.
Our business exposes us to potential liability for personal injury claims that could affect our financial condition.
Our business involves the testing of new drugs and medical devices on human volunteers and, if marketing approval is received for any of our drug candidates, their use by patients. This exposes us to the risk of liability for personal injury or death to patients resulting from, among other things, possible unforeseen adverse side effects or improper administration of a drug or device. Many of these volunteers and patients are already seriously ill and are at risk of further illness or death. For example, beginning in early 2007, we have been named as a co-defendant in various lawsuits alleging injuries to patients who took Sanofi-Avertis FDA-approved antibiotic Ketek, for which we provided certain clinical trial services. If we were required to pay damages or incur defense costs in connection with any personal injury claim that is outside the scope of indemnification agreements we have with clients and collaborative partners, if any indemnification agreement is not performed in accordance with its terms or if our liability exceeds the amount of any applicable indemnification limits or available insurance coverage, we could be materially and adversely affected both financially and reputationally. We might also not be able to get adequate insurance for these risks at reasonable rates in the future.
Our business uses biological and hazardous materials, which could injure people or violate laws, resulting in liability that could hurt our financial condition and business.
Our drug discovery and development activities involve the controlled use of potentially harmful biological materials, as well as hazardous materials, chemicals and various radioactive compounds. We cannot completely eliminate the risk of accidental contamination or injury from the use, storage, handling or disposal of these materials. In the event of contamination or injury, we could be held liable for damages that result, and any liability could exceed our ability to pay. Any contamination or injury could also damage our reputation, which is critical to getting new business. In addition, we are subject to federal, state and local laws and regulations governing the use, storage, handling and disposal of these materials and specified waste products. The cost of compliance with these laws and regulations is significant and if changes are made to impose additional requirements, these costs could increase and have an adverse impact on our financial condition and results of operations.
Our business is subject to international economic, currency, political and other risks that could negatively affect our revenue and results of operations.
Because we provide our discovery and development services worldwide, our business is subject to risks associated with doing business internationally. Our revenue from our non-U.S. operations represented approximately 36.5% of our total revenue for the year ended December 31, 2007. We anticipate that revenue from international operations will grow in the future. Accordingly, our future results could be harmed by a variety of factors, including:
For example, in 2007 our income from operations was negatively impacted by approximately $10.9 million, net of hedging loss, due to the effect of the weakening of the U.S. dollar relative to the euro, British pound and Brazilian real. Although we attempt to manage this risk through provisions in our contracts with our clients and other methods, including foreign currency hedging contracts, we might not be able to eliminate or manage these risks in the future and our income from operations could be materially and adversely affected by a significant decline in the value of the U.S. dollar.
Our inability to adequately protect our intellectual property rights could hurt our business.
Our success will depend in part on our ability to protect the proprietary software, compositions, processes and other technologies we develop during the drug development process. In addition, one of our business strategies is to in-license and/or out-license rights to drug candidates and enter into collaborations with pharmaceutical and biotechnology companies for the development of proprietary drug candidates. Any inability to protect our intellectual property rights could materially and adversely affect our business.
Any patents that we own or license might not provide valuable protection in the future for the covered technology or products. Our patent applications might never result in the issuance of a patent. Competitors might develop similar products or methods that are not covered by our issued patent claims. In addition, an issued patent might be narrowed or invalidated by a court challenge. The value of an issued patent could also be diminished if a patent is issued to a competitor that blocks our ability to use our patented technology. If blocked, we might be forced to stop using some or all of the technology or to license technology from third parties on unfavorable terms.
In addition to patent protection, we also rely on copyright, trademark and trade secret protection. In an effort to maintain the confidentiality and ownership of our intellectual property, we require our employees, consultants and advisors to execute confidentiality and proprietary information agreements. These agreements and other procedures, however, might not provide us with adequate protection against improper use or disclosure of confidential information. Also, there might not be adequate remedies in the event of unauthorized use or disclosure. Furthermore, from time to time we hire scientific personnel formerly employed by other companies involved in one or more areas similar to the activities we conduct. In some situations, our confidentiality and proprietary information agreements might conflict with, or be subject to, the rights of third parties with whom our employees, consultants or advisors have prior employment or consulting relationships. Although we require our employees and consultants to maintain the confidentiality of all confidential information of previous employers, both the company and these individuals might be subject to allegations of trade secret misappropriation or other similar claims as a result of their prior affiliations. Finally, others might independently develop substantially equivalent proprietary information or otherwise gain access to our trade secrets. Our failure to protect our proprietary information and techniques might inhibit or limit our ability to exclude competitors from the market and to execute our business strategies.
The drug discovery and development industry has a history of patent and other intellectual property litigation, and we might be involved in costly intellectual property lawsuits.
The drug discovery and development industry has a history of patent and other intellectual property litigation and these lawsuits will likely continue. Because we provide many different services in this industry and have rights to compounds, we face potential patent infringement suits by companies that have patents for similar products and methods used in business or other suits alleging infringement of their intellectual property rights. In addition to the possibility of having to defend an infringement claim asserted against us, in order to protect or enforce our intellectual property rights, we might have to initiate legal proceedings against third parties. Legal proceedings relating to intellectual property could be expensive, take significant time and divert managements attention from other business concerns, whether we win or lose. The cost of this kind of litigation could affect our profitability. Further, if we do not prevail in an infringement lawsuit brought against us, we might have to pay substantial damages, including treble damages, and we could be required to stop the infringing activity or obtain a license to use technology on unfavorable terms.
We have relatively limited experience in the drug discovery business, and our prospects for success in this business remain uncertain and are dependent on third parties with whom we collaborate.
It takes many years for a drug discovery business like ours to generate revenue and income. We established our drug discovery group in 1997 and have relatively limited experience with these activities and might not be successful in our drug discovery efforts. Generating revenue and income from our drug discovery business and compound partnering activities will depend on our ability to:
Since 1997, we have entered into collaborative agreements to develop and commercialize drugs with others. Our ability to succeed in our drug discovery business will depend on successfully executing existing and new arrangements we enter into for the development and commercialization of drug candidates. The third parties that we collaborate with might not perform their obligations as expected or they might breach or terminate their agreements with us or otherwise fail to conduct their collaborative activities successfully and in a timely manner. Further, parties collaborating with us might elect not to develop the product candidates or not to devote sufficient resources to the development, manufacture, regulatory strategy and approvals, marketing or sale of these product candidates. If the parties to our collaborative agreements do not fulfill their obligations, elect not to develop a candidate or fail to devote sufficient resources to it, we could be materially and adversely affected.
We are dependent on third parties for essential business functions for our risk-sharing arrangements and failures of these third party providers could materially adversely affect our business, financial condition and results of operations.
We and some of our collaborative partners are dependent on third parties for functions associated with the development and commercialization of our potential drug candidates, including manufacturing and marketing and sales. Our dependence on third parties for these services might adversely affect us and our ability to develop and commercialize a drug candidate on a timely and competitive basis. If we or our collaborative partners are unable to retain or replace third-party providers of required services on commercially acceptable terms, our potential drug candidates might be delayed and might not be developed and commercialized as planned, if at all. If we encounter delays or failures by these third parties to perform, we might have to seek alternative sources of supply, lose sales or abandon a drug candidate, and our business, financial condition and results of operations could be materially and adversely affected.
We might not be able to obtain government approval for our product candidates.
The development and commercialization of pharmaceutical products are subject to extensive governmental regulation in the United States and foreign countries. Government approvals are required to develop, market and sell the potential drug candidates we are developing alone or with others under our risk-sharing arrangements. Obtaining government approval to develop, market and sell drug candidates is time-consuming and expensive, and the clinical trial results for a particular drug candidate might not satisfy requirements to obtain government approvals. For example, in late 2005, ALZA Corporation, our collaborator on dapoxetine, received a not approvable letter from the FDA. In addition, governmental approvals might not be received in a timely manner, if at all, and we and our collaborative partners might not be able to meet other regulatory requirements for our products. Even if we are successful in obtaining all required approvals to market and sell a drug candidate, post-approval requirements and the failure to comply with other regulations could result in suspension or limitation of government approvals.
In connection with drug discovery activities outside the United States, we and our collaborators will be subject to foreign regulatory requirements governing the testing, approval, manufacture, labeling, marketing and sale
of pharmaceutical products. These requirements vary from country to country. Even if approval has been obtained for a product in the United States, approvals in foreign countries must be obtained prior to marketing the product in those countries. The approval process in foreign countries may be more or less rigorous and the time required for approval may be longer or shorter than that required in the United States. Clinical studies conducted outside of any particular country may not be accepted by that country, and the approval of a pharmaceutical product in one country does not assure that the product will be approved in another country.
We might incur substantial expense to develop products that are never successfully developed and commercialized.
We have incurred and expect to continue to incur substantial research and development and other expenses in connection with our compound partnering agreements. The potential drug candidates to which we devote resources might never be successfully developed or commercialized by us or our collaborative partners for numerous reasons, including:
For example, we terminated the implitapide program for various reasons, including the risks associated with continued development and limited market potential. Incurring significant expenses for a potential drug candidate that is not successfully developed and/or commercialized could have a material adverse effect on our business, financial condition, prospects and stock price.
Our operations might be affected by the occurrence of a natural disaster or other catastrophic event.
We depend on our clients, investigators, collaboration partners, our own laboratories and other facilities for the continued operation of our business. Although we have contingency plans in effect for natural disasters or other catastrophic events, these events, including terrorist attacks, pandemic flu, hurricanes and ice storms, could still disrupt our operations or those of our clients, investigators and collaboration partners, which could also affect us. Even though we carry business interruption insurance policies and typically have provisions in our contracts that protect us in certain events, we might suffer losses as a result of business interruptions that exceed the coverage available under our insurance policies or for which we do not have coverage. Any natural disaster or catastrophic event affecting us or our clients, investigators or collaboration partners could have a significant negative impact on our operations and financial performance.
Our development operations might be affected if there was a disruption to the air travel system.
Our global central laboratories and some of our other discovery and development services rely heavily on air travel for transport of clinical trial kits, other materials and people, and disruption to the air travel system could have a material adverse effect on our business. While we have developed contingency plans for a variety of events that could disrupt or limit available air transportation, these plans might not be effective or sufficient to avert such a material adverse effect.
Risks Related to Owning Our Stock
You might not receive any dividends, and the reduction or elimination of dividends might negatively affect the market price of our common stock.
We only began paying dividends as a public company in late 2005. Future dividend payments are not guaranteed and are within the absolute discretion of our Board of Directors. You might not receive any dividends as a result of any of the following factors:
Our dividend policy is based upon our current assessment of the cash needs of our business and the environment in which it operates. That assessment could change due to, among other things, changes in our results of operations, cash requirements, financial condition, contractual restrictions, growth opportunities, acquisitions, competitive or technological developments, provisions of applicable law and other factors that our Board of Directors might deem relevant. The reduction or elimination of dividends might negatively affect the market price of our common stock.
