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Pharmaceutical Product Development 10-Q 2005
Form 10-Q
Table of Contents

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

 


 

FORM 10-Q

 


 

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934.

 

For the quarterly period ended June 30, 2005.

 

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

 

For the transition period from              to             .

 

Commission File Number 0-27570

 


 

PHARMACEUTICAL PRODUCT

DEVELOPMENT, INC.

(Exact name of registrant as specified in its charter)

 


 

North Carolina   56-1640186

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

 

3151 South Seventeenth Street

Wilmington, North Carolina

(Address of principal executive offices)

 

28412

(Zip Code)

 

Registrant’s telephone number, including area code: (910) 251-0081

 


 

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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).    Yes  x    No  ¨

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 57,613,164 shares of common stock, par value $0.10 per share, as of July 25, 2005.

 



Table of Contents

INDEX

 

     Page

Part I. FINANCIAL INFORMATION     
Item 1. Financial Statements     
   

Consolidated Condensed Statements of Operations for the Three and Six Months Ended June 30, 2004 and 2005 (unaudited)

   3
   

Consolidated Condensed Balance Sheets as of December 31, 2004 and June 30, 2005 (unaudited)

   4
    Consolidated Condensed Statements of Cash Flows for the Six Months Ended June 30, 2004 and 2005 (unaudited)    5
   

Notes to Consolidated Condensed Financial Statements (unaudited)

   6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations    22
Item 3. Quantitative and Qualitative Disclosures about Market Risk    37
Item 4. Controls and Procedures    38
Part II. OTHER INFORMATION     
Item 4. Submission of Matters to a Vote of Security Holders    39
Item 6. Exhibits    39
Signatures    40

 

2


Table of Contents

Part I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

 

CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

(unaudited)

(in thousands, except per share data)

 

    

Three Months Ended

June 30,


  

Six Months Ended

June 30,


 
     2004

    2005

   2004

    2005

 

Net Revenue:

                               

Development revenue

   $ 183,178     $ 224,862    $ 357,892     $ 437,783  

Discovery sciences revenue

     2,033       3,636      9,581       16,496  

Reimbursed out-of-pockets

     15,325       16,644      28,343       34,917  
    


 

  


 


Total net revenue

     200,536       245,142      395,816       489,196  
    


 

  


 


Direct Costs:

                               

Development

     90,834       112,787      179,044       221,117  

Discovery sciences

     1,282       1,992      2,848       3,757  

Reimbursable out-of-pocket expenses

     15,325       16,644      28,343       34,917  
    


 

  


 


Total direct costs

     107,441       131,423      210,235       259,791  
    


 

  


 


Research and development expenses

     3,638       11,445      4,924       20,266  

Selling, general and administrative expenses

     47,816       58,987      92,975       114,419  

Depreciation

     6,883       9,512      13,600       17,871  

Amortization

     417       279      742       567  

Gain on exchange of assets

     —         —        —         (5,144 )

Restructuring charges

     2,114       —        2,619       —    
    


 

  


 


Total operating expenses

     168,309       211,646      325,095       407,770  
    


 

  


 


Income from operations

     32,227       33,496      70,721       81,426  

Interest income, net

     258       1,940      450       3,215  

Impairment of investment

     (2,000 )     —        (2,000 )     —    

Other income, net

     950       952      1,262       857  
    


 

  


 


Income before provision for income taxes

     31,435       36,388      70,433       85,498  

Provision for income taxes

     8,121       12,736      22,355       26,225  
    


 

  


 


Net income

   $ 23,314     $ 23,652    $ 48,078     $ 59,273  
    


 

  


 


Net income per share:

                               

Basic

   $ 0.41     $ 0.41    $ 0.86     $ 1.04  
    


 

  


 


Diluted

   $ 0.41     $ 0.41    $ 0.85     $ 1.03  
    


 

  


 


Weighted average number of common shares outstanding:

                               

Basic

     56,223       57,059      56,188       56,909  

Dilutive effect of stock options

     433       838      432       810  
    


 

  


 


Diluted

     56,656       57,897      56,620       57,719  
    


 

  


 


 

The accompanying notes are an integral part of these consolidated condensed financial statements.

 

3


Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

 

CONSOLIDATED CONDENSED BALANCE SHEETS

 

(in thousands)

 

    

December 31,

2004


  

June 30,

2005


 
          (unaudited)  

Assets

               

Current assets

               

Cash and cash equivalents

   $ 144,348    $ 288,081  

Short-term investments

     105,020      —    

Accounts receivable and unbilled services, net

     265,067      255,670  

Income tax receivable

     6,321      366  

Investigator advances

     15,251      13,392  

Prepaid expenses and other current assets

     28,189      33,256  

Deferred tax asset

     10,867      12,229  
    

  


Total current assets

     575,063      602,994  

Property and equipment, net

     136,501      201,275  

Goodwill

     179,781      209,487  

Investments

     66,658      18,253  

Intangible assets

     3,895      3,327  

Long-term deferred tax asset

     12,374      10,342  

Other assets

     929      10,303  
    

  


Total assets

   $ 975,201    $ 1,055,981  
    

  


Liabilities and Shareholders’ Equity

               

Current liabilities

               

Accounts payable

   $ 12,863    $ 10,231  

Payables to investigators

     43,726      45,485  

Accrued income taxes

     5,118      13,059  

Other accrued expenses

     101,714      111,690  

Deferred tax liability

     770      53  

Unearned income

     153,170      133,252  

Current maturities of long-term debt and capital lease obligations

     599      2,000  
    

  


Total current liabilities

     317,960      315,770  

Long-term debt and capital lease obligations, less current maturities

     6,371      6,407  

Accrued additional pension liability

     9,923      9,267  

Long-term deferred tax liability

     370      2,983  

Deferred rent and other

     5,267      14,722  
    

  


Total liabilities

     339,891      349,149  

Shareholders’ equity

               

Common stock

     5,662      5,743  

Paid-in capital

     293,200      317,790  

Retained earnings

     325,269      384,542  

Deferred compensation

     —        (2,097 )

Accumulated other comprehensive income

     11,179      854  
    

  


Total shareholders’ equity

     635,310      706,832  
    

  


Total liabilities and shareholders’ equity

   $ 975,201    $ 1,055,981  
    

  


 

The accompanying notes are an integral part of these consolidated condensed financial statements.

 

4


Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

 

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

 

(unaudited)

(in thousands)

 

    

Six Months Ended

June 30,


 
     2004

    2005

 

Cash flows from operating activities:

                

Net income

   $ 48,078     $ 59,273  

Adjustments to reconcile net income to net cash provided by operating activities:

                

Impairment of investment

     2,000       —    

Depreciation and amortization

     14,342       18,438  

Stock compensation amortization

     —         91  

Restructuring charges

     2,619       —    

Gain on exchange of assets

     —         (5,144 )

Loss on disposition of property and equipment, net

     27       173  

Provision for doubtful accounts

     403       50  

(Benefit) provision for deferred income taxes

     (4,702 )     2,770  

Change in operating assets and liabilities, net of acquisitions

     13,651       12,268  
    


 


Net cash provided by operating activities

     76,418       87,919  
    


 


Cash flows from investing activities:

                

Purchases of property and equipment

     (23,972 )     (72,440 )

Proceeds from sale of property and equipment

     183       86  

Purchases of available-for-sale investments

     (385,153 )     (24,720 )

Maturities and sales of available-for-sale investments

     372,406       129,740  

Deposit on warrants of investee

     —         (5,000 )

Purchases of investments

     (5,900 )     (5,405 )

Proceeds from sale of investment

     —         25,000  

Cash refunded related to business acquired

     1,450       —    
    


 


Net cash (used in) provided by investing activities

     (40,986 )     47,261  
    


 


Cash flows from financing activities:

                

Principal repayments of long-term debt

     (174 )     (185 )

Repayment of capital leases obligation

     (460 )     (857 )

Proceeds from exercise of stock options and employee stock purchase plan

     4,212       14,907  
    


 


Net cash provided by financing activities

     3,578       13,865  
    


 


Effect of exchange rate changes on cash and cash equivalents

     37       (5,312 )
    


 


Net increase in cash and cash equivalents

     39,047       143,733  

Cash and cash equivalents, beginning of the period

     60,677       144,348  
    


 


Cash and cash equivalents, end of the period

   $ 99,724     $ 288,081  
    


 


 

The accompanying notes are an integral part of these consolidated condensed financial statements.

 

5


Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

(unaudited)

 

1. SIGNIFICANT ACCOUNTING POLICIES

 

The significant accounting policies followed by Pharmaceutical Product Development, Inc. and its subsidiaries (collectively the “Company”) for interim financial reporting are consistent with the accounting policies followed for annual financial reporting. We prepared these unaudited consolidated condensed financial statements in accordance with Rule 10-01 of Regulation S-X and, in management’s opinion, we have included all adjustments of a normal recurring nature necessary for a fair presentation. The accompanying consolidated condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004. The results of operations for the three-month and six-month periods ended June 30, 2005 are not necessarily indicative of the results to be expected for the full year or any other period. We derived the amounts on the December 31, 2004 consolidated condensed balance sheet from the audited financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

 

Use of estimates in the preparation of financial statements

 

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 from those estimates.

 

Principles of consolidation

 

The accompanying unaudited consolidated condensed financial statements include the accounts and results of operations of the Company. All intercompany balances and transactions have been eliminated in consolidation.

 

Earnings per share

 

The computation of basic income per share information is based on the weighted average number of common shares outstanding during the period. The computation of diluted income per share information is based on the weighted average number of common shares outstanding during the period plus the effects of any dilutive common stock equivalents.

 

Reclassification

 

The Company has reclassified certain 2004 financial statement amounts to conform to the 2005 financial statement presentation.

 

6


Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

(unaudited)

 

1. SIGNIFICANT ACCOUNTING POLICIES (continued)

 

Stock-based compensation

 

The Company has adopted the disclosure requirements of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” and Statement of Financial Accounting Standards No. 148, “Accounting for Stock Based Compensation - Transition and Disclosure - an Amendment of FASB Statement No. 123”, which require compensation expense to be disclosed in the notes based on the fair value of the options granted at the date of the grant. Had compensation cost for the Company’s stock option plan been determined based on the fair value at the grant dates for awards under the plan consistent with the method required by SFAS No. 123, the Company’s net income and diluted net income per common share would have been the pro forma amounts indicated below.

 

    

Three Months Ended

June 30,


  

Six Months Ended

June 30,


(in thousands, except per share data)    


   2004

   2005

   2004

   2005

Net income, as reported

   $ 23,314    $ 23,652    $ 48,078    $ 59,273

Less: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects

     1,615      2,853      2,926      5,593
    

  

  

  

Pro forma net income

   $ 21,699    $ 20,799    $ 45,152    $ 53,680
    

  

  

  

Net income per share:

                           

Basic – as reported

   $ 0.41    $ 0.41    $ 0.86    $ 1.04

Basic – pro forma

   $ 0.39    $ 0.36    $ 0.80    $ 0.94

Diluted – as reported

   $ 0.41    $ 0.41    $ 0.85    $ 1.03

Diluted – pro forma

   $ 0.38    $ 0.36    $ 0.80    $ 0.93

 

Restructuring charges

 

In the first and second quarter of 2004, the Company recorded a $0.5 million and a $2.1 million restructuring charge, respectively, associated with exiting the Company’s chemistry facility in Research Triangle Park, North Carolina. These charges include lease payments and termination costs, net of sublease rentals, of approximately $2.1 million and a loss on sale of assets used in the chemistry services business of approximately $0.5 million. The lease termination liability will be paid over the remaining life of the lease, which terminates in 2015. During the three months ended June 30, 2004 and 2005, lease payments and related expenses of $0 and $0.2 million were paid, respectively. During the six months ended June 30, 2004 and 2005, lease payments and related expenses of $0 and $0.5 million were paid, respectively. At June 30, 2005, the Company recorded the remaining restructuring liability of $0.7 million in the consolidated condensed balance sheet as a component of other accrued expenses and deferred rent and other. The loss on sale of assets was a non-cash item and was charged to expense during the three months ended March 31, 2004.

 

Inventory

 

Inventories, which consist principally of laboratory supplies, are valued at the lower of cost (first-in, first-out method) or market. Inventories totaling $2.2 million and $2.3 million as of December 31, 2004 and June 30, 2005, respectively, were included in prepaid expenses and other current assets.