Our dividend policy and stock repurchase plan might limit our ability to pursue other growth opportunities.
Our Board of Directors has adopted an annual cash dividend policy which reflects an intention to distribute to our shareholders via regular quarterly dividends a portion of the cash generated by our business that exceeds our operating needs and capital expenditures. In addition, our Board of Directors authorized the Company to repurchase up to $350 million of its common stock from time to time in the open market. In developing the dividend policy and the stock repurchase plan, we have made assumptions for and judgments about our expected results of operations, anticipated levels of capital expenditures, income taxes and working capital. Payment of dividends or stock repurchases could limit our ability to finance any material expansion of our business, including through acquisitions, investments or increased capital spending, or to fund our operations.
Because our stock price is volatile, our stock price could experience substantial declines.
The market price of our common stock has historically experienced and might continue to experience volatility. Our quarterly operating results, changes in general conditions in the economy or the financial markets, both of which have been experiencing uncertainty in early 2008, and other developments affecting us or our competitors could cause the market price of our common stock to fluctuate substantially. In addition, in recent years, the stock market has experienced significant price and volume fluctuations. The stock market, and in particular the market for pharmaceutical and biotechnology company stocks, has also experienced significant decreases in value in the past. This volatility and valuation decline have affected the market prices of securities issued by many companies, often for reasons unrelated to their operating performance, and might adversely affect the price of our common stock.
As of February 15, 2008, we had 69 offices located in 30 countries on six continents. All locations relate to our Development services, and the Morrisville, North Carolina, Wilmington, North Carolina and Menlo Park, California locations also house Discovery Sciences services. Our principal executive offices are located in Wilmington, North Carolina. We own and operate four facilities, including a building in Wilmington, North Carolina, a building in Bellshill, Scotland, a laboratory building in Brussels, Belgium and a building in Durham, North Carolina. We lease all of our other facilities. We believe that our facilities are adequate for our operations and that suitable additional space will be available when needed. The locations, approximate square footage and lease expiration dates of our operating facilities comprising more than 20,000 square feet as of February 15, 2008 were as follows:
Beginning early 2007, we were named as a co-defendant in lawsuits alleging injuries to patients who took Sanofi-Aventis FDA-approved antibiotic Ketek, for which we provided certain clinical trial services. These lawsuits include: Campbell v. Sanofi-Aventis, et al. in the United States District Court for the Northern District of Alabama; Gregg and Gregg v. Sanofi-Aventis, et al., Manley and Manley v. Sanofi-Aventis, et al., Bennett v. Sanofi-Aventis et al., Henry v. Sanofi-Aventis et al., and Hamm v. Sanofi-Aventis, et al., each filed in Superior Court of New Jersey, Middlesex County; and Carpenter v. Sanofi-Aventis, et al. filed in the Superior Court in Mecklenburg County, North Carolina. Additional suits have been filed in New Jersey and Wisconsin and more similar suits are possible. These suits allege multiple causes of action, including negligence, misrepresentation, breach of warranty, conspiracy, wrongful death and violations of various state and federal statutes, including unfair and deceptive trade practices acts. Generally, the plaintiffs are seeking unspecified damages from alleged injuries from the ingestion of Ketek, and in some of the cases claim damages of at least $20.0 million. While there can be no assurance of a successful outcome and litigation costs can be material, we do not believe that these claims against us have merit and intend to vigorously defend ourself in these matters.
No matter was submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 2007.
The following table contains information concerning our executive officers as of February 15, 2008:
Fredric N. Eshelman, Pharm.D. has served as Chief Executive Officer and as a director since July 1990, and as Vice Chairman of the Board of Directors since 1993. Dr. Eshelman founded our companys predecessor in 1985 and served as its Chief Executive Officer until 1989. Prior to rejoining us in 1990, Dr. Eshelman served as Senior Vice President, Development and as a director of Glaxo Inc., a subsidiary of Glaxo Holdings plc.
Paul S. Covington, M.D. is our Executive Vice President Development. Dr. Covington joined us in September 1991 as a Medical Director. He was promoted from Senior Vice President to his current position in January 2002. He is board certified in internal medicine and licensed in North Carolina and Alabama. Prior to joining us, Dr. Covington was in private practice in Clanton, Alabama from 1985 to 1990 where he served as Chief of Staff and Director of Critical Care and Cardiopulmonary Disease for the local hospital. From 1991 to 1992, he was Medical Director for the Birmingham site of Future Healthcare Research Centers.
Daniel G. Darazsdi is our Chief Financial Officer, Treasurer and Assistant Secretary. Mr. Darazsdi joined us in October 2007. Prior to his employment by us, Mr. Darazsdi spent 25 years with Honeywell International where he most recently served as vice president and Chief Financial Officer of finance transformation and operations. Over the years at Honeywell, he was Chief Financial Officer of the companys global specialty materials business segment, VP of finance for Asia Pacific and held a variety of leadership roles in finance including, business analysis and planning and technology and business development leadership. Mr. Darazsdi is a Certified Management Accountant.
William W. Richardson is our Senior Vice President Global Business Development. Prior to joining us in November 2005, Mr. Richardson served as Executive Vice President of Sales for Mylan Bertek Pharmaceuticals Inc. from 2000 to 2005. He was President and Chief Executive Officer of Bertek Pharmaceuticals Inc. from 1996 to 2000. He began his career as Sales Manager for Dow Hickam Pharmaceuticals and rose through its ranks to serve as President and CEO from 1992 to 1996.
William J. Sharbaugh is our Chief Operating Officer. Before Mr. Sharbaugh joined PPD in May 2007, he spent six years at Bristol-Myers Squibb where he most recently served as Vice President, Global Development Operations from 2005 to 2007 in which he was responsible for strategic direction for clinical operations located in 55 countries. From 2001 to 2005, Mr. Sharbaugh served as Executive Director of Global Clinical Supply Operations where he was responsible for planning, manufacturing, packaging and distributing investigational products worldwide. Prior to his tenure with Bristol-Meyers Squibb, he spent 10 years at Merck and Co. in a variety of assignments in clinical supply operations, sales and manufacturing.
Our common stock is traded under the symbol PPDI and is quoted on the Nasdaq Global Select Market. The following table sets forth the high and low sales prices, adjusted to give effect to our two-for-one stock split in February 2006, for shares of our common stock, as reported by Nasdaq for the periods indicated.
As of February 15, 2008, there were approximately 67,300 holders of our common stock.
In October 2005, our Board of Directors adopted an annual cash dividend policy to pay an aggregate annual cash dividend of $0.10 on each outstanding share of common stock, payable quarterly at a rate of $0.025 per share, as adjusted to give effect to our February 2006 two-for-one stock split. Effective beginning in the fourth quarter of 2006, our Board of Directors amended the annual cash dividend policy to increase the annual dividend rate by 20%, from $0.10 to $0.12 per share, or $0.03 per share quarterly. In the fourth quarter of 2007, our Board of Directors further amended the annual cash dividend policy to increase the annual dividend rate from $0.12 to $0.40 per year, payable quarterly at a rate of $0.10 per share. The annual cash dividend policy and the payment of future quarterly cash dividends under that policy are not guaranteed and are subject to the discretion of and continuing determination by our Board of Directors that the policy remains in the best interests of our shareholders and in compliance with applicable laws and agreements.
Stock Repurchase Plan
On February 20, 2008, the Board of Directors authorized the Company to repurchase up to $350 million of its common stock from time to time in the open market. The manner and timing of repurchases, the amount the Company spends and the number of shares repurchased, if any, will depend on a variety of factors, including the Companys stock price and blackout periods in which the Company is restricted from repurchasing shares.
Equity Compensation Plans
The information required by Item 5 of Form 10-K regarding equity compensation plans is incorporated herein by reference to Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The following table represents selected historical consolidated financial data. The statement of operations data for the years ended December 31, 2005, 2006 and 2007 and balance sheet data at December 31, 2006 and 2007 are derived from our audited consolidated financial statements included elsewhere in this report. The statement of operations data for the years ended December 31, 2003 and 2004, and the balance sheet data at December 31, 2003, 2004 and 2005 are derived from audited consolidated financial statements not included in this report. The historical results are not necessarily indicative of the operating results to be expected in the future. The selected financial data should be read together with Managements Discussion and Analysis of Financial Condition and Results of Operations and our consolidated financial statements and notes to the financial statements included elsewhere in this report.
Consolidated Statement of Operations Data (in thousands, except per share data):
The following discussion and analysis is provided to increase understanding of, and should be read in conjunction with, our consolidated financial statements and accompanying notes. In this discussion, the words PPD, we, our and us refer to Pharmaceutical Product Development, Inc., together with its subsidiaries where appropriate.
This Form 10-K contains forward-looking statements within the meaning of the federal securities laws. These statements relate to future events or our future financial performance. Forward-looking statements include statements concerning plans, objectives, goals, strategies, future events or performance, expectations, predictions, assumptions and other statements that are not statements of historical facts. In some cases, you can identify forward-looking statements by terminology such as might, will, should, expect, plan, anticipate, believe, estimate, predict, intend, potential or continue, or the negative of these terms, or other comparable terminology. These statements are only predictions. These statements rely on a number of assumptions and estimates that could be inaccurate and that are subject to risks and uncertainties. Actual events or results might differ materially due to a number of factors, including those listed in Potential Volatility of Quarterly Operating Results and Stock Price and in Item 1A. Risk Factors. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements.
Our revenues are dependent on a relatively small number of industries and clients. As a result, we closely monitor the market for our services. For a discussion of the trends affecting the market for our services, see Item 1. Business Trends Affecting the Drug Discovery and Development Industry. Although we cannot predict the demand for CRO services for 2008, particularly in light of current general economic uncertainties, we continue to believe that the overall market for these services is strong. The volume of requests for proposals for our Phase II-IV clinical development services continues to grow, reflecting strong demand for outsourcing services generally and evidencing that the market for these services remains intact. For 2008, we plan to continue to focus on execution in our core development business and on our business development efforts to improve our sales hit rate.
We believe there are specific opportunities for continued growth in certain areas of our core development business. Our Global Phase II-IV units had solid operating and financial performance in 2007, and we expect to see continued revenue growth in 2008. We continue to add headcount within Phase II-IV global operations and added new offices in several countries in 2007 and are planning expansions in others in 2008. In
February 2008, we announced that we had entered into an agreement to acquire InnoPharm Ltd., an independent contract research organization. InnoPharm employs more than 300 professionals and has offices in Smolensk, Moscow and St. Petersburg in Russia and Kiev, Ukraine. In addition to our Phase II-IV business, during 2007 our bioanalytical laboratory completed construction of a new immunochemistry laboratory to support growth in large molecule testing services. Our cGMP laboratory increased capacity, added customized laboratories and added new technologies during 2007. While the revenue in our central laboratory in 2007 was below our expectations, new central laboratory authorizations for this business were well above expectations and should provide a solid basis for growth in 2008. Finally, with the passage of the Food and Drug Administration Amendments Act in late 2007, we believe there are opportunities for significant growth in the post-approval services arena.
We review various metrics to evaluate our financial performance, including period-to-period changes in backlog, new authorizations, cancellation rates, revenue, margins and earnings. In 2007, we had new authorizations of $2.2 billion, an increase of 11.5% over 2006. The cancellation rate for 2007 was 22.1%, which is higher than the 19.4% cancellation rate for 2006, but lower than our projected cancellation rate for 2007. Despite the increase in cancellations in 2007, backlog grew to $2.7 billion as of December 31, 2007, up 18.6% over December 31, 2006. The average length of our contracts increased to 34.2 months as of December 31, 2007 from 32.8 months as of December 31, 2006.
Backlog by client type as of December 31, 2007 was 48.8% pharmaceutical, 38.9% biotech and 12.3% government/other, as compared to 54.5% pharmaceutical, 32.3% biotech and 13.2% government/other as of December 31, 2006. The change in the composition of our backlog from 2006 to 2007 is primarily the result of an increase in authorizations from biotech companies in 2007. Net revenue by client type for the year ended December 31, 2007 was 58.7% pharmaceutical, 29.1% biotech and 12.2% government/other, compared to 58.5% pharmaceutical, 29.5% biotech and 12.0% government/other as of December 31, 2006.
For 2007, net revenue contribution by service area was 81.0% for Phase II-IV services, 14.1% for laboratory services, 3.3% for the Phase I clinic and 1.6% for discovery sciences, compared to net revenue contribution for the year ended December 31, 2006 of 78.0% for Phase II-IV services, 15.3% for laboratory services, 3.8% for Phase I clinic and 2.9% for discovery sciences. Top therapeutic areas by net revenue for the year ended December 31, 2007 were oncology, anti-infective/anti-viral, endocrine/metabolic, circulatory/cardiovascular and central nervous system. For a detailed discussion of our revenue, margins, earnings and other financial results for the year ended December 31, 2007, see Results of Operations - Year Ended December 31, 2006 versus Year Ended December 31, 2007 below.
Capital expenditures for the year ended December 31, 2007 totaled $95.0 million. These capital expenditures were primarily for construction in progress for our new headquarters building in Wilmington, North Carolina, computer software and hardware, scientific equipment for our laboratory units and various building improvements. We made these investments to support our growing businesses and to improve the efficiencies of our operations. For 2008, we expect to spend between $80 million and $90 million for capital expenditures, primarily associated with facility expansions and improvements, as well as investments in information technology and new laboratory equipment.
As of December 31, 2007, we had $502.4 million of cash, cash equivalents and short-term investments. In 2007, we generated $226.7 million in cash from operations. The number of days revenue outstanding in accounts receivable and unbilled services, net of unearned income, also known as DSO, was 50.8 and 44.0 days as of December 31, 2007 and 2006, respectively. DSO rose in 2007 due to longer payment terms with some clients and delayed billing milestones and a decrease in unearned income as a percentage of accounts receivable and unbilled services at December 31, 2007 compared to December 31, 2006. Collection efficiency remains solid, demonstrated by our aged accounts receivable less than 90 days which remain over 90% at December 31, 2007. We plan to continue to monitor DSO and the various factors that affect it. However, we expect DSO and unbilled services will continue to fluctuate in the future depending on contract terms, the mix of contracts performed within a quarter, the levels of investigator advances and unearned income, and our success in collecting receivables.
In October 2007, we announced our board of directors has amended the annual cash dividend policy to increase the annual dividend rate from $0.12 to $0.40 per year, payable quarterly at a rate of $0.10 per share. The new dividend rate was effective beginning in the fourth quarter 2007.
With regard to our compound partnering arrangements, we saw significant progress in 2007. First, Johnson and Johnson announced in early December that it filed a marketing authorization application to regulatory authorities in seven European countries under the decentralized filing procedure and that additional filings should follow in other regions. Second, Accentia advanced the SinuNase Phase III program and announced that it completed enrollment in the Phase III program and expects to announce top-line results in the first quarter of 2008. Finally, the dipeptidyl peptidase, or DPP-4, program in type 2 diabetes with Takeda Pharmaceuticals continues to progress. Takeda completed the Phase III trials for its lead DPP-4 inhibitor, alogliptin, and submitted the NDA for this compound in late December 2007. Takeda also continues to advance the development for a second DPP-4 inhibitor and a combination product with DPP-4 and Actos, Takedas leading diabetes drug.
In early 2007, we exercised an option to license a statin compound from Ranbaxy Laboratories Ltd. that we are developing as a potential treatment for dyslipidemia, a metabolic disorder often characterized by high cholesterol levels. We are solely responsible, and will bear all costs and expenses, for the development, manufacture, marketing and commercialization of the compound and licensed products. We filed the investigational new drug application, or IND, for the statin compound in late March 2007. We completed a single ascending dose, first-in-human study for this statin in June 2007, and the compound was safe and well tolerated at all doses in this trial. We also completed a first-in-patient study, and a drug-drug interaction study to evaluate the interaction between our statin and gemfibrozil, a fibrate commonly used to lower triglycerides. We are currently conducting additional trials to further evaluate the safety and efficacy of this statin. We have preliminary results from the first part of a high dose comparator trial. These preliminary results suggest that our statin was well-tolerated in the first part of this trial based on adverse event and clinical lab oratory data and compared favorably to the comparator statins with respect to lipid lowering. The second part of the study is in progress and final results could vary materially from the preliminary results. We anticipate having final results from this high dose comparator study in the first quarter of 2008 and plan to decide upon a course of action related to this statin program after evaluating the full and complete results from these trials.
These drug development collaborations allow us to leverage our resources and global drug development expertise to create new opportunities for growth and to share the risks and potential rewards of drug development with our collabrators. For a background discussion of our compound partnering arrangements, see Item 1. Business Our Services Our Discovery Sciences Group Compound Collaboration Programs. We believe our compound partnering strategy uses our cash resources and drug development expertise to drive mid- to long-term shareholder value. In 2008, we plan to continue advancing our existing collaborations and evaluate new potential strategies and opportunities in this area.
New Business Authorizations and Backlog
New business authorizations, which are sales of our services, are added to backlog when we enter into a contract or letter of intent or receive a verbal commitment. Authorizations can vary significantly from quarter to quarter and contracts generally have terms ranging from several months to several years. We recognize revenue on these authorizations as services are performed. Our new authorizations for the years ended December 31, 2005, 2006 and 2007 were $1.8 billion, $2.0 billion and $2.2 billion, respectively.
Our backlog consists of new business authorizations for which the work has not started but is anticipated to begin in the future and contracts in process that have not been completed. As of December 31, 2007, the remaining duration of the contracts in our backlog ranged from one to 106 months, with an average duration of 34.2 months. We expect the average duration of the contracts in our backlog to fluctuate from year to year in the future, based on the contracts constituting our backlog at any given time. Amounts included in backlog represent future revenue and exclude revenue that we have recognized. We adjust backlog on a monthly basis to account for fluctuations in exchange rates. Our backlog as of December 31, 2005, 2006 and 2007 was $1.8 billion, $2.2 billion and $2.7 billion, respectively. For various reasons discussed in Item 1. Business Backlog, our backlog might never be recognized as revenue and is not necessarily a meaningful predictor of future performance.
Results of Operations
We record revenue from contracts, other than time-and-material contracts, on a proportional performance basis in our Development and Discovery Sciences segments. To measure performance on a given date, we compare direct costs through that date to estimated total direct costs to complete the contract. Direct costs relate primarily to the amount of labor and labor related overhead costs for the delivery of services. We believe this is the best indicator of the performance of the contractual obligations. Changes in the estimated total direct costs to complete a contract without a corresponding proportional change to the contract value result in a cumulative adjustment to the amount of revenue recognized in the period the change in estimate is determined. For time-and-material contracts in both our Development and Discovery Sciences segments, we recognize revenue as hours are worked, multiplied by the applicable hourly rate. For our Phase I, laboratory and biomarker businesses, we recognize revenue from unitized contracts as subjects or samples are tested, multiplied by the applicable unit price. We offer volume discounts to our large customers based on annual volume thresholds. We record an estimate of the annual volume rebate as a reduction of revenue throughout the period based on the estimated total rebate to be earned for the period.
In connection with the management of clinical trials, we pay, on behalf of our clients, fees to investigators and test subjects as well as other out-of-pocket costs for items such as travel, printing, meetings and couriers. Our clients reimburse us for these costs. As required by Emerging Issues Task Force 01-14, amounts paid by us as a principal for out-of-pocket costs are included in direct costs as reimbursable out-of-pocket expenses and the reimbursements we receive as a principal are reported as reimbursed out-of-pocket revenue. In our statements of operations, we combine amounts paid by us as an agent for out-of-pocket costs with the corresponding reimbursements, or revenue, we receive as an agent. During the years ended December 31, 2005, 2006 and 2007, fees paid to investigators and other fees we paid as an agent and the associated reimbursements were approximately $279.8 million, $292.6 million and $335.7 million, respectively.
Most of our contracts can be terminated by our clients either immediately or after a specified period following notice. These contracts typically require the client to pay us the fees earned to date, the fees and expenses to wind down the study and, in some cases, a termination fee or some portion of the fees or profit that we could have earned under the contract if it had not been terminated early. Therefore, revenue recognized prior to cancellation generally does not require a significant adjustment upon cancellation. If we determine that a loss will result from the performance of a contract, the entire amount of the estimated loss is charged against income in the period in which such determination is made.
The Discovery Sciences segment also generates revenue from time to time in the form of milestone payments in connection with licensing of compounds. We only recognize milestone payments as revenue if the specified milestone is achieved and accepted by the client, and continued performance of future research and development services related to that milestone is not required.
Recording of Expenses
We generally record our operating expenses among the following categories:
Direct costs consist of amounts necessary to carry out the revenue and earnings process, and include direct labor and related benefit charges, other costs directly related to contracts, an allocation of facility and information technology costs, and reimbursable out-of-pocket expenses. Direct costs, as a percentage of net revenue, tend to and are expected to fluctuate from one period to another as a result of changes in labor utilization and the mix of service offerings involved in the hundreds of studies being conducted during any period of time.
Research and development, or R&D, expenses consist primarily of patent expenses, labor and related benefit charges associated with personnel performing internal research and development work, supplies associated with this work, consulting services and an allocation of facility and information technology costs.