 

7


Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

(unaudited)

 

1. SIGNIFICANT ACCOUNTING POLICIES (continued)

 

Recent accounting pronouncements

 

In October 2004, the EITF finalized its consensuses on EITF 04-01, “Accounting for Preexisting Relationships between the Parties to a Business Combination”. The consensuses in EITF 04-01 provide guidance on how to account for the settlement of a preexisting relationship and how it affects the accounting of the business combination. EITF 04-01 is effective for business combinations consummated and goodwill impairment tests performed in reporting periods beginning after October 13, 2004. In February 2005, the Company recorded a gain on the termination of a preexisting lease arrangement as part of the acquisition of SurroMed, Inc.’s biomarker business in accordance with the guidance in EITF 04-01. See Note 2.

 

In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123 (Revised 2004) “Share-Based Payment” that will require compensation costs related to share-based payment transactions to be recognized in the financial statements. With limited exceptions, the amount of compensation cost will be measured based on the fair value on the date of grant of the equity or liability instruments issued. In addition, liability instruments will be remeasured each reporting period. Compensation cost will be recognized over the period that an employee provides service in exchange for the award. In March 2005, the SEC issued Staff Accounting Bulletin 107 which describes the SEC staff’s expectations in determining the assumptions that underlie the fair value estimates and discusses the interaction of SFAS No. 123 (Revised) with certain existing SEC guidance. In April 2005, the SEC deferred the effective date for SFAS No. 123 (Revised) to the beginning of the first fiscal year that begins after June 15, 2005. The Company is currently evaluating the impact of the adoption of this statement on the Company’s financial statements.

 

In December 2004, the FASB issued SFAS No. 153, “Exchange of Nonmonetary Assets, an amendment of APB Opinion No. 29”. SFAS No. 153 replaces the exception from fair value measurement included in APB Opinion No. 29 for nonmonetary exchanges of similar productive assets with a general exception from fair value measurement for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. This statement will be applied prospectively and is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The Company does not believe adoption of this statement will have a material impact on the Company’s financial statements.

 

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections”, which changes the requirements for the accounting and reporting of a change in accounting principle. SFAS No. 154 applies to all voluntary changes in accounting principle as well as to changes required by an accounting pronouncement that does not include specific transition provisions. SFAS No. 154 requires that changes in accounting principle be retrospectively applied. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company does not believe adoption of this statement will have a material impact on the Company’s financial statements.

 

8


Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

(unaudited)

 

2. ACQUISITIONS

 

In February 2005, the Company completed its acquisition of substantially all of the assets of SurroMed, Inc.’s biomarker business. The assets acquired by the Company consist of equipment, fixtures, leasehold improvements, intellectual property and contracts. The biomarker business supports drug discovery and drug development by identifying biomarkers using biological, chemical and bioinformatics expertise and technologies. The acquisition expands the Company’s business by adding biomarker discovery and patient sample analysis capability to the services offered by the Company. In exchange for the assets, the Company surrendered to SurroMed all shares of preferred stock of SurroMed it held. As additional consideration for the acquisition, the Company assumed approximately $3.4 million of SurroMed liabilities under capital leases and additional operating liabilities, and agreed to guarantee repayment of up to $1.5 million under a SurroMed bank loan. In accordance with the requirements of FASB Statement No. 5, “Accounting for Contingencies”, as clarified by FASB Interpretation No. 45, the Company has recorded a liability in the amount of $150,000 for the estimated fair value of the obligation it has assumed under this guarantee. The Company recognized a pre-tax gain on exchange of assets of $5.1 million, primarily related to the $4.9 million gain on the termination of a preexisting facility lease arrangement with SurroMed in accordance with EITF 04-01, “Accounting for Preexisting Relationships between the Parties to a Business Combination”. The fair value of the leasing arrangement was determined based on the discounted cash flows of the difference between the future required rental payments under the lease agreement and the current market rate for similar facilities. The results of operations from the biomarker assets acquired are included in the Company’s consolidated condensed statement of operations as of and since February 1, 2005, the effective date of the acquisition. This biomarker business is part of the Discovery Sciences segment of the Company.

 

This acquisition was accounted for using the purchase method of accounting, using appropriate fair value techniques to allocate the purchase price based on the estimated fair values of the assets acquired and liabilities assumed. Accordingly, the estimated fair value of assets acquired and liabilities assumed were included in the Company’s consolidated condensed balance sheet as of the effective date of the acquisition.

 

The total purchase price for the acquisition was allocated to the estimated fair value of assets acquired and liabilities assumed as set forth in the following table:

 

(in thousands)


      

Condensed balance sheet:

        

Current assets

   $ 186  

Property and equipment, net

     8,780  

Deferred rent and other

     (742 )

Current liabilities

     (3,512 )

Long-term liabilities

     (2,267 )

Value of identifiable intangible assets:

        

Goodwill

     33,001  
    


Total

   $ 35,446  
    


 

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Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

(unaudited)

 

2. ACQUISITIONS (continued)

 

The purchase price allocation has been finalized for this acquisition. Goodwill will be evaluated annually as required by SFAS 142. Goodwill related to SurroMed is expected to be deductible for tax purposes.

 

The unaudited pro forma results from operations for the Company assuming the acquisition was consummated as of January 1, 2004 were as follows:

 

    

Three Months Ended

June 30,


  

Six Months Ended

June 30,


(in thousands, except per share data)


   2004

   2005

   2004

   2005

Total revenue

   $ 202,601    $ 245,142    $ 399,756    $ 489,858

Net income

   $ 22,198    $ 23,652    $ 45,687    $ 59,072

Net income per share:

                           

Basic

   $ 0.39    $ 0.41    $ 0.81    $ 1.04

Diluted

   $ 0.39    $ 0.41    $ 0.81    $ 1.02

 

The above amounts are based upon assumptions and estimates the Company believes are reasonable, but they do not reflect any benefit from economies that might be achieved from combined operations. Pro forma adjustments were made to income tax benefit, increasing net income by $0.6 million, $0, $1.3 million and $0.1 million for the three-month and six-month periods ended June 30, 2004 and 2005, respectively. These adjustments are reflected in the above table. The pro forma financial information presented above is not necessarily indicative of either the results of operations that would have occurred had the acquisition taken place at the beginning of the period indicated or of future results of operations of the Company.

 

3. ACCOUNTS RECEIVABLE AND UNBILLED SERVICES

 

Accounts receivable and unbilled services consisted of the following:

 

(in thousands)        


  

December 31,

2004


   

June 30,

2005


 

Billed

   $ 183,765     $ 169,553  

Unbilled

     85,404       89,996  

Provision for doubtful accounts

     (4,102 )     (3,879 )
    


 


     $ 265,067     $ 255,670  
    


 


 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

(unaudited)

 

4. PROPERTY AND EQUIPMENT

 

Property and equipment, stated at cost, consisted of the following:

 

(in thousands)


  

December 31,

2004


   

June 30,

2005


 

Land

   $ 7,392     $ 10,872  

Buildings and leasehold improvements

     45,493       55,047  

Construction in progress and software under development

     21,649       27,378  

Furniture and equipment

     99,778       144,904  

Computer equipment and software

     86,367       99,089  
    


 


       260,679       337,290  

Less accumulated depreciation and amortization

     (124,178 )     (136,015 )
    


 


     $ 136,501     $ 201,275  
    


 


 

In February 2005, the Company acquired a Dassault Falcon 900EX aircraft for $30.5 million in cash. The Company uses the aircraft for corporate purposes. The Company financed the acquisition from available cash.

 

Property and equipment under capital leases, stated at cost, consisted of the following as of June 30, 2005:

 

(in thousands)


      

Leasehold improvements

   $ 824  

Computer equipment and software

     656  

Furniture and equipment

     1,849  
    


       3,329  

Less accumulated depreciation and amortization

     (497 )
    


     $ 2,832  
    


 

As of December 31, 2004, the Company did not have any property and equipment under capital lease. The property and equipment under capital lease as of June 30, 2005 was acquired by the Company in the acquisition of SurroMed’s biomarker business.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

(unaudited)

 

5. GOODWILL AND INTANGIBLE ASSETS

 

Changes in the carrying amount of goodwill for the twelve months ended December 31, 2004 and the six months ended June 30, 2005, by operating segment, were as follows:

 

(in thousands)


   Development

    Discovery

   Total

 

Balance as of January 1, 2004

   $ 157,461     $ 20,615    $ 178,076  

Changes in goodwill recorded during the period for prior year acquisitions (finalization of purchase price adjustments)

     (699 )     —        (699 )

Translation adjustments

     2,404       —        2,404  
    


 

  


Balance as of December 31, 2004

     159,166       20,615      179,781  

Goodwill recorded during the period for current year acquisitions

     —         33,001      33,001  

Translation adjustments

     (3,295 )     —        (3,295 )
    


 

  


Balance as of June 30, 2005

   $ 155,871     $ 53,616    $ 209,487  
    


 

  


 

Information regarding the Company’s other intangible assets follows:

 

     As of December 31, 2004

   As of June 30, 2005

(in thousands)


   Carrying
Amount


   Accumulated
Amortization


   Net

   Carrying
Amount


   Accumulated
Amortization


   Net

Backlog and customer relationships

   $ 2,733    $ 2,381    $ 352    $ 2,733    $ 2,458    $ 275

Patents

     280      271      9      263      260      3

License and royalty agreements

     5,000      1,466      3,534      5,000      1,951      3,049
    

  

  

  

  

  

Total

   $ 8,013    $ 4,118    $ 3,895    $ 7,996    $ 4,669    $ 3,327
    

  

  

  

  

  

 

The Company amortizes all intangible assets on a straight-line basis, based on estimated useful lives of three to five years for backlog and customer relationships, five years for patents and three to ten years for license and royalty agreements. The approximate weighted average amortization period is 4.1 years for backlog, 5.0 years for patents, 6.4 years for license and royalty agreements, and 6.1 years for all intangibles collectively.

 

Amortization expense for the three months ended June 30, 2004 and 2005 was $0.4 million and $0.3 million, respectively. Estimated amortization expense for the next five years is as follows:

 

(in thousands)


    

2005 (remaining 6 months)

   $ 553

2006

     606

2007

     362

2008

     333

2009

     300

 

12


Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

(unaudited)

 

6. SHORT-TERM INVESTMENTS AND INVESTMENTS

 

Short-term investments, which are composed of available-for-sale securities, and investments consisted of the following:

 

(in thousands)


  

December 31,

2004


  

June 30,

2005


Short-term investments:

             

Preferred stock

   $ 48,225    $ —  

State and municipal securities

     51,850      —  

Other debt securities

     4,945      —  
    

  

Total short-term investments

   $ 105,020    $ —  
    

  

Investments:

             

Cost-basis investments

             

SurroMed, Inc.

   $ 29,007    $ —  

Syrrx, Inc.

     25,000      —  

Accentia Biopharmaceuticals, Inc.

     4,771      9,662

Spotlight Health, Inc.

     1,230      2,230

Oriel Therapeutics, Inc.

     1,800      2,150

Other equity investments

     250      415
    

  

Total cost-basis investments

     62,058      14,457

Marketable equity securities

             

BioDelivery Sciences International, Inc.

     2,850      2,236

Chemokine Therapeutics Corp.

     1,750      1,560
    

  

Total marketable equity securities

     4,600      3,796
    

  

Total investments

   $ 66,658    $ 18,253
    

  

 

Short-term investments

 

At December 31, 2004, the Company’s short-term investments consisted of Auction Rate Securities, or ARS. ARS generally have stated maturities of 20 to 30 years. However, these securities have economic characteristics of short-term investments due to a rate-setting mechanism and the ability to liquidate them through a Dutch auction process that occurs on pre-determined intervals of less than 90 days. As such, these investments are classified as short-term investments. The Company’s short-term investments were classified as available-for-sale securities due to management’s intent regarding these securities. As of December 31, 2004, there were no unrealized gains or losses associated with these investments and the fair market value equaled the adjusted cost. At June 30, 2005, the Company had disposed of all short-term investments.

 

The gross realized (losses)/gains on available-for-sale securities were $53,000 and $0 in the three months ended June 30, 2004 and 2005, respectively, and $95,000 and $(17,000) for the six months ended June 30, 2004 and 2005, respectively determined on a specific identification basis.