Selling, general and administrative, or SG&A, expenses consist primarily of administrative payroll and related benefit charges, sales, advertising and promotional expenses, recruiting and relocation expenses, training costs, administrative travel, an allocation of facility and information technology costs, and costs related to operational employees performing administrative tasks.
We record depreciation expenses on a straight-line method, based on estimated useful lives of 40 years for buildings, five years for laboratory equipment, two to five years for software, computers and related equipment, and five to ten years for furniture and equipment, except for aircrafts, which we depreciate over 30 years. We depreciate leasehold improvements over the shorter of the life of the relevant lease or the useful life of the improvement. We depreciate property under capital leases over the life of the lease or the service life, whichever is shorter. We record amortization expenses on intangible assets on a straight-line method over the life of the intangible assets.
Year Ended December 31, 2006 versus Year Ended December 31, 2007
The following table sets forth amounts from our consolidated financial statements along with the dollar and percentage change for the full year of 2006 compared to the full year of 2007.
Total net revenue increased $166.8 million to $1.4 billion in 2007. The increase in total net revenue resulted primarily from an increase in our Development segment revenue. The Development segment generated net revenue of $1.3 billion, which accounted for 90.2% of total net revenue for 2007. The 14.6% increase in Development net revenue was primarily attributable to an increase in the level of Phase II-IV services we provided in 2007 as compared to 2006.
The Discovery Sciences segment generated net revenue of $20.0 million in 2007, a decrease of $13.2 million from 2006. The higher 2006 Discovery Sciences net revenue was mainly attributable to the $15.0 million milestone payment we earned from Takeda in March 2006 as a result of the dosing of the twentieth patient in the Phase III trial for Takedas lead DPP-4 inhibitor, alogliptin. Takeda completed the Phase III studies and submitted the alogliptin NDA to the FDA in late December 2007.
Total direct costs increased $101.1 million to $771.6 million in 2007 primarily as the result of an increase in the Development segment direct costs. Development segment direct costs increased $82.1 million to $641.9 million in 2007. The primary reason for this was an increase in personnel costs of $63.6 million due to the addition of approximately 800 new employees in our global Phase II-IV division. The remaining increase in the development direct costs was primarily due to increased facility costs of $9.0 million as a result of our headcount growth and an increase in contract labor for clinical personnel of $10.2 million. These increases in direct costs were also attributable to foreign currency fluctuation, as discussed below.
R&D expenses increased $13.8 million to $19.2 million in 2007. The increase in R&D expense was primarily due to development costs associated with Ranbaxy statin we are developing as a potential treatment for dyslipidemia. We are solely responsible for all costs and expenses for the development, manufacture, marketing and commercialization of the compound and licensed products. As a result, we expect to incur additional R&D expenses in future periods as we continue to advance the development of this compound. We also plan to continue evaluating other compound partnering strategies and opportunities to drive mid- and long-term shareholder value.
SG&A expenses increased $34.0 million to $338.1 million in 2007. As a percentage of total net revenue, SG&A expenses decreased to 23.9% in 2007 as compared to 24.4% in 2006. The increase in SG&A expenses in absolute terms includes additional personnel costs of $32.2 million due to hiring additional operations infrastructure and administrative personnel to support expanding operations and revenue growth. These increases in SG&A expenses in 2007 were also attributable to foreign currency fluctuations, as discussed below.
Depreciation and amortization expenses increased $7.9 million to $55.6 million in 2007. The increase was related to property and equipment we acquired to accommodate our growth. Capital expenditures were $95.0 million in 2007. Capital expenditures included $32.2 million for our new corporate headquarters building and related parking facility in Wilmington, North Carolina, $26.3 million for computer software and hardware, $13.1 million for additional scientific equipment for our laboratory units and $10.4 million related to leasehold improvements at various sites. We expect depreciation to increase in 2008 as a result of substantial investments over the past couple years in information technology systems to support our global Phase II-IV business.
Income from operations increased $10.0 million to $230.0 million in 2007. Income from operations in 2007 was negatively impacted by approximately $10.9 million due to foreign currency fluctuation, primarily the weakening of the U.S. dollar relative to the pound sterling, euro and Brazilian real. Although these currency movements increased net revenue in the aggregate, the negative impact on income from operations is attributable to dollar-denominated contracts for services rendered in countries other than the United States. In these cases, revenue is not impacted by the weakening of the U.S. dollar, but the costs associated with performing these contracts and maintaining the foreign infrastructure, which are paid in local currency, increase when translated to U.S. dollars, resulting in lower operating profits. In addition, it is important to note that income from operations in 2006 included a $15.0 million milestone payment from Takeda under the DPP-4 collaboration agreement.
Interest and other income, net increased $3.1 million to $18.7 million in 2007. This was due primarily to increased interest income due to a 20.6% increase in our average cash, cash equivalents and short-term investment balance in 2007 compared to 2006.
Our provision for income taxes increased $5.7 million to $84.6 million in 2007. Our effective income tax rate for 2006 was 33.5% compared to 34.1% for 2007. The effective tax rate for 2007 was positively impacted by the settlement of tax audits and closing of certain statutory limitations. The effective tax rate for 2006 was positively impacted by 1.8% as a result of the recognition of benefit for state economic development tax credits as well as a decrease in liabilities for tax contingencies and a decrease in the valuation allowance due to the closing of certain state tax statutes and audits. The remaining difference in our effective tax rates for 2007 compared to 2006 is due to an increase in nontaxable income from cash investments and the change in the geographic distribution of our pretax earnings among locations with varying tax rates.
Net income of $163.4 million in 2007 represents an increase of 4.3% from $156.7 million in 2006. Net income per diluted share of $1.36 in 2007 represents a 3.0% increase from $1.32 net income per diluted share in 2006. Earnings per diluted share for 2006 included $0.08 per diluted share related to the $15.0 million milestone payment from Takeda under our DPP-4 collaboration agreement.
Year Ended December 31, 2005 versus Year Ended December 31, 2006
The following table sets forth amounts from our consolidated financial statements along with the dollar and percentage change for the full year of 2005 compared to the full year of 2006.
Total net revenue increased $210.6 million to $1.2 billion in 2006. The increase in total net revenue resulted primarily from an increase in our Development segment revenue. The Development segment generated net revenue of $1.1 billion, which accounted for 89.2% of total net revenue for 2006. The 20.8% increase in Development net revenue was primarily attributable to an increase in the level of global CRO Phase II-IV services we provided in 2006 as compared to 2005.
The Discovery Sciences segment generated net revenue of $33.2 million in 2006, a decrease of $7.0 million from 2005. The higher 2005 Discovery Sciences net revenue was mainly attributable to the $10.0 million milestone payment from ALZA Corporation we received in 2005 for the filing of the dapoxetine NDA. This was partially offset by increased revenue generated by our preclinical oncology division in 2006 as compared to 2005. We received a $15.0 million milestone payment from Takeda in connection with the DPP-4 collaboration in both 2005 and 2006.
Total direct costs increased $120.0 million to $670.5 million in 2006 primarily as the result of an increase in the Development segment direct costs. Development direct costs increased $92.8 million to $559.8 million in 2006. The primary reason for this was an increase in personnel costs of $80.8 million due to over 1,000 additional employees in our global Phase II-IV division. The remaining increase in the Development direct costs is primarily due to increased facility costs of $11.2 million related to the increase in personnel.
R&D expenses decreased $18.0 million to $5.4 million in 2006. R&D expenses decreased primarily as a result of decreased spending in connection with the DPP-4 program, which was transferred to Takeda. Under the DPP-4 agreement with Takeda that we entered into in July 2005, Takeda assumed the obligation to fund all future development and commercialization costs of the DPP-4 inhibitor program. In February 2007, we exercised an option to license a statin compound from Ranbaxy Laboratories Ltd. which we intend to develop as a treatment for dyslipidemia.
SG&A expenses increased $52.6 million to $304.0 million in 2006. As a percentage of total net revenue, SG&A expenses increased slightly to 24.4% in 2006 as compared to 24.2% in 2005. The increase in SG&A expenses includes additional personnel costs of $40.7 million. The increase in personnel costs related mainly to an increased level of new hires of both operations infrastructure and administrative personnel to support expanding operations and revenue growth. The increase in SG&A costs also includes an additional $3.2 million related to additional provisions for bad debt expense. In addition, SG&A costs include an increase of $2.0 million in accounting and legal fees.
Depreciation expense increased $8.0 million to $47.2 million in 2006. The increase was related to property and equipment we acquired to accommodate our growth, a significant portion of which related to information technology investments we made in 2005. Capital expenditures were $148.0 million in 2006. Capital expenditures included $73.5 million for our new corporate headquarters building and related parking facility in Wilmington, North Carolina, $23.4 million for computer software and hardware, $16.1 million related to leasehold improvements at various sites, $8.9 million for additional scientific equipment for our Phase I and laboratory units and $8.7 million for our new building in Scotland.
Income from operations increased $43.3 million to $220.0 million in 2006. As a percentage of net revenue, income from operations increased from 17.0% in 2005 to 17.6% in 2006. Income from operations in 2006 included a significant decrease in R&D expenses as discussed above. Income from operations in 2006 was negatively impacted by approximately $3.3 million due to foreign currency fluctuation, primarily the weakening of the U.S. dollar relative to the pound sterling, euro and Brazilian real. Income from operations in 2005 included a $5.1 million gain on exchange of assets associated with the acquisition of SurroMeds biomarker business. Income from operations in 2005 also included a $10.0 million milestone payment related to the filing of the dapoxetine NDA.
During 2005, we recorded charges to earnings for other-than-temporary declines in the fair market value of our cost basis investments of $5.9 million, which included $1.6 million related to the outstanding balance of a revolving line of credit that was guaranteed by us, and our marketable equity securities of $0.3 million. The write-downs were due to a business failure, current fair market values, historical and projected performance and liquidity needs of the investees.
Interest and other income, net increased $6.5 million to $15.5 million in 2006. This was due primarily to increased interest income due to higher interest rates and a 28.2% increase in our average cash, cash equivalents and short-term investment balance.
Our provision for income taxes increased $18.9 million to $78.9 million in 2006. Our effective income tax rate for 2005 was 33.3% compared to 33.5% for 2006. The effective tax rate for 2006 was positively impacted by 1.8% by the recognition of benefit for state economic development tax credits as well as a decrease in liabilities for tax contingencies and a decrease in the valuation allowance due to the closing of certain state tax statutes and audits. The effective tax rate for 2005 was positively impacted by a $6.9 million reduction in our valuation allowance provided for the deferred tax asset relating to capital loss carryforwards. The reduction was a result of the utilization of capital loss carryforwards that previously had a valuation allowance recorded against them as well as recognition of capital gains for dapoxetine NDA milestone payment received in the first quarter of 2005 and the $15.0 million up-front payment received from Takeda during the third quarter of 2005 with respect to the DPP-4 program. This reduction in the valuation allowance decreased the effective tax rate in 2005 by 3.5%. The remaining difference in our effective tax rates for 2006 compared to 2005 is due to the tax on the repatriation of foreign earnings in 2005 and the change in the geographic distribution of our pretax earnings among locations with varying tax rates.
Net income of $156.7 million in 2006 represents an increase of 30.7% from $119.9 million in 2005. Net income per diluted share of $1.32 in 2006 represents a 28.2% increase from $1.03 net income per diluted share in
2005. Net income per diluted share for 2005 included $0.03 per diluted share for the gain on exchange of assets associated with the acquisition of SurroMeds biomarker business which was offset by $0.03 per diluted share for impairment of equity investments.
Liquidity and Capital Resources
As of December 31, 2007, we had $171.4 million of cash and cash equivalents and $331.0 million of short-term investments. Our cash and cash equivalents and short-term investments are invested in financial instruments that are rated A or better by Standard and Poors or Moodys and earn interest at market rates. Our expected primary cash needs on both a short- and long-term basis are for capital expenditures, expansion of services, possible acquisitions, investments and compound partnering collaborations, geographic expansion, dividends, working capital and other general corporate purposes. We have historically funded our operations, dividends and growth, including acquisitions, primarily with cash flow from operations.
We held approximately $209.5 million in tax-exempt auction rate securities at December 31, 2007. We do not believe that these investments have been impaired as a result of the recent sub-prime mortgage market crisis. Our investments in auction rate securities consist principally of interests in government guaranteed student loans and insured and uninsured municipal debt obligations. None of the auction rate securities in our portfolio were asset or mortgage-backed, and as of December 31, 2007 there had been no failed auctions for securities we held. During February 2008, a significant number of auction rate securities auctions began to fail, including auctions for approximately $123.3 million of securities held by us as of February 22, 2008. As a result of these failed auctions or future failed auctions, we may not be able to liquidate these securities until a future auction is successful, the issuer redeems the outstanding securities or the securities mature. If we determine that an issuer of the securities is unable to successfully close future auctions or redeem or refinance the obligations, we might have to reclassify the investments from a current asset to a non-current asset. If an issuers financial stability or credit rating deteriorates or adverse developments occur in the bond insurance market, we might be required to adjust the carrying value of our action rate securities through a future impairment charge. We have evaluated the market conditions and credit worthiness of the issuers of our action rate securities and have determined that there have been no decreases in market value. We will continue to monitor the market and take actions to limit our exposure to auction rate securities.
In 2007, our operating activities provided $226.7 million in cash as compared to $187.4 million for the same period last year. The change in cash flow was due primarily to a $6.7 million increase in net income and adjustments to remove the effects of (i) noncash items whose cash effects are investing or financing activities totaling $8.1 million (most significantly, depreciation and amortization) and (ii) deferrals of past, and accruals of expected future, operating cash receipts and payments totaling $24.5 million. The change in adjustments for accruals of expected future operating cash receipts and payments include: accounts receivable and unbilled services of $29.4 million; accrued and deferred income taxes of $2.8 million; payables to investigators of $17.0 million; and accounts payable, other accrued expenses and deferred rent of $7.9 million. The change in adjustments for deferrals of past operating cash receipts and payments include: prepaid expenses and investigator advances of $(10.6) million; other assets of $(3.3) million; and unearned income of $(18.6) million. Fluctuations in receivables and unearned income occur on a regular basis as we perform services, achieve milestones or other billing criteria, send invoices to clients and collect outstanding accounts receivable. Such activity varies by individual client and contract. We attempt to negotiate payment terms which provide for payment of services prior to or within close proximity to the provision of services, but the levels of unbilled services and unearned revenue can vary significantly.
In 2007, we used $171.9 million in cash related to investing activities. We used cash to purchase available-for-sale investments of $550.0 million, make capital expenditures of $95.0 million and purchase other investments of $2.8 million. These amounts were partially offset by maturities and sales of available-for-sale investments of $473.3 million, proceeds from our investments of $1.0 million and proceeds from the sale of property and equipment of $1.6 million primarily related to the sale of our building in Scotland. Our capital expenditures in 2007 primarily consisted of $32.2 million for our new corporate headquarters building, $26.3 million for computer software and hardware, $13.1 million for additional scientific equipment for our laboratory units, $10.4 million related to leasehold improvements at various sites. We expect our capital expenditures in 2008 will be approximately $80.0 million to $90.0 million, primarily associated with facility expansions and improvements, as well as investments in information technology and new laboratory equipment.
In 2007, we used $64.9 million of cash in financing activities. We paid $74.8 million to retire the construction loan for our new headquarters building and paid dividends of $22.6 million. These amounts were partially offset by $27.9 million in proceeds from stock option exercises and purchases under our employee stock purchase plan and $4.9 million in income tax benefits from the exercise of stock options and disqualifying dispositions of stock. In addition, we borrowed and subsequently repaid $25.0 million under our revolving credit facility in connection with the construction of our new headquarters building.
The following table sets forth amounts from our consolidated balance sheet affecting our working capital along with the dollar amount of the change from 2006 to 2007.
Working capital as of December 31, 2007 was $600.0 million, compared to $412.7 million at December 31, 2006. The increase in working capital was due primarily to the increase in short-term investments and accounts receivable and unbilled services and decreases in current maturities of debt as a result of the repayment of the loan for the construction of our new corporate headquarters building. These increases in working capital were partially offset by increases in accounts payable, payables to investigators, other accrued expenses and unearned income.
The number of days revenue outstanding in accounts receivable and unbilled services, net of unearned income, also known as DSO, increased to 50.8 days for the year ended December 31, 2007 from 44.0 days for the year ended December 31, 2006. We calculate DSO by dividing accounts receivable and unbilled services less unearned income by average daily gross revenue for the applicable period. Accounts receivable, net of allowance for doubtful accounts, as of December 31, 2007 were $295.4 million. While DSO increased in part due to the increase in accounts receivable, 87.8% of our accounts receivable balance as of December 31, 2007 was less than 60 days old. Unearned income as of December 31, 2007 was $205.8 million, which represented 42.7% of our accounts receivable and unbilled services balance. This percentage has decreased from December 31, 2006 when our unearned income of $195.7 million represented 47.9% of our accounts receivable and unbilled services balance. This decrease in unearned income as a percentage of receivables and unbilled services caused DSO to increase. DSO also rose in 2007 due to longer payment terms with some clients and delayed billing milestones. We expect DSO will continue to fluctuate in the future depending on contract terms, the mix of contracts performed within a quarter, the levels of investigator advances and unearned income, and our success in collecting receivables.
We maintain a defined benefit pension plan for certain employees and former employees in the United Kingdom. This pension plan was closed to new participants as of December 31, 2002. The projected benefit obligation for the benefit plan at December 31, 2006 and December 31, 2007, as determined in accordance with SFAS No. 87, Employers Accounting for Pensions, was $51.8 million and $57.1 million, respectively, and the value of the plan assets was $40.9 million and $47.3 million, respectively. As a result, the plan was under-funded by $10.8 million in 2006 and by $9.8 million in 2007, respectively. The amount of contributions to the plan for the years ended December 31, 2006 and 2007 were $3.2 million and $2.5 million, respectively. It is likely that the amount of our contributions to the plan could increase in future years. We expect the pension cost to be recognized in our financial statements will increase slightly from the $2.0 million in 2007 to approximately $2.1 million in 2008. The expense to be recognized in future periods could increase or decrease depending upon the change in the fair market value of the plan assets and changes in the projected benefit obligation.
A decrease in the market value of plan assets and/or declines in interest rates, both of which seem possible in light of general economic conditions in early 2008, are likely to cause the amount of the under-funded status to increase. After completion of the actuarial valuations in 2008, we could be required to record an additional reduction to shareholders equity. In connection with the plan, we recorded an increase to shareholders equity in 2006 of $2.8 million, offset by a decrease of $3.3 million due to the adoption of SFAS No. 158 in 2006 and an increase to shareholders equity in 2007 of $0.5 million. Given the impact that the discount rate and stock market performance have on the projected benefit obligation and market value of plan assets, future changes in either one of these factors could significantly reduce or increase the amount of our pension plan under-funding.
Effective July 1, 2007, we renewed our $50.0 million revolving credit facility with Bank of America, N.A. Indebtedness under the facility is unsecured and subject to covenants relating to financial ratios and restrictions on certain types of transactions. This revolving credit facility does not expressly restrict or limit the payment of dividends. We were in compliance with all loan covenants as of December 31, 2007. Outstanding borrowings under the facility bear interest at an annual fluctuating rate equal to the one-month London Interbank Offered Rate, or LIBOR, plus a margin of 0.6%. Borrowings under this credit facility are available to provide working capital and for general corporate purposes. This credit facility is currently scheduled to expire in June 2008, at which time any outstanding balance will be due. As of December 31, 2007, no borrowings were outstanding under this credit facility, although the aggregate amount available for borrowing had been reduced by $1.8 million due to outstanding letters of credit issued under this facility.
In February 2006, we entered into an $80.0 million construction loan facility with Bank of America, N.A. Borrowings under this credit facility were used to finance the construction of our new corporate headquarters building and related parking facility in Wilmington, North Carolina, and bore interest at an annual fluctuating rate equal to the one-month LIBOR plus a margin of 0.6%. This credit facility was scheduled to mature in February 2008, but in May 2007 we repaid all outstanding borrowings under this facility totaling $74.8 million.
On October 3, 2005, our Board of Directors adopted a cash dividend policy. We paid the first quarterly cash dividend under our dividend policy in the fourth quarter of 2005, and in each of the first three quarters of 2006, we paid a similar dividend of $0.025 per share. In October 2006, our Board of Directors amended the annual cash dividend policy to increase the annual dividend rate by 20%, from $0.10 to $0.12 per share, payable quarterly at a rate of $0.03 per share. This dividend rate was effective beginning in the fourth quarter of 2006. In October 2007, our Board of Directors further amended the annual cash dividend policy to increase the annual dividend rate from $0.12 to $0.40 per share, payable quarterly at a rate of $0.10 per share. The new dividend rate was effective beginning in the fourth quarter of 2007. The cash dividend policy and the payment of future quarterly cash dividends under that policy are not guaranteed and are subject to the discretion of and continuing determination by our Board of Directors that the policy remains in the best interests of our shareholders and in compliance with applicable laws and agreements.