 

13


Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

(unaudited)

 

6. SHORT-TERM INVESTMENTS AND INVESTMENTS (continued)

 

Investments

 

The Company’s equity investments are classified as long-term assets due to management’s intent to hold these securities for more than twelve months.

 

The Company has equity investments in publicly traded entities. Investments in publicly traded entities are classified as available-for-sale securities and are measured at market value. The Company records net unrealized gains or losses associated with investments in publicly traded entities as a component of shareholders’ equity until they are realized or an other-than-temporary decline has occurred. The market value of the Company’s equity investments in publicly traded entities is based on the closing price as quoted by the applicable stock exchange or market at the end of the reporting period. As of December 31, 2004 and June 30, 2005, gross unrealized gains were $1.6 million and $0.8 million, respectively, and gross unrealized losses as of December 31, 2004 and June 30, 2005 were $0 and $48,000, respectively.

 

The Company also has investments in privately held entities in the form of equity and convertible debt instruments that are not publicly traded and for which fair values are not readily determinable. The Company records all of its investments in private entities under the cost method of accounting. The Company assesses the net realizable value of these entities on a quarterly basis to determine if there has been a decline in the fair value of these entities, and if so, if the decline is other than temporary. 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. The impairment analysis requires significant judgment to identify events or circumstances that would likely have a significant adverse effect on the fair value of the investment.

 

In January 2004, the Company purchased 5.0 million shares of Accentia Biopharmaceuticals, Inc. Series E convertible preferred stock for $5.0 million. At that time, the Company also received a Class A and Class B warrant, each to purchase up to an additional 5.0 million shares of Series E convertible preferred stock for $1.00 per share. The Company received dividends on its Series E convertible preferred stock in excess of Accentia’s earnings in the first half of 2005 and for the full year of 2004 and thus recorded these as a return of the investment in Accentia. In January 2005, the Company exercised the Class A warrant. The Class B warrant will expire on the earlier of January 7, 2006 or the effective date of a registration statement for the public sale of Accentia common stock in a qualifying initial public offering. The Company owned approximately 12.4% of the outstanding capital stock of Accentia as of June 30, 2005. Accentia is a privately held, specialty biopharmaceutical company that focuses on commercializing targeted therapeutics in the respiratory, oncology and critical care areas. In February 2005, Accentia filed a registration statement with the SEC for its proposed initial public offering of common stock. In June 2005, the Company conditionally exercised the Class B warrant and deposited $5.0 million with Accentia. Accentia will be entitled to deposit and retain the Class B warrant exercise price if a qualifying IPO occurs on or before September 1, 2005. If this condition is not met, Accentia must refund the Company’s deposit. The $5.0 million deposit is included in other assets on the Company’s consolidated condensed balance sheet at June 30, 2005. Accentia proposes to sell in this public offering, in addition to shares for its own account, 1.0 million shares of common stock issuable to the Company upon conversion of Series E convertible preferred stock.

 

14


Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

(unaudited)

 

6. SHORT-TERM INVESTMENTS AND INVESTMENTS (continued)

 

In April 2000, the Company purchased 1.0 million shares of Spotlight Health Series C convertible preferred stock for $5.0 million. The Company recorded a charge to earnings for other than temporary decline in the fair value of its investment in Spotlight Health of $3.9 million in 2003. In July 2003, the Company entered into an agreement with Spotlight Health and Bank of America, N.A. to guarantee a $2.0 million revolving line of credit provided to Spotlight Health by Bank of America. This new line of credit was used to refinance existing Spotlight Health debt that was also guaranteed by the Company. In June 2005, the Company purchased 970,873 shares of Spotlight Health’s Series D convertible preferred stock for a purchase price of $1.03 per share. In connection with that transaction, the parties amended the loan agreement with Bank of America to provide for, a quarterly reduction of the principal amount of the revolving line of credit of $250,000 on September 30 and December 31, 2005, and $500,000 on March 31, June 30 and September 30, 2006. Spotlight Health also granted Bank of America a first lien security interest on its assets to secure its obligations under the loan agreement. As of June 30, 2005, the Company owned approximately 11.6% of Spotlight’s outstanding capital stock.

 

In December 2002, the Company purchased 150,000 shares of Oriel Therapeutics, Inc. Series A convertible preferred stock for $150,000. The Company also received, as part of the purchase, a warrant to purchase an equal number of shares of stock offered by Oriel Therapeutics in its next round of financing at a discount. In April 2003, the Company exercised the warrant for 150,000 shares of Oriel Therapeutics Series B convertible preferred stock for $200,000. At the same time, the Company also purchased an additional 255,000 shares of Oriel’s Series B for $500,000. In March 2004, the Company loaned Oriel $900,000 in the form of secured debt convertible into Oriel Therapeutics’ Series B preferred stock at $2.00 per share. The loan is secured by a first lien on Oriel’s assets. In June 2005, the Company loaned Oriel an additional $350,000 and received a warrant to purchase shares offered by Oriel Therapeutics in a future equity financing transaction and a promissory note to secure the debt. The Company owned approximately 13.9% of Oriel Therapeutics’ outstanding common stock as of June 30, 2005. Oriel is a privately held company pursuing the development of technology to improve drug delivery in the treatment of respiratory and pulmonary diseases.

 

In November 2003, the Company became a limited partner in A. M. Pappas Life Science Ventures III, LP, a venture capital fund. The Pappas Fund was established for the purpose of making investments in equity securities of privately held companies in the life sciences, healthcare and technology industries. The Company has committed to invest up to an aggregate of approximately $2.5 million in the Pappas Fund. No capital call can exceed 10% of the Company’s aggregate capital commitment. As such, the Company anticipates that its aggregate investment will be made through a series of future capital calls over the next several years. Capital calls through June 30, 2005 were $165,000. The Company’s capital commitment will expire in May 2009.

 

In March 2005, Takeda Pharmaceutical Company Limited completed its acquisition of 100% of the equity of Syrrx, Inc. The Company owned $25.0 million in preferred stock of Syrrx. Takeda paid the Company $25.0 million in April 2005 for this preferred stock. Syrrx is now known as Takeda San Diego, Inc.

 

15


Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

(unaudited)

 

7. COMPREHENSIVE INCOME

 

Comprehensive income consisted of the following:

 

    

Three Months Ended

June 30,


   

Six Months Ended

June 30,


 

(in thousands)        


   2004

    2005

    2004

    2005

 

Net income, as reported

   $ 23,314     $ 23,652     $ 48,078     $ 59,273  

Other comprehensive income (loss)

                                

Cumulative translation adjustment

     (881 )     (5,222 )     (1,321 )     (8,215 )

Change in fair value of hedging transaction, net of taxes of $384, $484, $384 and $532, respectively

     (102 )     (1,129 )     (1,974 )     (1,218 )

Reclassification adjustment for hedging results included in direct costs, net of taxes of $0, $11, $0 and $40, respectively

     643       (26 )     1,123       (89 )

Unrealized gain (loss) on investments, net of taxes of $0

     (193 )     (520 )     469       (804 )
    


 


 


 


Total other comprehensive loss

     (533 )     (6,897 )     (1,703 )     (10,326 )
    


 


 


 


Comprehensive income

   $ 22,781     $ 16,755     $ 46,375     $ 48,947  
    


 


 


 


 

Accumulated other comprehensive income consisted of the following:

 

(in thousands)


  

December 31,

2004


   

June 30,

2005


 

Translation adjustment

   $ 14,903     $ 6,688  

Minimum pension liability, net of tax

     (5,753 )     (5,752 )

Fair value on hedging transaction, net of tax

     413       (894 )

Unrealized gain on investment

     1,616       812  
    


 


     $ 11,179     $ 854  
    


 


 

8. ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

 

In January 2004, the Company began entering into foreign exchange forward and option contracts that are designated and qualify as cash flow hedges under SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities”. Changes in the fair value of the effective portion of these outstanding forward and option contracts are recognized in accumulated other comprehensive income, or OCI. These amounts are reclassified from OCI and recognized in earnings when either the forecasted transaction occurs or it becomes probable that the forecasted transaction will not occur.

 

Changes in the ineffective portion of a derivative instrument are recognized in earnings in the current period. Effectiveness for forward cash flow hedge contracts is measured by comparing the fair value of the forward contract to the change in the forward value of the anticipated transaction. The fair market value of the hedged exposure is presumed to be the market value of the hedge instrument when critical terms match. Ineffectiveness in 2004 and 2005 was not significant.

 

16


Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

(unaudited)

 

8. ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES (continued)

 

The Company has significant international revenues and purchase transactions and related receivables and payables denominated in non-functional currencies at the Company’s foreign subsidiaries. As a result, the Company purchased currency option and forward contracts as cash flow hedges to reduce or eliminate foreign currency exposures that can be identified and quantified. Pursuant to its foreign exchange risk hedging policy, the Company may hedge anticipated and recorded transactions and the related receivables and payables denominated in non-functional currencies using forward foreign exchange rate contracts and foreign currency options. Foreign currency derivatives are used only to meet the Company’s objective of minimizing the variability in the Company’s operating results arising from foreign currency exchange rate movements. The Company does not enter into derivative financial instruments for speculative or trading purposes. Hedging contracts are measured at fair value using dealer quotes and mature within twelve months from their inception.

 

The Company’s hedging contracts are primarily intended to protect against the impact of changes in the value of the U.S. dollar against other currencies and its impact on operating results. Accordingly, for forecasted transactions, non-U.S. dollar functional subsidiaries incurring expenses in foreign currencies hedge U.S. dollar revenue contracts. OCI associated with hedges of foreign currency revenue is reclassified into revenue upon recognition of the forecasted transaction in the statement of operations. All values reported in OCI at June 30, 2005 will be reclassified to earnings within twelve months. At June 30, 2005, the face amount of the foreign exchange contracts designated as cash flow hedges was $45.0 million.

 

The Company also enters into foreign currency forward contracts to hedge against changes in the fair value of monetary assets and liabilities denominated in a non-functional currency. These derivative instruments are not designated as hedging instruments; therefore, changes in the fair value of these contracts are recognized immediately in other income, net, as an offset to the changes in the fair value of the monetary assets or liabilities being hedged. At June 30, 2005, the face amount of these contracts was $18.2 million.

 

At June 30, 2005, the fair value of the Company’s foreign currency derivative portfolio was a $1.4 million loss recorded as a component of other accrued expenses.

 

9. INCOME TAXES

 

The effective tax rate for the second quarter of 2005 and the first six months of 2005 was 35.0% and 30.7%, respectively. The effective tax rate for the first six months of 2005 was positively impacted by a $4.7 million reduction in the valuation allowance provided for the deferred tax asset relating to a capital loss carryforwards. This reduction was a result of the utilization of capital loss carryforwards that previously had a valuation allowance recorded against them as well as the recognition of capital gains for both the SurroMed transaction and the $10.0 million dapoxetine new drug application milestone payment. This reduction in the valuation allowance decreased the effective tax rate by 5.6%.

 

The Company records current and deferred income tax expense related to its foreign operations to the extent those earnings are taxable in a foreign jurisdiction. The American Jobs Creation Act of 2004 introduced a special one-time dividends received deduction on the repatriation of foreign earnings to a U.S. taxpayer. We have not previously recorded a U.S. tax liability on these revenues because we intended to permanently reinvest them in our foreign operations. We have been evaluating the impact of this law on our permanent reinvestment position and have recorded $0.8 million tax expense in the second quarter related to the projected repatriation of $22.2 million in foreign earnings. We continue to analyze the effect of the new Act on the remaining $46.9 million of the Company’s undistributed foreign earnings and expect to complete this analysis by the end of the year. The income tax effect of repatriating the remaining undistributed earnings is not estimable at this tine.

 

17


Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

(unaudited)

 

10. PENSION PLAN

 

The Company determined pension costs under the provisions of Statement of Financial Accounting Standards No. 87, “Employers’ Accounting for Pensions”, and related disclosures under the provisions of Statement of Financial Accounting Standards No. 132 (Revised 2003), “Employers’ Disclosures about Pensions and other Postretirement Benefits”.