In February 2008, we announced our plan to begin a stock repurchase program whereby up to $350 million of our common stock may be purchased from time to time in the open market. We decided to initiate a share repurchase program in view of the current price at which stock is trading, the strength of our balance sheet and our ability to generate cash, as well as to minimize earnings dilution from future equity compensation awards. We expect to finance the share repurchases from existing cash on hand and cash generated from future operations.
We have commitments to invest up to an aggregate additional $23.8 million in four venture capital funds. For further details, see Note 6 in the Notes to Consolidated Financial Statements.
We adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109, or FIN 48, as of January 1, 2007. As of December 31, 2006, we had recorded a contingent tax liability of $9.1 million. As a result of the implementation of FIN 48, we reclassified $8.2 million of this liability to non-current liabilities and recognized an increase in this non-current liability of $22.7 million. This increase was accounted for as a $5.5 million decrease in retained earnings, a $15.9 million increase in deferred tax assets, and a $1.3 million increase in long-term assets as of January 1, 2007.
We had gross unrecognized tax benefits of approximately $28.0 million as of January 1, 2007. Of this total, $11.6 million, net of the federal benefit on state taxes, is the amount that, if recognized, would result in a reduction of our effective tax rate. As of December 31, 2007, the total gross unrecognized tax benefits were $23.8 million and of this total, $9.3 million is the amount that, if recognized, would reduce our effective tax rate. We do not anticipate a significant change in total unrecognized tax benefits or our effective tax rate due to the settlement of audits and the expiration of statute of limitations within the next 12 months.
Our policy for recording interest and penalties associated with tax audits is to record such items as a component of provision for income taxes. In conjunction with the adoption of FIN 48, we recognized approximately $4.0 million for the payment of interest and penalties at January 1, 2007. As of December 31, 2007, $4.1 million of interest was accrued and $1.3 million was recognized for penalties. To the extent interest and penalties are not assessed with respect to uncertain tax positions, amounts accrued will be reduced and reflected as a reduction of the overall income tax provision.
We analyzed filing positions in all of the significant federal, state and foreign jurisdictions where we are required to file income tax returns, as well as open tax years in these jurisdictions. The only periods subject to examination by the major tax jurisdictions where we do business are the 2004 through 2007 tax years. Various foreign and state income tax returns are under examination by taxing authorities. We do not believe that the outcome of any examination will have a material impact on our financial condition or results of operations.
We have been involved in compound development and commercialization collaborations since 1997. We developed a risk-sharing research and development model to help pharmaceutical and biotechnology clients develop compounds. Through collaborative arrangements based on this model, we assist our clients by sharing the risks and potential rewards associated with the development and commercialization of drugs at various stages of development. We currently have four such arrangements that involve the potential future receipt of one or more of the following forms of revenue: payments upon the achievement of specified development and regulatory milestones; royalty payments if the compound is approved for sale; sales-based milestone payments; and a share of net sales up to a specified dollar limit. The compounds that are the subject of these collaborations are either still in development or are awaiting regulatory approvals in certain countries. None of the compounds have been approved for sale in any country in the world. As a result of the risks associated with drug development, including poor or unexpected clinical trial results and obtaining regulatory approval to sell in any country, the receipt of any further milestone payments, royalties or other payments with respect to any of our drug development collaborations is uncertain.
As of December 31, 2007, we had two collaborations that involved future expenditures. The first is the collaboration with ALZA Corporation, subsequently acquired by Johnson and Johnson, for dapoxetine. In connection with this collaboration, we have an obligation to pay a royalty to Eli Lilly and Company of 5% on annual net sales of the compound in excess of $800 million. Johnson and Johnson received a not approvable letter from the FDA in October 2005, but continued its global development program. In December 2007, Johnson and Johnson submitted a marketing authorization application for dapoxetine to regulatory authorities in seven countries in the European Union. Although this regulatory application has been submitted, we do not know if or when Johnson and Johnson will obtain regulatory approval for dapoxetine in these countries. We also do not know if or when Johnson and Johnson will submit an application for or obtain regulatory approval for dapoxetine in the United States or any other country.
The second collaboration involving future expenditures is with Ranbaxy Laboratories Ltd. In February 2007, we exercised an option to license from Ranbaxy a statin compound that we are developing as a potential
treatment for dyslipidemia, a metabolic disorder often characterized by high cholesterol levels. Upon exercise of the option, we paid a one-time license fee of $0.25 million. Under the agreement, we have an exclusive license to make, use, sell, import and sublicense the compound and any licensed product anywhere in the world for any human use. Ranbaxy retained a non-exclusive right to co-market licensed products in India and generic equivalents in any country in the world in which a third party has sold the generic equivalent of a licensed product. We are solely responsible, and will bear all costs and expenses, for the development, manufacture, marketing and commercialization of the compound and licensed products. In addition to the one-time license fee, we are obligated to pay Ranbaxy milestone payments upon the occurrence of specified clinical development events. If a licensed product is approved for sale, we must also pay Ranbaxy royalties based on sales of the product, as well as commercial milestone payments based on the achievement of specified worldwide sales targets. If all criteria are met, the total amount of potential clinical and sales-based milestones would be $44.0 million. We filed the investigational new drug application, or IND, for the statin compound in late March 2007. We completed a single ascending dose, first-in-human study for this statin in July 2007, and the compound was safe and well tolerated at all doses in this trial. We also completed a first-in-patient study, and a drug-drug interaction study to evaluate the interaction between our statin and gemfibrozil, a fibrate commonly used to lower triglycerides. We are currently conducting additional trials to further evaluate the safety and efficacy of this statin. We have preliminary results from the first part of a high dose comparator trial. These preliminary results suggest that our statin was well-tolerated in the first part of this trial based on adverse event and clinical laboratory data and compared favorably to the comparator statins with respect to lipid lowering. The second part of the study is in progress and final results could vary materially from the preliminary results. We anticipate having final results from this high dose comparator study in the first quarter of 2008 and plan to decide upon a course of action related to this statin program after evaluating the full and complete results from these trials.
In September 2007, we entered into a contract with a client to construct a laboratory within a leased building, to supply laboratory equipment and to provide specified laboratory services. The client has agreed to reimburse us for the costs of construction of the laboratory and related equipment. We expect these costs will be approximately $5.5 million and that construction will be completed in mid-2008.
Under most of our agreements for Development services, we typically agree to indemnify and defend the sponsor against third-party claims based on our negligence or willful misconduct. Any successful claims could have a material adverse effect on our financial condition, results of operations and future prospects.
We expect to continue expanding our operations through internal growth, strategic acquisitions and investments. For example, we announced in February 2008, that we had entered into an agreement to acquire InnoPharm Ltd., an independent contract research organization. We expect to fund these activities and the payment of future cash dividends from existing cash, cash flows from operations and, if necessary or appropriate, borrowings under our existing or future credit facilities. We believe that these sources of liquidity will be sufficient to fund our operations and dividends for the foreseeable future. From time to time, we evaluate potential acquisitions, investments and other growth and strategic opportunities that might require additional external financing, and we might seek funds from public or private issuances of equity or debt securities. While we believe we have sufficient liquidity to fund our operations for the foreseeable future, our sources of liquidity and ability to pay dividends could be affected by our dependence on a small number of industries and clients; compliance with regulations; reliance on key personnel; breach of contract, personal injury or other tort claims; international risks; environmental or intellectual property claims; or other factors described under Item 1A. Risk Factors, in this Item 7 under the subheadings Contractual Obligations, Critical Accounting Policies and Estimates, Potential Liability and Insurance, Potential Volatility of Quarterly Operating Results and Stock Price and under Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
As of December 31, 2007, future minimum payments for all contractual obligations for years subsequent to December 31, 2007 are as follows:
We are a limited partner in four venture capital funds and have committed to invest up to an aggregate additional $23.8 million in these funds. We anticipate that our aggregate investment in these funds will be made through a series of future capital calls over the next several years. We also have a long-term liability on our balance sheet regarding the underfunding of our U.K. pension plan in the amount of $9.8 million. We do not know if or when this will be funded because this liability will change based on the performance of the investments of the plan and changes in the benefit obligations. Also, in February 2007, we exercised an option to license a statin compound from Ranbaxy Laboratories Ltd. which we intend to develop as a treatment for dyslipidemia. We are solely responsible, and will bear all costs and expenses, for the development, manufacture, marketing and commercialization of the compound and licensed products. We are also obligated to pay Ranbaxy milestone payments upon the occurrence of specified clinical development events. If a licensed product is approved for sale, we must also pay Ranbaxy royalties based on sales of such product and commercial milestone payments based on the achievement of specified worldwide sales targets. If all criteria are met, the total amount of potential clinical and sales-based milestones over the development and commercialization period would be $44.0 million. Lastly, we have a liability of unrecognized tax benefits of approximately $23.8 million. We estimate that less than $0.1 million will be paid in the next 12 months. We are unable to reasonably estimate the amount or timing of payments for the remainder of the liability.
Off-balance Sheet Arrangements
From time to time, we cause letters of credit to be issued to provide credit support for guarantees, contractual commitments and insurance policies. The fair values of the letters of credit reflect the amount of the underlying obligation and are subject to fees competitively determined in the marketplace. As of December 31, 2007, we had four letters of credit outstanding for a total of $1.8 million.
Critical Accounting Policies and Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates. We believe that the following are the primary areas in which management must make significant judgments in applying our accounting policies to determine our financial condition and results of operations. We have discussed the application of these critical accounting policies with the Finance and Audit Committee of our Board of Directors.
The majority of our Development segment revenues are recorded on a proportional performance basis. To measure performance on a given date, we compare direct costs through that date to estimated total direct costs to complete the contract. Direct costs relate primarily to the amount of labor and labor related overhead costs related to the delivery of services. We believe this is the best indicator of the performance of the contractual obligations.
Our contracts are generally based on a fixed fee or unitized pricing model and have a duration of a few months to ten years. The contract value for a fixed fee contract equals the agreed upon aggregate amount of the fixed fees. We measure the contract value for unitized pricing models using the estimated units (number of patients to be dosed or study sites to be initiated, for example) to be completed and the agreed upon unit prices. As part of
the client proposal and contract negotiation process, we develop a detailed project budget for the direct costs to be expended based on the scope of the work, the complexity of the study, the geographic locations involved and our historical experience. We then establish the individual contract pricing based on our internal pricing guidelines, discount agreements, if any, and negotiations with the client.
Contracts with the same customer generally are not linked, although some large customers enter into annual or multi-year pricing agreements, which generally provide for specified discounts with periodic rate increases or other price adjustment mechanisms. We negotiate pricing for each project individually, based on the scope of the work, and any discounts and rate increases are reflected within the contract for the project. Other large customers negotiate rebates based on the volume of services purchased. These agreements are generally negotiated at the beginning of each year and require a one-time rebate in the following year based upon the volume of services purchased or recognized during the relevant year. We record an estimate of the annual volume rebate as a reduction of revenues throughout the period based on the estimated total rebate to be earned for the period.