 

The Company has a separate contributory defined benefit plan for its qualifying U. K. employees employed by the Company’s U.K. subsidiaries. This pension plan was closed to new participants as of December 31, 2002. The benefits for the U.K. Plan are based primarily on years of service and average pay at retirement. Plan assets consist principally of investments managed in a mixed fund.

 

Pension costs for the U.K. Plan included the following components:

 

    

Three Months Ended

June 30,


   

Six Months Ended

June 30,


 

(in thousands)


   2004

    2005

    2004

    2005

 

Service cost

   $ 307     $ 299     $ 620     $ 603  

Interest cost

     432       516       871       1,041  

Expected return on plan assets

     (361 )     (431 )     (729 )     (869 )

Amortization of transition asset amount

     (4 )     (1 )     (8 )     (3 )

Amortization of net loss

     155       152       313       307  
    


 


 


 


Net periodic pension cost

   $ 529     $ 535     $ 1,067     $ 1,079  
    


 


 


 


 

For the six months ended June 30, 2005, the Company made contributions of $0.9 million and anticipates contributing an additional $0.9 million to fund this plan during the remainder of 2005.

 

11. COMMITMENTS AND CONTINGENCIES

 

The Company currently maintains insurance for risks associated with the operation of its business, provision of professional services, and ownership of property. These policies provide coverage for a variety of potential losses, including loss or damage to property, bodily injury, general commercial liability, professional errors and omissions, and medical malpractice. The Company’s retentions and deductibles associated with these insurance policies range from $0.25 million to $0.5 million.

 

The Company is self-insured for health insurance for employees located within the United States. The Company maintains stop-loss insurance on a “claims made” basis for expenses in excess of $0.25 million per member per year. As of December 31, 2004 and June 30, 2005, the Company maintained a reserve of approximately $3.6 million and $3.9 million, respectively, included in other accrued expenses on the consolidated condensed balance sheets, to cover open claims and estimated claims incurred but not reported.

 

In April 2000, the Company made an investment in Spotlight Health, Inc. The Company subsequently entered into an agreement to guarantee a $2.0 million revolving line of credit that is now being provided to Spotlight Health by Bank of America. For further details see Note 6 to the Notes to Consolidated Condensed Financial Statements.

 

In February 2005, the Company acquired substantially all of SurroMed’s assets related to its biomarker business. As part of this acquisition, the Company agreed to guarantee repayment of up to $1.5 million under a SurroMed bank loan with a maturity date of December 31, 2006. In accordance with the requirements of FASB Statement No. 5, “Accounting for Contingencies”, as clarified by FASB Interpretation No. 45, the Company has recorded a liability in the amount of $150,000 for the estimated fair value of the obligation it has assumed under this guarantee.

 

18


Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

(unaudited)

 

11. COMMITMENTS AND CONTINGENCIES (continued)

 

In November 2003, the Company entered into an agreement with Syrrx, Inc. to jointly develop and commercialize human dipeptidyl peptidase IV, or DPP IV, inhibitors as drug products for the treatment of type 2 diabetes and other major human diseases. The Company expensed a milestone payment of $2.5 million relating to the commencement of the Phase II studies in the second quarter of 2005. In March 2005, Takeda Pharmaceutical Company Limited acquired 100% of the equity of Syrrx, which is now known as Takeda San Diego, Inc. In July 2005, Takeda San Diego acquired the development and marketing rights to all DPP IV inhibitors previously granted to the Company under the collaboration agreement between PPD and Syrrx. Under the new agreement, Takeda San Diego will pay the Company a $15.0 million up-front payment in the third quarter of 2005. The Company will also be entitled to receive potential milestone payments and royalties associated with the future development and commercialization of specified DPP IV inhibitors and will be the sole provider of clinical and bioanalytical services to Takeda San Diego for Phase II and Phase III trials of DPP IV inhibitors conducted in the U.S. and Europe. As a result of this agreement, the Company will have no further material expense associated with the development and commercialization of a DDP IV inhibitor.

 

In April 2003, the Company made an equity investment in Chemokine Therapeutics Corp. In connection with this investment, Chemokine granted the Company an exclusive option to license a proprietary peptide for a one-time license fee of $1.5 million. The Company is waiting for the results of an on-going Phase I study to determine if it will exercise its option. If the Company chooses to exercise this option, it will be obligated to pay the license fee plus the costs for future development work on the peptide. Chemokine also granted the Company the right to first negotiate a license to other peptides.

 

In November 2003, the Company became a limited partner in A. M. Pappas Life Science Ventures III, LP, a venture capital fund. The Company has committed to invest up to an aggregate of approximately $2.5 million in the Pappas Fund. For further details see Note 6 to the Notes to Consolidated Condensed Financial Statements.

 

In the fourth quarter of 2003, the Company acquired from Eli Lilly & Company the patents for the compound dapoxetine for development in the field of genitourinary disorders. This compound is currently licensed to ALZA Corporation, a subsidiary of Johnson & Johnson, which is developing it for premature ejaculation. Under the terms of the agreement with Lilly, the Company paid Lilly $65.0 million in cash and agreed to pay Lilly a royalty of 5% on annual net sales of dapoxetine in excess of $800 million. ALZA submitted a new drug application for dapoxetine to the FDA in December 2004. Dapoxetine has not been approved for sale in the United States or any foreign country.

 

In March 2005, the Company signed a new lease for additional space in Austin, Texas for its Phase II-IV operations. The facility is adjacent to the Company’s new Phase I clinic. Under the terms of the new lease, the lessor placed $5.5 million in an escrow account to be distributed to the Company to cover the monthly rental on the old facility until the old facility is subleased. If the facility is subleased, the Company will receive an immediate distribution totaling the amount of the sublease income to be received under the sublease and the escrow account will receive the future sublease rental income and remit the future rental payments due under the original facility lease to the lessor. The Company will continue to be responsible for its obligations under the original lease and, therefore, subject to the risk of default by a sublessee. The Company will also be responsible to fund the escrow account to the extent the rent payments under the original lease exceed the rent payments under a sublease. The Company accounts for the $5.5 million to be received from the escrow account as a lease incentive which will be recognized in income over the ten-year term of the new lease. As of June 30, 2005, the escrow account balance was $5.5 million, $1.6 million of which was included as a component of prepaid expenses and other current assets and $3.9 million of which was included as a component of other assets.

 

As of June 30, 2005, the Company had liabilities of $5.5 million in connection with tax positions taken in the Company’s tax returns that include interpretations of applicable income tax laws and regulations. These amounts are based on management’s expectation regarding the ultimate tax treatment and outcome of these matters. The Company believes it is unlikely that the resolution of these matters will have a material adverse effect on the Company’s financial position or results of operations.

 

19


Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

(unaudited)

 

11. COMMITMENTS AND CONTINGENCIES (continued)

 

In January 2005, the Company acquired approximately 7.5 acres of property located in downtown Wilmington, North Carolina, on which the Company is constructing a new headquarters building. The total purchase price for the land was approximately $2.8 million. In connection with the sale of the property, the seller, Almont Shipping Company, refinanced existing liens on the property with the proceeds of an $8.0 million loan from Bank of America. This loan will mature in January 2006 and is secured by a lien on substantially all of Almont’s assets, including an approximately 30-acre tract of land adjacent to the tract the Company acquired. This loan is also secured by a guarantee from the Company. In accordance with the requirements of FASB Statement No. 5, “Accounting for Contingencies”, as clarified by FASB Interpretation No. 45, the Company has recorded a liability in the amount of $0.8 million for the estimated fair value of the obligation the Company has assumed under this guarantee. Almont’s obligation to reimburse the Company in the event the Company is required to pay any sums to Bank of America under the guarantee is also secured by a lien on substantially all of Almont’s assets. As a part of this transaction, Almont granted the Company an option to purchase all or a portion of the adjacent 30-acre tract of land at an agreed upon price per acre. The option will expire on January 31, 2007.

 

Under most of the agreements for Development Group services, the Company agrees to indemnify and defend the sponsor against third-party claims based on the Company’s negligence or willful misconduct. Any successful claims could have a material adverse effect on the Company’s financial condition, results of operations and future prospects.

 

In the normal course of business, the Company is a party to various claims and legal proceedings. In addition to other pending claims, the Company is currently in litigation with a former client that has sued the Company for breach of contract and tortious acts in conducting a clinical trial. The former client is claiming that it does not owe the Company the remaining amounts due under the contract and is seeking other damages from the Company’s alleged breach of contract and tortious acts. The Company records a reserve for litigation matters when an adverse outcome is probable and the amount of the potential liability is reasonably estimable. Although the ultimate outcome of these matters is currently not determinable, management of the Company, after consultation with legal counsel, does not believe that the resolution of these matters will have a material effect upon the Company’s financial condition, results of operations or cash flows for an interim or annual period.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

(unaudited)

 

12. BUSINESS SEGMENT DATA

 

Revenue by principal business segment is separately stated in the consolidated condensed financial statements. Income from operations and identifiable assets by principal business segment were as follows:

 

    

Three Months Ended

June 30,


   

Six Months Ended

June 30,


 

(in thousands)


   2004

    2005

    2004

    2005

 

Income (loss) from operations:

                                

Development

   $ 37,955     $ 45,419     $ 73,437     $ 87,266  

Discovery sciences

     (5,728 )     (11,923 )     (2,716 )     (5,840 )
    


 


 


 


Total

   $ 32,227     $ 33,496     $ 70,721     $ 81,426  
    


 


 


 


                

December 31,

2004


   

June 30,

2005


 

Identifiable assets:

                                

Development

                   $ 879,123     $ 967,316  

Discovery sciences

                     96,078       88,665  
                    


 


Total

                   $ 975,201     $ 1,055,981  
                    


 


 

21


Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion and analysis is provided to increase understanding of, and should be read in conjunction with, our consolidated condensed 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.

 

Forward-looking Statements

 

This Form 10-Q 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 performances, expectations, predictions, assumptions and other statements that are not statements of historical facts. In some cases, you can identify forward-looking statements by words 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” below. 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.

 

Company Overview

 

We are a leading global provider of drug discovery and development services and products to pharmaceutical, biotechnology and medical device companies. Our corporate mission is to help clients maximize the return on their research and development investments. We offer broad therapeutic expertise, advanced technologies and extensive resources for drug discovery and drug and device development. In addition to providing discovery through post-market services, we also offer our clients compound partnering opportunities.

 

We have been in the drug development business for more than 19 years. Our development services include preclinical programs and Phase I to Phase IV clinical development services. We have extensive clinical trial experience across a multitude of therapeutic areas and various parts of the world, including regional, national and global studies. In addition, for drugs that have received approval for market use, we also offer post-market support services such as product launch services, patient compliance programs, disease registry programs and medical communications programs for consumer and healthcare providers on product use and adverse events.

 

With more than 7,400 professionals worldwide, we have provided services to 41 of the top 50 pharmaceutical companies in the world as ranked by 2003 healthcare research and development spending, in addition to our work with leading biotechnology and medical device companies. We believe that we are one of the world’s largest providers of drug development services to pharmaceutical, biotechnology and medical device companies based on 2004 annual net revenues generated from contract research organizations.

 

Building on our outsourcing relationship with pharmaceutical and biotechnology clients, we established our discovery services business in 1997. After restructuring the Discovery Sciences segment in 2003 and 2004, this business now primarily focuses on preclinical evaluations of anticancer therapies and compound partnering arrangements associated with the development and commercialization of potential drug products. 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’ research and evaluate the development and commercial potential for compounds at various stages of development. In February 2005, we completed the acquisition of a biomarker business. This acquisition will expand our discovery sciences business by adding biomarker discovery and patient sample analysis capability to the services offered by us.

 

We believe that our integrated drug discovery and development services offer our clients a way to identify and develop successful drugs more quickly and cost-effectively. We also use our proprietary informatics technology to support our development services. In addition, because we are positioned globally, we are able to accommodate the multinational drug discovery and development needs of our customers. As a result of having these core areas of expertise in discovery and development, we can provide integrated services across the entire drug development spectrum. For more detailed information on PPD, see our Annual Report on Form 10-K for the year ended December 31, 2004.

 

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Executive Overview

 

Because our revenues are dependent on a relatively small number of industries and clients, we closely monitor the market for our services. For a discussion of the trends affecting our market, see “Item 1. Business—Trends Affecting the Drug Discovery and Development Industry” in our Annual Report on Form 10-K for the year ended December 31, 2004.

 

While we cannot predict the demand for CRO services in the remainder of 2005, we believe the overall historical market drivers for our industry remain intact. To grow authorizations in the remainder of 2005, we will continue to focus on our business development efforts, including increasing the percentage of successful proposals, and the delivery of timely, high quality services to our clients. We currently conduct a significant amount of government-sponsored research and in July 2005, were awarded a five-year contract to provide comprehensive research management and support to the National Institute of Allergy and Infectious Disease (“NIAID”) Division of AIDS. NIAID is a component of the National Institutes of Health, an agency of the U.S. Department of Health and Human Services. The aggregate value of this contract is $245 million, of which approximately $43 million is expected to be for subcontractor costs and approximately $25 million is for travel costs and other reimbursed out-of-pockets. We plan to continue our efforts to win new projects in this market. We also believe there are specific opportunities for growth in other areas of our business in 2005. Our Latin American and European Phase II through IV units had strong operating and financial performance in 2004 and first half of 2005 and we believe there are opportunities for continued growth in these regions. We have also experienced an increase in the demand for our Phase I services, so we expanded our Phase I clinic in Austin, Texas to 300 beds to enhance our ability to service large, complex studies. This expansion was completed in April 2005 and the new Phase I unit is in operation. In 2004 and the first half of 2005, the demand for our bioanalytical and GMP services increased and we are again expanding our GMP laboratory facilities and plan to add new services over the next two years. We have continued to invest in scientific equipment in our bioanalytical laboratory and now have 61 liquid chromatography/mass spectrometry, or LCMS, systems in this laboratory to process fluid samples for preclinical studies. Finally, we also believe the demand for our post-marketing development services will continue to grow.

 

We review various metrics, including period-to-period growth in backlog, new authorizations, cancellation rates, revenue, margins and earnings, to evaluate our financial performance. In the second quarter of 2005, we had new authorizations of $372.1 million, an increase of 39.9% over the second quarter of 2004. The cancellation rate for the second quarter of 2005 was 18% compared to 22% in the full year of 2004. On a net basis, authorizations were up 38% in the second quarter of 2005 compared to the same period in 2004. Backlog grew to $1.4 billion as of June 30, 2005, up 19% over June 30, 2004. Backlog by client type as of June 30, 2005 was 56% pharmaceutical, 33% biotech and 11% government/other. Backlog by client type as of December 31, 2004 was 58% pharmaceutical, 28% biotech and 14% government/other. This change in the composition of our backlog primarily reflects an increase in new authorizations from both large and small biotech clients. Net revenue by client type for the quarter ended June 30, 2005 was 61% pharmaceutical, 28% biotech and 11% government/other. Top therapeutic areas by net revenue for the quarter ended June 30, 2005 were anti-infective/anti-viral, oncology, central nervous system, circulatory/cardiovascular and endocrine/metabolic. For a detailed discussion of our revenue, margins, earnings and other financial results for the quarter ended June 30, 2005, see “Results of Operations – Three Months Ended June 30, 2005 versus Three Months Ended June 30, 2004” below.

 

Capital expenditures for the three months ended June 30, 2005 totaled approximately $14.0 million. These capital expenditures included $2.7 million related to land and building costs for our new corporate headquarters in Wilmington, North Carolina, and $1.2 million related to land and building cost for a new facility in Scotland. Capital expenditures also included $4.9 million on software and computer hardware and $2.4 million for additional scientific equipment for our Phase I and laboratory units. In addition to investing in our growing business, we are also working on a number of initiatives to improve the efficiency of our operations, including streamlining training matrices and clinical procedural documents, decreasing the number of documents needed for study initiation, centralizing regulatory document collection and rolling out a new clinical trial management system.

 

In February 2005, we acquired substantially all of the assets of SurroMed, Inc.’s biomarker business. This acquisition expands our discovery business by adding biomarker discovery and patient sample analysis to the

 

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discovery services offered by us. Our Discovery Sciences segment also includes our compound collaboration arrangements. These 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 clients. For a background discussion of our compound partnering arrangements, see “Item 1. Business – Our Services – Our Discovery Sciences Group – Compound Partnering Programs” in our Annual Report on Form 10-K for the year ended December 31, 2004.

 

In the first half of 2005, we made significant progress on two important collaborations. First, in February 2005, the FDA accepted the dapoxetine new drug application for filing and we received the $10.0 million payment from ALZA Corporation for this milestone in March. Secondly, with regard to the DPP IV collaboration with Takeda San Diego, Inc. (formerly Syrrx, Inc.), we completed the Phase Ib study in patients for the first DPP IV inhibitor in March 2005 and initiated the Phase II program for that inhibitor in April. We also commenced the Phase I first in man study for the second DPP IV inhibitor in April 2005. In July 2005, we achieved another significant milestone on the DPP IV program. We entered into an agreement under which Takeda San Diego acquired the development and marketing rights to all DPP IV inhibitors previously granted to us under the collaboration agreement between PPD and Syrrx. Under the new agreement, Takeda San Diego will pay us a $15.0 million up-front payment in the third quarter of 2005 and a $15.0 million development milestone if and when a Phase III trial is initiated. We will also be entitled to receive other potential milestone payments of up to an aggregate of $70.5 million, sales-based milestones of up to an aggregate of $33.0 million and royalties associated with the future development and commercialization of specified DPP IV inhibitors. We will also be the sole provider of clinical and bioanalytical services to Takeda San Diego for Phase II and Phase III trials of DPP IV inhibitors conducted in the U.S. and Europe. Furthermore, we will not have any responsibility for future expenses associated with the development and commercialization of a DPP IV inhibitor. As a result, we do not expect to incur significant R&D expense in the Discovery Sciences segment during the remainder of 2005. For additional information on the agreement with Takeda San Diego, see Current Report on Form 8-K filed on July 18, 2005.

 

In the first quarter of 2005, we terminated the implitapide program for various reasons and are in the process of winding down these studies and our related collaboration with Bayer A.G. With regard to our collaboration with Chemokine Therapeutics Corp. regarding its proprietary peptide for possible use as a blood recovery agent, we are waiting on the results of the Phase I study before deciding whether to exercise our option to license this peptide.

 

In addition to progressing our existing collaborations, we plan to continue to evaluate opportunities for new collaborations and investments that we believe will help us achieve our mid- to long-term growth objectives.

 

Acquisitions

 

In February 2005, we completed our acquisition of substantially all of the assets of SurroMed, Inc.’s biomarker business. The assets acquired by us consist of equipment, fixtures, leasehold improvements, intellectual property and contracts. The biomarker business supports drug discovery and drug development by identifying biomarkers using biological, chemical and bioinformatics expertise and technologies. The acquisition expands our business by adding biomarker discovery and patient sample analysis capability to the services offered by us. In exchange for the assets, we surrendered to SurroMed for cancellation all shares of preferred stock of SurroMed we held. As additional consideration for the acquisition, we assumed approximately $3.4 million of SurroMed liabilities under capital leases and additional operating liabilities and agreed to guarantee repayment of up to $1.5 million under a SurroMed bank loan. We recognized a pre-tax gain on the exchange of assets of $5.1 million. The biomarker business is now part of the Discovery Sciences segment.

 

We accounted for this acquisition using the purchase method of accounting, utilizing appropriate fair value techniques to allocate the purchase price based on the estimated fair values of the assets acquired and liabilities assumed. Accordingly, the estimated fair value of assets acquired and liabilities assumed were included in our consolidated condensed balance sheet as of the effective date of the acquisition. For further details regarding this acquisition, see Note 2 to the Notes to Consolidated Condensed Financial Statements.

 

Investments

 

In January 2004, we purchased 5.0 million shares of Accentia Biopharmaceuticals, Inc. Series E convertible preferred stock for $5.0 million. At that time, we also received a Class A and Class B warrant, each to

 

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purchase up to an additional 5.0 million shares of Series E convertible preferred stock for $1.00 per share. In January 2005, we exercised the Class A warrant. In February 2005, Accentia filed a registration statement with the SEC for its proposed initial public offering of common stock. In June 2005, we conditionally exercised the Class B warrant and deposited $5.0 million with Accentia. Accentia will be entitled to deposit and retain the Class B warrant exercise price if a qualifying IPO occurs on or before September 1, 2005. If this condition is not met, Accentia must refund our deposit. The $5.0 million deposit is included in other assets in our consolidated condensed balance sheet at June 30, 2005. Accentia proposes to sell in this public offering, in addition to shares for its own account, 1.0 million shares of common stock issuable to us upon conversion of Series E convertible preferred stock. We owned approximately 12.4% of the outstanding capital stock of Accentia as of June 30, 2005.

 

In March 2005, Takeda Pharmaceutical Company Limited completed its acquisition of 100% of the equity of Syrrx, Inc. We owned $25.0 million in preferred stock of Syrrx. Takeda paid us $25.0 million in April 2005 for our preferred stock in Syrrx in accordance with Syrrx’s certificate of incorporation.

 

In April 2000, we purchased 1.0 million shares of Spotlight Health Series C convertible preferred stock for $5.0 million. In June 2005, we purchased 970,873 shares of Spotlight Health’s Series D convertible preferred stock at $1.03 per share. As of June 30, 2005, we owned approximately 11.6% of Spotlight’s outstanding capital stock.

 

In December 2002, we purchased 150,000 shares of Oriel Therapeutics, Inc. Series A convertible preferred stock for $150,000. We also received, as part of the purchase, a warrant to purchase an equal number of shares of stock offered by Oriel Therapeutics in its next round of financing at a discount. In April 2003, we exercised the warrant for 150,000 shares of Oriel Therapeutics Series B convertible preferred stock for $200,000. At the same time, we also purchased an additional 255,000 shares of Oriel’s Series B for $500,000. In March 2004, we loaned Oriel $900,000 in the form of secured debt that is convertible into Oriel Therapeutics’ Series B preferred stock at $2.00 per share. The loan is secured by a first lien on Oriel’s assets. In June 2005, we loaned Oriel an additional $350,000 and received a warrant to purchase shares offered by Oriel Therapeutics in a future equity financing transaction and a promissory note to secure the debt. We owned approximately 13.9% in Oriel Therapeutics’ outstanding common stock as of June 30, 2005. Oriel is a privately held company pursuing the development of technology to improve drug delivery in the treatment of respiratory and pulmonary diseases.

 

For further details regarding investments, see Note 6 to the Notes to Consolidated Condensed Financial Statements.

 

Restructuring Charges

 

In the first quarter and second quarter of 2004, we recorded $0.5 million and $2.1 million restructuring charges, respectively, associated with exiting our chemistry facility in Research Triangle Park, North Carolina. These charges include lease payments and termination costs, net of sublease rentals, of approximately $2.1 million and a loss on sale of assets used in our chemistry services of approximately $0.5 million. The lease termination liability will be paid over the remaining life of the lease, which terminates in 2015.

 

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 three months ended June 30, 2004 and 2005 were $266.0 million and $372.1 million, respectively.

 

Our backlog consists of new business authorizations for which the work has not started but is anticipated to begin in the near future and contracts in process that have not been completed. As of June 30, 2005, the remaining duration of the contracts in our backlog ranged from one month to 108 months with an average duration of 27.5 months. Amounts included in backlog represent potential future revenue and exclude revenue that we have previously recognized. Once work begins on a project included in backlog, net revenue is recognized over the life of the contract. However, there can be no assurance that our backlog will ever be recognized as revenue. Our backlog as of June 30, 2004 and 2005 was $1.20 billion and $1.43 billion, respectively.

 

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Results of Operations

 

Revenue Recognition

 

We record revenue from contracts on a proportional performance basis in our Development Group. To measure performance on a given date, we compare direct costs incurred through that date to estimated total contract direct costs. We believe this is the best indicator of the performance of the contractual obligations because the costs relate primarily to the amount of labor incurred to perform the service. Changes to the estimated total contract direct costs result in a cumulative adjustment to the amount of revenue recognized. For time-and-materials contracts in both our Development Group and Discovery Sciences Group, we recognize revenues as hours are worked, multiplied by the applicable hourly rate. For our Phase I and laboratory businesses, we recognize revenues from unitized contracts as subjects or samples are tested, multiplied by the applicable unit price.