Generally, payment terms are based on the passage of time, the monthly completion of units or non-contingent project milestones that represent progression of the project plan, such as contract signing, site initiation and database lock. The timing of payments can vary significantly. We attempt to negotiate payment terms which provide for payment of services prior to or within close proximity to the provision of services, but the levels of unbilled services and unearned revenue can vary significantly.
Most of our contracts can be terminated by the client either immediately or after a specified period following notice. These contracts typically require the client to pay us the expenses to wind down the study, fees earned to date and, in some cases, a termination fee or some portion of the fees or profit that we could have earned under the contract if it had not been terminated early. Therefore, revenue recognized prior to cancellation generally does not require a significant adjustment upon cancellation.
Each month we accumulate direct costs on each project and compare them to the total current estimated direct costs to complete the project in order to determine the percentage-of-completion. We then multiply this percentage by the contract value to determine the amount of revenue that can be recognized. This process includes a review of, among other things:
As a result of this review, we might determine that our previous estimates of contract value or direct costs need to be revised based upon the new information. Changes in the scope of work generally results in the negotiation of contract modifications to increase or decrease the contract value along with an associated increase or decrease in the estimated total direct costs to complete. If a contract modification is not agreed to, we could bear the risk of cost overruns. Contract values and modifications to contract values are only included in the calculation of revenue when we believe that realization is reasonably assured and we have appropriate evidence of arrangement.
If we determine that a loss will result from the performance of a contract, the entire amount of the estimated loss is charged against income in the period in which such determination is made. The payment terms for our contracts do not necessarily coincide with the recognition of revenue. We record unbilled services for revenue recognized to date that are not then billable under the relevant customer agreement. Conversely, we record unearned income for cash received from customers for which revenue has not been recognized at the balance sheet date.
In 2007 and prior years, we had to commit unanticipated resources to complete projects, resulting in lower gross margins on those projects. We might experience similar situations in the future. Increases in the estimated
total direct costs to complete a contract without a corresponding proportional increase to the contract value result in a cumulative adjustment to the amount of revenue recognized in the period the change in estimate is determined. Should our estimated direct costs to complete a fixed price contract prove to be low, gross margins could be materially adversely affected, absent our ability to negotiate a contract modification. Historically, the majority of our estimates and assumptions have been materially correct, but these estimates might not continue to be accurate in the future. A hypothetical increase of 1% in the total estimated remaining project direct costs to complete, without a corresponding proportional increase in the contract value, for open projects accounted for under the proportional performance method as of December 31, 2005, 2006 and 2007 would have resulted in a cumulative reduction in revenue and gross margin of approximately $2.5 million, $3.3 million, and $3.5 million, respectively.
In our Discovery Sciences segment, we generate revenue from time to time in the form of milestone payments in connection with licensing of compounds. We only recognize milestone payments as revenue if the specified milestone is achieved and accepted by the client, and continued performance of future research and development services related to that milestone is not required. Future potential milestone payments under various discovery contracts might never be received if the milestones are not achieved.
Allowance for Doubtful Accounts
Included in Accounts receivable and unbilled services, net on our consolidated balance sheets is an allowance for doubtful accounts. Generally, before we do business with a new client, we perform a credit check. We also review our accounts receivable aging on a monthly basis to determine if any receivables will potentially be uncollectible. The allowance for doubtful accounts includes specific accounts and an estimate of other losses based on historical loss experience. After all attempts to collect the receivable have failed, the receivable is written off against the allowance. Based on the information available to us, we believe our allowance for doubtful accounts as of December 31, 2007 was adequate to cover uncollectible balances. However, actual invoice write-offs might exceed the recorded reserve.
Our investments consist of equity and debt investments in publicly traded and privately held entities. Our investments in publicly traded securities are classified as available-for-sale securities and recorded at their current quoted market price. Our investments in privately held entities do not have readily determinable fair values and are, therefore, recorded using the cost method of accounting. Most of our investments are in relatively early stage life sciences and biotechnology companies or investment funds that invest in similar companies. These early stage life sciences and biotechnology companies generally do not have established products or proven technologies or material revenue, if any. The fair value of these investments might from time to time be less than their recorded value. We assess our investment portfolio on a quarterly basis for other-than-temporary impairments. For our investments in privately held entities, we must identify events or circumstances that would likely have a significant adverse effect on the fair value of the investment. In addition, any decline in the fair value of publicly traded or privately held investments must be evaluated to determine the extent and timing of recovery, if any. If we deem the impairment to be other-than-temporary, the impairment of the investment must be recorded in the income statement. This quarterly review includes an evaluation of, among other things, the market condition of the overall industry, historical and projected financial performance, expected cash needs and recent funding events, as well as our expected holding period and the length of time and the extent to which the fair value of the investment has been less than cost. This analysis of the fair values and the extent and timing of recoveries of decreases in fair value requires significant judgment.
Tax Valuation Allowances and Tax Liabilities
We adopted FIN 48 as of January 1, 2007. FIN 48 requires significant judgment in determining what constitutes an individual tax position as well as assessing the outcome of each tax position. Changes in judgment as to recognition or measurement of tax positions can materially affect the estimate of our effective tax rate and, consequently, our operating results. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes.
Estimates and judgments are required in the calculation of certain tax liabilities and in the determination of the recoverability of certain deferred tax assets, which arise from net operating losses, tax credit carryforwards and
temporary differences between the tax and financial statement recognition of revenue and expense. SFAS No. 109, Accounting for Income Taxes, also requires that the deferred tax assets be reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the recorded deferred tax assets will not be realized in future periods.
In evaluating our ability to recover our deferred tax assets, in full or in part, we consider all available positive and negative evidence including our past operating results, the existence of cumulative losses in the most recent fiscal years and our forecast of future taxable income on a jurisdiction-by-jurisdiction basis. In determining future taxable income, assumptions include the amount of state, federal and international pre-tax income from operations, international transfer pricing policies, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates we use to manage the underlying businesses. Based on our analysis of the above factors, we determined that a valuation allowance of $5.9 million was required as of December 31, 2007 for carryforwards of foreign and state tax losses and credits. Changes in our assumptions could result in an adjustment to the valuation allowance, up or down, in the future.
In addition, the calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations in a multitude of jurisdictions. We determine our liability for uncertain tax positions globally under the provisions in FIN 48. As of December 31, 2007, we had recorded a gross FIN 48 liability of $23.8 million. If events occur and the payment of these amounts ultimately proves to be unnecessary, the reversal of liabilities would result in tax benefits being recognized in the period when we determine the liabilities are no longer necessary. If our calculation of liability related to uncertain tax positions proves to be more or less than the ultimate assessment, a tax expense or benefit to expense, respectively, would result. The total liability reversal that could effect the tax rate is $9.3 million.
We review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset might not be recoverable. If indicators of impairment are present, we evaluate the carrying value of property and equipment in relation to estimates of future undiscounted cash flows. These undiscounted cash flows and fair values are based on judgments and assumptions. Additionally, we test goodwill for impairment on at least an annual basis by comparing the underlying reporting units goodwill to their estimated fair value. These tests for impairment of goodwill involve the use of estimates related to the fair market value of the reporting unit with which the goodwill is associated, and are inherently subjective.
We account for our share-based compensation plan using the provisions of SFAS No. 123 (revised), Share-Based Payment. Accordingly, we measure stock-based compensation cost at grant date, based on the fair value of the award, and recognize it as expense over the employees requisite service period. The fair value of each option award is estimated on the grant date using the Black-Scholes option-pricing model. The model requires the use of the following assumptions: an expected dividend yield; expected volatility; risk-free interest rate; and expected term. Based on our assumptions for these factors, the weighted-average fair value of options granted during the year ended December 31, 2007 was $10.93 per option. A change in these assumptions could have a significant impact on the weighted-average fair value of options. For example, if we changed our assumption for the expected term to increase expected life by a half of a year, the weighted average fair value of options granted during 2007 would have increased by $0.71 or 6.5% from $10.93 to $11.64, and the resulting stock-based employee compensation expense determined under the fair value based method for stock option awards, net of related tax effect, would have increased by $0.6 million. Diluted earnings per share under this example would not have been impacted. See Note 10 in the Notes to our Consolidated Financial Statements for details regarding the assumptions used in estimating fair value for the years ended December 31, 2005, 2006 and 2007 regarding our equity compensation plan and our employee stock purchase plan.
Recent Accounting Pronouncements
Recently issued accounting standards relevant to our financial statements, which are described in Recent Accounting Pronouncements in Note 1 in the Notes to our Consolidated Financial Statements are:
Because we conduct operations on a global basis, our effective tax rate has and will continue to depend upon the geographic distribution of our pretax earnings among locations with varying tax rates. Our profits are also impacted by changes in the tax rates of the various tax jurisdictions. In particular, as the geographic mix of our pretax earnings among various tax jurisdictions changes, our effective tax rate might vary from period to period. The effective rate will also change due to the discrete recognition of tax benefits when tax positions are effectively settled.
Our long-term contracts, those in excess of one year, generally include an inflation or cost of living adjustment for the portion of the services to be performed beyond one year from the contract date. In the event that actual inflation rates are greater than our contractual inflation rates or cost of living adjustments, inflation could have a material adverse effect on our operations or financial condition.
Potential Liability and Insurance
Drug development services involve the testing of potential drug candidates on human volunteers pursuant to a study protocol. This testing exposes us to the risk of liability for personal injury or death to volunteers and patients resulting from, among other things, possible unforeseen adverse side effects or improper administration of the study drug or use of the drug following regulatory approval. For example, we have been named as a defendant in a number of lawsuits relating to the antibiotic Ketek, as described in Part I, Item 3 Legal Proceedings. We attempt to manage our risk of liability for personal injury or death to volunteers and patients from administration of study products through standard operating procedures, patient informed consent, contractual indemnification provisions with clients and insurance. We monitor clinical trials in compliance with government regulations and guidelines. We have established global standard operating procedures intended to satisfy regulatory requirements in all countries in which we have operations and to serve as a tool for controlling and enhancing the quality of drug development services. The contractual indemnifications generally do not protect us against all our own actions, such as gross negligence. We currently maintain professional liability insurance coverage with limits we believe are adequate and appropriate.
Potential Volatility of Quarterly Operating Results and Stock Price
Our quarterly and annual operating results have fluctuated in the past, and we expect that they will continue to fluctuate in the future. Factors that could cause these fluctuations to occur include:
Delays and terminations of trials are often the result of actions taken by our clients or regulatory authorities, and are not typically controllable by us. Because a large percentage of our operating costs are relatively fixed while revenue is subject to fluctuation, variations in the timing and progress of large contracts can materially affect our quarterly operating results. For these reasons, we believe that comparisons of our quarterly financial results are not necessarily meaningful and should not be relied upon as an indication of future performance.