 

In connection with the management of multi-site clinical trials, we pay, on behalf of our customers, 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, “Income Statement Characterization of Reimbursements Received for ‘Out-of-Pocket’ Expenses Incurred”, 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 three months ended June 30, 2004 and 2005, fees paid to investigators and other fees we paid as an agent and the associated reimbursements were approximately $50.3 million and $76.5 million, respectively.

 

Most of the contracts for our Development Group can be terminated by our clients either immediately or after a specified period following notice by the client. These contracts typically require payment to us of expenses to wind down a 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 does not generally require a significant adjustment upon cancellation. If we determine that a loss will result from the performance of a fixed-price contract, the entire amount of the estimated loss is charged against income in the period in which the determination is made.

 

The Discovery Sciences Group 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 customer, payment is received and continued performance of future research and development services related to that milestone are not required.

 

Recording of Expenses

 

We generally record our operating expenses among the following categories:

 

    direct costs;

 

    research and development;

 

    selling, general and administrative;

 

    depreciation and

 

    amortization.

 

Direct costs consist of appropriate 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, administrative travel, an allocation of facility and information technology costs, and costs related to operational employees performing administrative tasks.

 

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Depreciation consists of depreciation costs recorded on a straight-line method, based on estimated useful lives of 40 to 50 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 airplanes, 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.

 

Amortization consists of amortization costs recorded on intangible assets on a straight-line method over the life of the intangible assets.

 

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Three Months Ended June 30, 2005 Versus Three Months Ended June 30, 2004

 

The following table sets forth amounts from our consolidated condensed financial statements along with the dollar and percentage change for the three months ended June 30, 2005 compared to the three months ended June 30, 2004.

 

    

Three Months Ended
June 30,

(unaudited)


             

(in thousands, except per share data)


   2005

   2004

    $ Inc (Dec)

    % Inc (Dec)

 

Net revenue:

                             

Development revenue

   $ 224,862    $ 183,178     $ 41,684     22.8 %

Discovery sciences revenue

     3,636      2,033       1,603     78.8  

Reimbursed out-of-pockets

     16,644      15,325       1,319     8.6  
    

  


 


     

Total net revenue

     245,142      200,536       44,606     22.2  

Direct costs:

                             

Development

     112,787      90,834       21,953     24.2  

Discovery sciences

     1,992      1,282       710     55.4  

Reimbursable out-of-pocket expenses

     16,644      15,325       1,319     8.6  
    

  


 


     

Total direct costs

     131,423      107,441       23,982     22.3  

Research and development expenses

     11,445      3,638       7,807     214.6  

Selling, general and administrative expenses

     58,987      47,816       11,171     23.4  

Depreciation

     9,512      6,883       2,629     38.2  

Amortization

     279      417       (138 )   (33.1 )

Restructuring charges

     —        2,114       (2,114 )   (100.0 )
    

  


 


     

Income from operations

     33,496      32,227       1,269     3.9  

Impairment of investment

     —        (2,000 )     2,000     100.0  

Interest and other income, net

     2,892      1,208       1,684     139.4  
    

  


 


     

Income before taxes

     36,388      31,435       4,953     15.8  

Provision for income taxes

     12,736      8,121       4,615     56.8  
    

  


 


     

Net income

   $ 23,652    $ 23,314     $ 338     1.4  
    

  


 


     

Net income per diluted share

   $ 0.41    $ 0.41     $ 0.00     0.0  
    

  


 


     

 

Total net revenue increased $44.6 million to $245.1 million in the second quarter of 2005. The increase in total net revenue resulted primarily from an increase in our Development Group revenue. The Development Group’s operations generated net revenue of $224.9 million, which accounted for 91.7% of total net revenue for the second quarter of 2005. The 22.8% increase in the Development Group’s net revenue was primarily attributable to an increase in the level of global CRO Phase II through IV services we provided in the second quarter of 2005 as compared to the second quarter of 2004.

 

The Discovery Sciences Group generated net revenue of $3.6 million in the second quarter of 2005, an increase of $1.6 million from the second quarter of 2004. The increase in the Discovery Sciences net revenue was mainly attributable to revenue generated by the biomarker business from SurroMed. We expect Discovery Sciences net revenue in the third quarter of 2005 to include a $15.0 million up-front payment from Takeda San Diego in connection with the new DPP IV agreement.

 

Total direct costs increased $24.0 million to $131.4 million in the second quarter of 2005 primarily as the result of an increase in the Development Group direct costs. Development Group direct costs increased $22.0 million to

 

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$112.8 million in the second quarter of 2005. The primary reason for this increase was an increase in personnel costs of $15.5 million. Personnel costs increased due to hiring additional employees in our global CRO Phase II through IV division. The remaining $6.5 million increase in Development Group direct costs primarily consisted of increased facility costs related to the increase in personnel and increased subcontractor costs to support increased revenue.

 

Discovery Sciences direct costs increased $0.7 million to $2.0 million in the second quarter of 2005. The higher costs in the second quarter of 2005 related primarily to additional direct costs of the biomarker business acquired from SurroMed in February 2005.

 

R&D expenses increased $7.8 million to $11.4 million in the second quarter of 2005. R&D expenses increased primarily as a result of increased spending in connection with the DPP IV program under the collaboration arrangement with Takeda San Diego which included a milestone payment by us of $2.5 million as a result of the commencement of the Phase II studies in April 2005. Based on the new DPP IV agreement with Takeda San Diego that we entered into in July 2005, Takeda San Diego will be responsible for future potential development and commercialization costs of the DPP IV inhibitors. Thus, we do not expect to incur significant R&D expense during the remainder of 2005.

 

SG&A expenses increased $11.2 million to $59.0 million in the second quarter of 2005. As a percentage of total net revenue, SG&A expenses increased slightly to 24.1% in the second quarter of 2005 compared to 23.8% in the second quarter of 2004. The increase in SG&A expenses includes additional personnel costs of $7.2 million. The increase in personnel costs related to training costs for new personnel, higher levels of operations infrastructure to manage direct personnel and changes in utilization levels. The increase in SG&A costs also includes an increase of $1.2 million in travel costs due to training initiatives for new and existing operations personnel, increased travel expenses for personnel in administrative functions, and an increase of $1.3 million in facility costs related to the increase in personnel.

 

Depreciation increased $2.6 million to $9.5 million in the second quarter of 2005. The increase was related to the property and equipment we acquired to accommodate our growth. Our property, plant and equipment, net balance increased $79.4 million from June 30, 2004 to June 30, 2005. Capital expenditures were $14.0 million in the second quarter of 2005. Capital expenditures included $2.7 million related to land and building costs for our new corporate headquarters in Wilmington, North Carolina, and $1.2 million related to land and building costs for a new facility in Scotland. Capital expenditures also included $4.9 million on software and computer hardware and $2.4 million for additional scientific equipment for our Phase I and laboratory units.

 

Income from operations increased $1.3 million to $33.5 million in the second quarter of 2005. As a percentage of net revenue, income from operations decreased to 13.7% of net revenue in the second quarter of 2005 from 16.1% in the second quarter of 2004. Income from operations in the second quarter of 2005 included an increase in R&D expenses of $7.8 million compared to second quarter of 2004. Income from operations in the second quarter of 2005 was also negatively impacted by approximately $1.2 million due to the weakening of the U.S. dollar relative to the euro, British pound 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, which are paid in local currency, are negatively impacted when translated into U.S. dollars. Income from operations in the second quarter of 2004 included a $2.1 million restructuring charge associated with exiting our chemistry facility in Research Triangle Park, North Carolina.

 

Our provision for income taxes increased $4.6 million to $12.7 million in the second quarter of 2005. Our effective income tax rate for the second quarter of 2005 was 35.0% compared to 25.8% for the second quarter of 2004. During the second quarter of 2004, our effective tax rate was positively impacted by the $3.7 million reduction in our valuation allowance as a result of the utilization of capital loss carryforwards that previously had a valuation allowance recorded against them. This reduction in the valuation allowance decreased the effective tax rate by 11.8%. The remaining difference in our effective rates for the second quarter of 2005 compared to the second quarter of 2004 is due to the tax on the planned repatriation of foreign earnings and the change in the geographic distribution of our pretax earnings among locations with varying tax rates.

 

During the second quarter of 2004, we recorded a charge to earnings of $2.0 million for an other than temporary decline in the fair market of its investment in Chemokine Therapeutics Corp. The write-down of Chemokine was recorded based primarily on its individual historical and projected financial performance and completed or anticipated issuance of shares to new investors at lower valuations than our recorded value.

 

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Net income of $23.7 million in the second quarter of 2005 represents an increase of $0.3 million from $23.3 million in the second quarter of 2004. Net income per diluted share was $0.41 for both the second quarter of 2005 and the second quarter of 2004.

 

Six Months Ended June 30, 2005 Versus Six Months Ended June 30, 2004

 

The following table sets forth amounts from our consolidated condensed financial statements along with the dollar and percentage change for the six months ended June 30, 2005 compared to the six months ended June 30, 2004.

 

    

Six Months Ended

June 30,

(unaudited)


             

(in thousands, except per share data)


   2005

    2004

    $ Inc (Dec)

    % Inc (Dec)

 

Net revenue:

                              

Development revenue

   $ 437,783     $ 357,892     $ 79,891     22.3 %

Discovery sciences revenue

     16,496       9,581       6,915     72.2  

Reimbursed out-of-pockets

     34,917       28,343       6,574     23.2  
    


 


 


     

Total net revenue

     489,196       395,816       93,380     23.6  

Direct costs:

                              

Development

     221,117       179,044       42,073     23.5  

Discovery sciences

     3,757       2,848       909     31.9  

Reimbursable out-of-pocket expenses

     34,917       28,343       6,574     23.2  
    


 


 


     

Total direct costs

     259,791       210,235       49,556     23.6  

Research and development expenses

     20,266       4,924       15,342     311.6  

Selling, general and administrative expenses

     114,419       92,975       21,444     23.1  

Depreciation

     17,871       13,600       4,271     31.4  

Amortization

     567       742       (175 )   (23.6 )

Gain on exchange of assets

     (5,144 )     —         (5,144 )   NC  

Restructuring charges

     —         2,619       (2,619 )   (100.0 )
    


 


 


     

Income from operations

     81,426       70,721       10,705     15.1  

Impairment of investment

     —         (2,000 )     2,000     100.0  

Interest and other income, net

     4,072       1,712       2,360     137.9  
    


 


 


     

Income before taxes

     85,498       70,433       15,065     21.4  

Provision for income taxes

     26,225       22,355       3,870     17.3  
    


 


 


     

Net income

   $ 59,273     $ 48,078     $ 11,195     23.3  
    


 


 


     

Net income per diluted share

   $ 1.03     $ 0.85     $ 0.18     21.2  
    


 


 


     

 

Total net revenue increased $93.4 million to $489.2 million in the first six months of 2005. The increase in total net revenue resulted primarily from an increase in our Development Group revenue and the $10.0 million milestone payment from ALZA related to the filing of the new drug application, or NDA, for dapoxetine in the first six months of 2005. The Development Group’s operations generated net revenue of $437.8 million, which accounted for 89.5% of total net revenue for the first six months of 2005. The 22.3% increase in the Development Group’s net revenue was primarily attributable to an increase in the level of global CRO Phase II through IV services we provided in the first six months of 2005 as compared to the first six months of 2004. Net revenue for the Development Group also increased by approximately $1.7 million due to the effect of the U.S. dollar weakening relative to the euro and British pound in the first six months of 2005.

 

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The Discovery Sciences Group generated net revenue of $16.5 million in the first six months of 2005, an increase of $6.9 million from the first six months of 2004. The increase in the Discovery Sciences net revenue was mainly attributable to the $10.0 million milestone payment related to the filing of the dapoxetine NDA. In 2004, we received a $5.0 million payment from ALZA in connection with an amendment to the dapoxetine out-license agreement. We expect Discovery Sciences net revenue in the third quarter of 2005 to include a $15.0 million up-front payment from Takeda San Diego in connection with the new DPP IV agreement.

 

Total direct costs increased $49.6 million to $259.8 million in the first six months of 2005 primarily as the result of an increase in the Development Group direct costs. Development Group direct costs increased $42.1 million to $221.1 million in the first six months of 2005. The primary reason for this increase was an increase in personnel costs of $28.0 million. Personnel costs increased due to hiring additional employees in our global CRO Phase II through IV division and increased costs in our foreign operations due to the weakening of the U.S. dollar. The remaining $14.1 million of this increase in Development Group direct costs primarily consisted of increased facility costs related to the increase in personnel and increased subcontractor costs to support increased revenue.

 

Discovery Sciences direct costs increased $0.9 million to $3.8 million in the first six months of 2005. The higher costs in the first six months of 2005 related primarily to additional direct costs of the biomarker business acquired from SurroMed in February 2005.

 

R&D expenses increased $15.3 million to $20.3 million in the first six months of 2005. R&D expenses increased primarily as a result of increased spending in connection with the DPP IV program under the collaboration arrangement with Takeda San Diego which included a milestone payment by us of $2.5 million as a result of the commencement of the Phase II studies in April 2005. Based on the new DPP IV agreement with Takeda San Diego entered into in July 2005, Takeda San Diego will be responsible for future potential development and commercialization costs of the DPP IV inhibitors. Thus, we do not expect to incur significant R&D expense during the remainder of 2005.

 

SG&A expenses increased $21.4 million to $114.4 million in the first six months of 2005. As a percentage of total net revenue, SG&A expenses decreased to 23.4% in the first six months of 2005 compared to 23.5% in the first six months of 2004. The increase in SG&A expenses in absolute terms includes additional personnel costs of $13.1 million. The increase in personnel costs related to training costs for new personnel, higher levels of operations infrastructure to manage direct personnel and changes in utilization levels. The increase in SG&A costs also includes an increase of $2.6 million in travel costs due to training initiatives for new and existing operations personnel and increased travel related to additional personnel in administrative functions. In addition, SG&A costs include an additional $2.1 million in recruiting costs to hire additional personnel and an increase of $1.3 million in facility costs related to the increase in personnel.

 

Depreciation increased $4.3 million to $17.9 million in the first six months of 2005. The increase was related to property and equipment we acquired to accommodate our growth. Capital expenditures were $72.4 million in the first six months of 2005. Capital expenditures included $30.5 million for our new corporate airplane and $8.6 million related to leasehold improvements to the new clinic in Austin, Texas. The majority of the remaining capital expenditures included spending on land and building costs, software, computer hardware, and additional scientific equipment for our Phase I and laboratory units.

 

Income from operations increased $10.7 million to $81.4 million in the first six months of 2005. As a percentage of net revenue, income from operations decreased to 16.6% of net revenue in the first six months of 2005 from 17.9% in the first six months of 2004. Income from operations in the first six months of 2005 included a $5.1 million gain on exchange of assets associated with the acquisition of SurroMed’s biomarker business. Income from operations in the first six months of 2005 also included an increase in R&D expenses of $15.3 million compared to the first six months of 2004. Income from operations in the first quarter of 2005 was also negatively impacted by approximately $2.6 million due to the weakening of the U.S. dollar relative to the euro, British pound 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

 

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performing these contracts, which are paid in local currency, are negatively impacted when translated into U.S. dollars. Income from operations in the first six months of 2004 included a $2.6 million restructuring charge associated with exiting our chemistry facility in Research Triangle Park, North Carolina.

 

Our provision for income taxes increased $3.9 million to $26.2 million in the first six months of 2005. Our effective income tax rate for the first six months of 2005 was 30.7% compared to 31.7% for the first six months of 2004. The effective tax rate for the 2005 period was positively impacted by a $4.7 million reduction in our valuation allowance provided for the deferred tax asset relating to a capital loss carryforward. This reduction was a result of the utilization of capital loss carryforwards that previously had a valuation allowance recorded against them as well as the recognition of capital gains for both the SurroMed transaction and the dapoxetine NDA milestone payment. This reduction in the valuation allowance decreased the effective tax rate by 5.6%. During the first six months of 2004, our effective tax rate was positively impacted by the $3.7 million tax benefit which we recorded as a result of the utilization of capital loss carryforwards that previously had a valuation allowance recorded against them. The remaining difference in our effective rates for the first six months of 2005 compared to the first six months of 2004 is due to the tax on the planned repatriation of foreign earnings and the change in the geographic distribution of our pretax earnings among locations with varying tax rates.

 

Net income of $59.3 million in the first six months of 2005 represents an increase of $11.2 million from $48.1 million in the first six months of 2004. Net income per diluted share of $1.03 in the first six months of 2005 represents a 21.2% increase from net income per diluted share of $0.85 in the first six months of 2004. Net income per diluted share for the first quarter of 2005 included $0.07 per share, net of tax, for the gain on exchange of assets associated with the acquisition of SurroMed’s biomarker business.

 

Liquidity and Capital Resources

 

As of June 30, 2005, we had $288.1 million of cash and cash equivalents. Our expected primary cash needs on both a short- and long-term basis are for capital expenditures, including our new corporate headquarters, expansion of services, possible acquisitions, geographic expansion, working capital and other general corporate purposes. We have historically funded our operations and growth, including acquisitions, with cash flow from operations, leasing arrangements, borrowings and sales of our stock. We hold our cash and cash equivalents in financial instruments that are rated A or better by Standard & Poor’s or Moody’s, and earn interest at market rates.

 

In the first six months of 2005, our operating activities provided $87.9 million in cash as compared to $76.4 million for the same period last year. The increase in cash flow from operations is primarily due to a $11.2 million increase in net income and a non-cash increase in provision for deferred income taxes of $7.5 million, which was partially offset by a non-cash gain on exchange of assets of $5.1 million. The change in operating assets and liabilities of $12.3 million in the first six months of 2005 primarily consisted of an increase in current income taxes of $22.2 million due to the timing of tax payments and an increase in deferred rent of $8.7 million as a result of the additional facility leases partially offset by a decrease in unearned income of $18.6 million.

 

In the first six months of 2005, we generated $47.3 million in cash from investing activities. The net cash provided by purchases, maturities and sales of available-for-sale investments of $105.0 million and proceeds from sale of the Syrrx investment of $25.0 million were partially offset by capital expenditures of $72.4 million, purchases of investments of $5.4 million and a deposit on warrant exercise of $5.0 million. We expect our capital expenditures for the remainder of 2005 to be approximately $45.0 million to $50.0 million. This estimate includes 2005 construction costs of $25.0 million to $30.0 million for the new corporate headquarters building in Wilmington, North Carolina. We expect the majority of the remaining anticipated capital expenditures to be for construction costs for our new facility in Scotland, equipment for our Phase I and laboratory units, and information technology enhancement and expansion.

 

In the first six months of 2005, our financing activities provided $13.9 million in cash, as net proceeds from stock option exercises and purchases under our employee stock purchase plan totaling $14.9 million were partially offset by $0.9 million in repayments of capital lease obligations.

 

Working capital as of June 30, 2005 was $287.2 million, compared to $257.1 million at December 31, 2004. The increase in working capital was due primarily to an increase in cash and short-term investments of $38.7 million, which included the proceeds from the sale of investment of Syrrx for $25.0 million, a decrease in unearned income of $19.9 million partially offset by a increase in other accrued expenses of $10.0 million, an increase of accrued income

 

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taxes of $7.9 million due to the increase in pretax income and a decrease in accounts receivable and unbilled services of $9.4 million due to better collections of receivables. The number of days’ revenue outstanding in accounts receivable and unbilled services, net of unearned income, also known as DSO, was 33.0 and 41.6 days for the six months ended June 30, 2005 and June 30, 2004, respectively. We calculate DSO by dividing accounts receivable and unbilled services less unearned income by average daily gross revenue for the period presented. Over the past three years, our year-to-date DSO has fluctuated between 32.2 days and 42.2 days. We expect DSO will fluctuate in the future depending on the mix of contracts performed within a quarter, the level of investigator advances and unearned income and our success in collecting receivables.

 

In July 2005, we renewed our $50.0 million revolving credit facility with Bank of America, N. A. Indebtedness under the facility is unsecured and subject to traditional covenants relating to financial ratios and restrictions on certain types of transactions. Borrowings under this credit facility are available to provide working capital and for general corporate purposes. As of June 30, 2005, there was no amount outstanding under this credit facility. However, the aggregate amount we are able to borrow has been reduced by $0.8 million due to outstanding letters of credit issued under this facility. This credit facility is currently scheduled to expire in June 2006, at which time any outstanding balance would be due.

 

In April 2000, we purchased 1.0 million shares of Spotlight Health Series C convertible preferred stock for $5.0 million. In July 2003, we entered into an agreement with Spotlight Health and Bank of America, N.A. to guarantee a $2.0 million revolving line of credit provided to Spotlight Health by Bank of America. This new line of credit was used to refinance existing Spotlight Health debt that was also guaranteed by us. In June 2005, we purchased 970,873 shares of Spotlight Health’s Series D convertible preferred stock for a purchase price of $1.03 per share. In connection with that transaction, the parties amended the loan agreement with Bank of America to provide for, a quarterly reduction of the principal amount of the revolving line of credit of $250,000 on September 30 and December 31, 2005, and $500,000 on March 31, June 30 and September 30, 2006. Spotlight Health also granted Bank of America a first lien security interest on its assets to secure its obligations under the loan agreement. As of June 30, 2005, the Company owned approximately 11.6% of Spotlight’s outstanding capital stock.

 

In January 2004, we purchased 5.0 million shares of Accentia Biopharmaceuticals, Inc. Series E convertible preferred stock for $5.0 million. At that time, we also received a Class A and Class B warrant, each to purchase up to an additional 5.0 million shares of Series E convertible preferred stock for $1.00 per share. In January 2005, we exercised the Class A warrant. The Class B warrant will expire on the earlier of January 7, 2006 or the effective date of a registration statement for the public sale of Accentia common stock in a qualifying initial public offering. In February 2005, Accentia filed a registration statement with the SEC for its proposed initial public offering of common stock. In June 2005, we conditionally exercised the Class B warrant and deposited $5.0 million with Accentia. Accentia will be entitled to deposit and retain the Class B warrant exercise price if a qualifying IPO occurs on or before September 1, 2005. If this condition is not met, Accentia must refund our deposit. The $5.0 million deposit is included in other assets on our consolidated condensed balance sheet at June 30, 2005. Accentia proposes to sell in this public offering, in addition to shares for its own account, 1.0 million shares of common stock issuable to us upon conversion of Series E convertible preferred stock.

 

In February 2005, we acquired substantially all of SurroMed’s assets related to its biomarker business. As part of this acquisition, we agreed to guarantee repayment of up to $1.5 million under a SurroMed bank loan with a maturity date of December 31, 2006. In accordance with the requirements of FASB Statement No. 5, “Accounting for Contingencies”, as clarified by FASB Interpretation No. 45, we have recorded a liability in the amount of $150,000 for the estimated fair value of the obligation assumed under this guarantee.

 

In November 2003, we entered into a collaboration agreement with Syrrx to jointly develop and commercialize human dipeptidyl peptidase IV, or DPP IV, inhibitors as drug products for the treatment of type 2 diabetes and other major human diseases. In September 2004, we filed an investigational new drug application for one DPP IV inhibitor and the Phase I clinical study for that inhibitor commenced in late October 2004. In the fourth quarter of 2004, we paid Syrrx a milestone payment of $2.5 million as a result of the commencement of the Phase I studies. These studies were completed in March 2005. We began the Phase II program in April and paid a milestone payment of $2.5 million in the second quarter. In March 2005, Takeda Pharmaceutical Company Limited acquired 100% of the equity of Syrrx, which is now known as Takeda San Diego, Inc. We owned $25.0 million in preferred stock of Syrrx, for which Takeda paid us $25.0 million in April 2005. In July 2005, Takeda San Diego acquired the development and marketing rights to all DPP IV inhibitors previously granted to us under the collaboration agreement

 

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between PPD and Syrrx. Under the new agreement, Takeda San Diego will pay us a $15.0 million up-front payment in the third quarter of 2005 and a $15.0 million development milestone if and when a Phase III trial is initiated. We will also be entitled to receive other potential milestone payments of up to an aggregate of $70.5 million, sales-based milestones of up to an aggregate of $33.0 million and royalties associated with the future development and commercialization of specified DPP IV inhibitors. As a result of this agreement, we will have no further material expense associated with the development and commercialization of a DDP IV inhibitor.