Recent consolidations and other transactions involving competitors could increase the competition within our industry for clients, experienced personnel and acquisition candidates. These consolidations and other potential future transactions, such as the acquisition of PRA International by Genstar Capital, a private equity firm, could increase competition in our industry.
Fluctuations in quarterly results, actual or anticipated changes in our dividend policy, stock repurchase plan or other factors could affect the market price of our common stock. These factors include ones beyond our control, such as changes in revenue and earnings estimates by analysts, market conditions in our industry, disclosures by product development partners and actions by regulatory authorities with respect to potential drug candidates, changes in pharmaceutical, biotechnology and medical device industries and the government sponsored clinical research sector and general economic conditions. Any effect on our common stock could be unrelated to our longer-term operating performance. For further details, see Item 1A. Risk Factors.
We are exposed to foreign currency risk by virtue of our international operations. We derived approximately 29.2%, 32.3% and 36.5% of our net revenues for the years ended December 31, 2005, 2006 and 2007, respectively, from operations outside the United States. We generally reinvest funds generated by each subsidiary in the country where they are earned. Our operations in the United Kingdom generated 28.0% of our net revenue from international operations during 2007. Accordingly, we are exposed to adverse movements in foreign currencies, predominately in the pound sterling.
The vast majority of our contracts are entered into by our U.S. or U.K. subsidiaries. The contracts entered into by the U.S. subsidiaries are almost always denominated in U.S. dollars. Contracts entered into by our U.K. subsidiaries are generally denominated in U.S. dollars, pounds sterling or euros, with the majority in U.S. dollars. Although an increase in exchange rates for the pound sterling or euro relative to the U.S. dollar would increase net revenue from contracts denominated in these currencies, a negative impact on income from operations results from dollar-denominated contracts for services rendered in countries other than the United States. In these cases, revenue is not impacted by the weakening of the U.S. dollar, but the costs associated with performing these contracts, which are paid in local currency, are negatively impacted when translated into U.S. dollars.
We also have currency risk resulting from the passage of time between the invoicing of clients under contracts and the collection of client payments against those invoices. If a contract is denominated in a currency other than the subsidiarys local currency, we recognize a receivable at the time of invoicing for the local currency equivalent of the foreign currency invoice amount. Changes in exchange rates from the time the invoice is prepared until payment from the client will result in our receiving either more or less in local currency than the local currency equivalent of the receivable. We recognize this difference as a foreign currency transaction gain or loss, as applicable, and report it in other income, net. If the exchange rate on accounts receivable balances denominated in pounds sterling and euros had increased by 10%, our foreign currency transaction loss would have increased by $3.0 million in the year ended December 31, 2007.
Our strategy for managing foreign currency risk relies primarily on receiving payment in the same currency used to pay expenses. If the U.S. dollar had weakened an additional 10% relative to the pound sterling, euro and Brazilian real in 2007, net income would have been approximately $7.3 million lower for the year based on revenues and the costs related to our foreign operations. From time to time, we also enter into foreign currency hedging activities in an effort to manage our potential foreign exchange exposure. As of December 31, 2007, the face value of foreign exchange contracts was $60.0 million.
Changes in exchange rates between the applicable foreign currency and the U.S. dollar will affect the translation of foreign subsidiaries financial results into U.S. dollars for purposes of reporting our consolidated financial results. The process by which we translate each foreign subsidiarys financial results to U.S. dollars is as follows:
Translation of the balance sheet in this manner affects shareholders equity through the cumulative translation adjustment account. This account exists only in the foreign subsidiarys U.S. dollar balance sheet and is necessary to keep the foreign balance sheet, stated in U.S. dollars, in balance. We report translation adjustments with accumulated other comprehensive income (loss) as a separate component of shareholders equity. To date, cumulative translation adjustments have not been material to our consolidated financial position. However, future translation adjustments could materially and adversely affect us.
Currently, there are no material exchange controls on the payment of dividends or otherwise prohibiting the transfer of funds out of any country in which we conduct operations. Although we perform services for clients located in a number of jurisdictions, we have not experienced any material difficulties in receiving funds remitted from foreign countries. However, new or modified exchange control restrictions could have an adverse effect on our financial condition. If the Company were to repatriate dividends from the cumulative amount of undistributed earnings in foreign entities, the Company would incur a tax liability which is not currently provided for in the Companys balance sheet.
We are exposed to changes in interest rates on our cash, cash equivalents and short-term investments and amounts outstanding under notes payable and lines of credit. We invest our cash and cash equivalents in financial instruments with interest rates based on market conditions. If the interest rates on cash, cash equivalents and short-term investments decreased by 10%, our interest income would have decreased by approximately $1.8 million in the year ended December 31, 2007.
We are also exposed to market risk related to our investments in auction rate securities. For further details, see Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources.
The information called for by this Item is set forth herein commencing on page F-1.
Disclosure Controls and Procedures
Disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) are designed only to provide reasonable assurance that information to be disclosed in our Exchange Act Reports is recorded, processed, summarized and reported within the time periods specified in the SECs rules and forms. As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b). Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report to provide the reasonable assurance discussed above.
Internal Control Over Financial Reporting
No change to our internal control over financial reporting occurred during the last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Managements Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining effective internal control over financial reporting as defined in Rules 13a-15(f) under the Securities Exchange Act of 1934. Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting
principles. Our internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of management and our Board of Directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.
A control system, no matter how well designed and operated, can only provide reasonable, not absolute, assurance that the objectives of the control system are met and must reflect the fact that there are resource constraints that require management to consider the benefits of internal controls relative to their costs. Because of these inherent limitations, management does not expect that our internal controls over financial reporting will prevent all errors and all fraud. Also, internal controls might become inadequate because of changes in business conditions or a decline in the degree of compliance with our policies or procedures.
Management, with the participation of our Chief Executive Officer and Chief Financial Officer, assessed the effectiveness of our internal control over financial reporting as of December 31, 2007. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control Integrated Framework. Based on our assessment, we believe that, as of December 31, 2007, our internal control over financial reporting was effective based on those criteria.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of
Pharmaceutical Product Development, Inc. and Subsidiaries
Wilmington, North Carolina
We have audited the internal control over financial reporting of Pharmaceutical Product Development, Inc. and subsidiaries (the Company) as of December 31, 2007, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Companys management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Managements Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Companys internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A companys internal control over financial reporting is a process designed by, or under the supervision of, the companys principal executive and principal financial officers, or persons performing similar functions, and effected by the companys Board of Directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2007 of the Company and our report dated February 26, 2008 expressed an unqualified opinion on those financial statements and includes explanatory paragraphs relating to the adoption of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109, in 2007 and the adoption of FASB Statement No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans an amendment of FASB Statements No. 87, 88, 106 and 132(R), in 2006.
February 26, 2008
Certain information required by Part III is omitted from this report because the Registrant intends to file a definitive proxy statement for its 2008 Annual Meeting of Shareholders to be held on May 21, 2008 (the Proxy Statement) within 120 days after the end of its fiscal year pursuant to Regulation 14A promulgated under the Securities Exchange Act of 1934, as amended, and the information included therein is incorporated herein by reference to the extent provided below.
The information required by Item 10 of Form 10-K concerning the Registrants executive officers is set forth under the heading Executive Officers located at the end of Part I of this Form 10-K.
The Board of Directors has determined that Frederick Frank, Stuart Bondurant, Terry Magnuson and John A. McNeill, Jr., the members of the Finance and Audit Committee, are independent as defined in Rule 4200(a) (15) of the Nasdaq listing standards and Rule 10A-3 under the Securities Exchange Act of 1934. The Board of Directors has also determined that at least one committee member, namely Mr. Frank, is an audit committee financial expert as defined in Item 407(d)(5) of Regulation S-K.
Our Board of Directors has adopted a code of conduct that applies to all of our directors and employees. Our board has also adopted a separate code of ethics for our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer and Controller, or persons performing similar functions. We will provide copies of our code of conduct and code of ethics without charge upon request. To obtain a copy of the code of ethics or code of conduct, please send your written request to Pharmaceutical Product Development, Inc., 929 North Front Street, Wilmington, NC 28401, Attn: General Counsel.
The other information required by Item 10 of Form 10-K is incorporated by reference to the information under the headings Proposal No. 1Election of Directors and Other Information-Section 16(a) Beneficial Ownership Reporting Compliance in the Proxy Statement.
The information required by Item 11 of Form 10-K is incorporated by reference to the information under the heading Other Information Compensation of Non-Employee Directors, Director Compensation in Fiscal 2007, Executive Compensation, and Compensation Committee Interlocks and Insider Participation in the Proxy Statement.
Equity Compensation Plans
The following table sets forth the indicated information with respect to our equity compensation plans as of December 31, 2007:
The other information required by Item 12 of Form 10-K is incorporated by reference to the information under the heading Other Information Principal Shareholders in the Proxy Statement.
The information required by Item 13 of Form 10-K is incorporated by reference to the information under the headings Proposal No. 1Election of Directors - Nominees and Information About the Board of Directors and its Committees, and Other InformationRelated Party Transactions in the Proxy Statement.
The information required by Item 14 of Form 10-K is incorporated by reference to the information under the heading Other Information Report of the Finance & Audit Committee and Fees Paid to the Independent Registered Public Accounting Firm in the Proxy Statement.
Our consolidated financial statements filed as part of this report are listed in the attached Index to Consolidated Financial Statements. There are no schedules to our consolidated financial statements.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
Pharmaceutical Product Development, Inc. and Subsidiaries
Wilmington, North Carolina
We have audited the accompanying consolidated balance sheets of Pharmaceutical Product Development, Inc. and subsidiaries (the Company) as of December 31, 2007 and 2006, and the related consolidated statements of operations, shareholders equity and cash flows for each of the three years in the period ended December 31, 2007. These consolidated financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Pharmaceutical Product Development, Inc. and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Notes 1 and 11 to the consolidated financial statements, in 2007 the Company changed its method of accounting for income tax contingencies to conform to FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109.
As discussed in Notes 1 and 12 to the consolidated financial statements, in 2006 the Company changed its method of accounting for its defined benefit pension plan to conform to FASB Statement No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans an amendment of FASB Statements No. 87, 88, 106 and 132(R).
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Companys internal control over financial reporting as of December 31, 2007, based on the criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 26, 2008 expressed an unqualified opinion on the Companys internal control over financial reporting.
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 2005, 2006 AND 2007
(in thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31, 2006 AND 2007
(in thousands, except share data)
The accompanying notes are an integral part of these consolidated financial statements.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2005, 2006 AND 2007
(in thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2005, 2006 AND 2007