 

In November 2003, we became a limited partner in A. M. Pappas Life Science Ventures III, LP, a venture capital fund. The Pappas Fund was established for the purpose of making investments in equity securities of privately-held companies in the life sciences, healthcare and technology industries. We are committed to invest up to an aggregate of approximately $2.5 million in the Pappas Fund. No capital call can exceed 10% of our aggregate capital commitment. As such, we anticipate that our aggregate investment will be made through a series of future capital calls over the next several years. Capital calls through June 30, 2005 were $165,000. Our capital commitment will expire in May 2009.

 

In January 2005, we acquired approximately 7.5 acres of property located in downtown Wilmington, North Carolina, on which we plan to construct a new headquarters building. The new facility will be approximately 400,000 square feet and is expected to be completed in 2006 or early 2007. We plan to begin consolidating our Wilmington operations into the new building at that time. We expect the total cost for the construction and up-fit of the new building to be $80.0 million to $100.0 million. The purchase price for the land was approximately $2.8 million. In connection with the sale of the property, the seller, Almont Shipping Company, refinanced existing liens on the property with the proceeds of an $8.0 million loan from Bank of America. This loan will mature in January 2006 and is secured by a lien on substantially all of Almont’s assets, including an approximately 30-acre tract of land adjacent to the tract we acquired. This loan is also secured by a guarantee from us. In accordance with the requirements of FASB Statement No. 5, “Accounting for Contingencies”, as clarified by FASB Interpretation No. 45, we have recorded a liability in the amount of $0.8 million for the estimated fair value of the obligation we have assumed under this guarantee. Almont’s obligation to reimburse us in the event we are required to pay any sums to Bank of America under the guarantee is also secured by a lien on substantially all of Almont’s assets. As a part of this transaction, Almont granted us an option to purchase all or a portion of the adjacent 30-acre tract of land at an agreed upon price per acre. The option will expire on January 31, 2007.

 

In March 2005, we signed a new lease for additional space in Austin, Texas for our Phase II-IV operations. The facility is adjacent to our new Phase I clinic. Under the terms of the new lease, the lessor placed $5.5 million in an escrow account to be distributed to us to cover the monthly rental on the old facility until the old facility is subleased. If the facility is subleased, we will receive an immediate distribution totaling the amount of the sublease income to be received under the sublease and the escrow account will receive the future sublease rental income and remit the future rental payments due under the original facility lease to the lessor. We will continue to be responsible for our obligations under the original lease and, therefore, subject to risk of default by a sublessee. We will also be responsible to fund the escrow account to the extent the rent payments under the original lease exceed the rent payments under a sublease. We account for the $5.5 million to be received from the escrow account as a lease incentive which will be recognized in income over the 10-year term of the new lease. As of June 30, 2005, the escrow account balance was $5.5 million, $1.6 million of which was included as a component of prepaid expenses and other current assets and $3.9 million of which was included as a component of other assets.

 

The American Jobs Creation Act of 2004 introduced a one-time dividends received deduction on the repatriation of foreign earnings to a U.S. taxpayer. We have not previously recorded a U. S. tax liability on such revenues because we intended to permanently reinvest them in our foreign operations. We have been evaluating the impact of this law on our permanent reinvestment position and have recorded $0.8 million tax expense in the second quarter related to the projected repatriation of $22.2 million in foreign earnings. We continue to analyze the effect of the new Act on the remaining $46.9 million of undistributed foreign earnings and expect to complete this analysis by the end of the year. The income tax effect of repatriating the remaining undistributed earnings is not estimable at this tine.

 

As of June 30, 2005, we had liabilities of $5.5 million in connection with tax positions taken in our tax returns that include interpretations of applicable income tax laws and regulations. These amounts are based on management’s expectation regarding the ultimate tax treatment and outcome of these matters. We believe it is unlikely that the resolution of these matters will have a material adverse effect on our financial position or results of operations.

 

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Under most of our agreements for Development Group services, we 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 and strategic acquisitions and investments. We expect these activities will be funded from existing cash, cash flow 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 for at least the next 12 months. From time to time, we evaluate potential acquisitions, investments and other growth opportunities that might require additional external financing, and we might seek funds from public or private issuances of equity or debt securities. In any event, our sources of liquidity could be affected by our dependence on a small number of industries and clients, compliance with regulations, international risks, personal injury, environmental or intellectual property claims, as well as other factors described below under “Potential Volatility of Quarterly Operating Results and Stock Price” and “Quantitative and Qualitative Disclosures about Market Risk”. In addition, see “Contractual Obligations and Commercial Commitments” and “Critical Accounting Policies and Estimates” in our Annual Report on Form 10-K for the year ended December 31, 2004.

 

Critical Accounting Policies and Estimates

 

There were no material changes to our critical accounting policies and estimates in the first half of 2005. For detailed information on our critical accounting policies and estimates, see our Annual Report on Form 10-K for the year ended December 31, 2004.

 

Recently Issued Accounting Standards

 

For information about recently issued accounting standards, see “Recent Accounting Pronouncements” in Note 1 to the Notes to our Consolidated Condensed Financial Statements in Item I.

 

Income Taxes

 

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 taxing jurisdictions. In particular, as the geographic mix of our pre-tax earnings among various tax jurisdictions changes, our effective tax rate might vary from period to period.

 

Inflation

 

Our long-term contracts, those in excess of one year, generally include an inflation or cost of living adjustment or factor for the portion of the services to be performed beyond one year from the contract date. As a result, we expect that inflation generally will not have a material adverse effect on our operations or financial condition.

 

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:

 

    the timing and amount of costs associated with R&D and compound collaborations;

 

    the timing of the initiation, progress or cancellation of significant projects;

 

    the timing of our Discovery Sciences Group milestone payments or other revenue;

 

    exchange rate fluctuations between periods;

 

    our dependence on a small number of industries and clients;

 

    the timing and level of new business authorizations;

 

    the mix of products and services sold in a particular period;

 

    pricing pressure in the market for our services;

 

    our ability to recruit and retain experienced personnel;

 

    rapid technological change;

 

    the timing and amount of start-up costs incurred in connection with the introduction of new products and services;

 

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    the timing and extent of new government regulations;

 

    intellectual property risks;

 

    impairment of investments or intangible assets;

 

    the timing of the opening of new offices;

 

    the timing of other internal expansion costs; and

 

    the timing and amount of costs associated with integrating acquisitions.

 

Delays and terminations of trials are often the result of actions taken by our customers 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.

 

Fluctuations in quarterly results or other factors beyond our control could affect the market price of our common stock. These factors include changes in earnings estimates by analysts, market conditions in our industry, announcements by competitors, changes in pharmaceutical, biotechnology and medical device industries, general economic conditions, and differences in assumptions used as compared to actual results. Any effect on our common stock could be unrelated to our longer-term operating performance. For more detail, see “Factors that Might Affect our Business or Stock Price” in our Annual Report on Form 10-K for the year ended December 31, 2004.

 

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

 

We are exposed to foreign currency risk by virtue of our international operations. Approximately 25.9% and 29.6% of our total net revenue for the three months ended June 30, 2004 and 2005, respectively, were derived from operations outside the United States. Funds generated by each subsidiary are generally reinvested in the country where they are earned, although we are analyzing the effect of the one-time dividends received deduction of the American Jobs Creation Act of 2004 on undistributed foreign earnings. Our operations in the United Kingdom generated approximately 45.0% of our net revenue from international operations during the three months ended June 30, 2005. Accordingly, we are exposed to adverse movements in the pound sterling and other foreign currencies.

 

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 pounds sterling, U.S. dollars or euros, but the majority of these contracts are 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, 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, which are paid in local currency, are negatively impacted when translated into U.S. dollars. In January 2004, we began engaging in hedging activities in an effort to manage our potential foreign exchange exposure.

 

We also have currency risk resulting from the passage of time between the invoicing of customers under contracts and the ultimate collection of customer payments against those invoices. If a contract is denominated in a currency other than the subsidiary’s 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 customer is received will result in our receiving either more or less in local currency than the local currency equivalent of the invoice amount at the time the invoice was prepared and the receivable established. We recognize this difference as a foreign currency transaction gain or loss, as applicable, and report it in other income, net. We do not expect that a 10% increase or decrease in exchange rates would have a material effect on our financial statements.

 

Our strategy for management of currency risk relies primarily on conducting our operations in a country’s currency, making intercompany foreign currency denominated loans and from time to time, using currency derivatives, primarily forward exchange contracts. As of June 30, 2005, we had open foreign exchange derivative contracts with a face amount totaling $63.2 million to buy the local currencies of our foreign subsidiaries. The estimated fair value of the foreign currency derivative portfolio was $1.4 million loss recorded as a component of other accrued expenses. The potential loss resulting from a hypothetical weakening of the U.S. dollar relative to the pound sterling and euro of 10% would have been approximately $1.7 million for the quarter ended June 30, 2005 based on second quarter 2005 revenues and the costs related to our foreign operations. Our foreign currency hedging activities would partially offset these potential losses. We do not expect that a 10% change in exchange rates in the future would have a material effect on our financial statements.

 

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 subsidiary’s financial results to U.S. dollars is as follows:

 

    we translate income statement accounts at average exchange rates for the period;

 

    we translate balance sheet assets and liability accounts at end of period exchange rates; and

 

    we translate equity accounts at historical exchange rates.

 

Translation of the balance sheet in this manner affects shareholders’ equity through the cumulative translation adjustment account. This account exists only in the foreign subsidiary’s U.S. dollar balance sheet and is necessary to keep the foreign balance sheet, stated in U.S. dollars, in balance. Translation adjustments are reported 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 our financial position.

 

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Currently, there are no material exchange controls on the payment of dividends or otherwise prohibiting the transfer of funds out of or from within any country in which we conduct operations. Although we perform services for clients located in a number of foreign jurisdictions, we have not experienced any difficulties in receiving funds remitted from foreign countries. However, new or modified exchange control restrictions could have an adverse effect on our financial condition.

 

We are exposed to changes in interest rates on our cash equivalents 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 financial market conditions. We do not expect that a 10% change in interest rates in the future would have a material effect on our financial statements.

 

Item 4. Controls and Procedures

 

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 SEC’s 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 are effective to provide the reasonable assurance discussed above.

 

Internal Control Over Financial Reporting

 

There were no changes in internal control over financial reporting during the second quarter of 2005 that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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Part II. OTHER INFORMATION

 

Item 4. Submission of Matters to a Vote of Security Holders

 

The 2005 Annual Meeting of Shareholders of the Company was held on May 18, 2005. At the Annual Meeting, the following directors were elected to office for the ensuing year and were approved by the following votes:

 

     For

     Against*

Stuart Bondurant

   49,168,023      3,577,239

Fredric N. Eshelman

   49,342,109      3,403,153

Marye Anne Fox

   50,624,387      2,120,875

Frederick Frank

   42,748,648      9,996,614

David L. Grange

   52,296,832      448,430

Catherine M. Klema

   50,572,727      2,172,535

Terry Magnuson

   50,617,561      2,127,701

Ernest Mario

   49,315,437      3,429,825

John A. McNeill, Jr.

   47,205,983      5,539,279

* Includes abstentions.

 

Item 6. Exhibits

 

(a) Exhibits

 

10.216    Second Amendment dated June 30, 2005, to Loan Agreement by and among Spotlight Health, Inc., Pharmaceutical Product Development, Inc. and Bank of America, N.A
10.217    Third Amendment to Loan Agreement dated June 30, 2005, between Pharmaceutical Product Development, Inc. and Bank of America, N.A
31.1    Certification of the Chief Executive Officer pursuant to Rule 13a-14(a)
31.2    Certification of the Chief Financial Officer pursuant to Rule 13a-14(a)
32.1    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of The Sarbanes-Oxley Act of 2002 – Chief Executive Officer
32.2    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of The Sarbanes-Oxley Act of 2002 – Chief Financial Officer

 

 

39


Table of Contents

SIGNATURES

 

In accordance with the requirements of the Securities Exchange Act of 1934, the registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC.
(Registrant)

By

 

/s/ Fredric N. Eshelman


    Chief Executive Officer
    (Principal Executive Officer)

By

 

/s/ Linda Baddour


    Chief Financial Officer
    (Principal Financial and Accounting Officer)

 

Date: July 29, 2005

 

40

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