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Pharmaceutical Product Development 10-Q 2008
Form 10-Q
Table of Contents

 

 

UNITED STATES

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 September 30, 2008.

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)

929 North Front Street

Wilmington, North Carolina

(Address of principal executive offices)

28401

(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 a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer   x    Accelerated filer   ¨
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 117,900,576 shares of common stock, par value $0.05 per share, as of October 31, 2008.

 

 

 


Table of Contents

INDEX

 

         Page
Part I. FINANCIAL INFORMATION   
Item 1. Financial Statements   
 

Consolidated Condensed Statements of Operations for the Three and Nine Months Ended September 30, 2007 and 2008 (unaudited)

   3
  Consolidated Condensed Balance Sheets as of December 31, 2007 and September 30, 2008 (unaudited)    4
  Consolidated Condensed Statements of Cash Flows for the Nine Months Ended September 30, 2007 and 2008 (unaudited)    5
  Notes to Consolidated Condensed Financial Statements (unaudited)    6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations    26
Item 3. Quantitative and Qualitative Disclosures about Market Risk    41
Item 4. Controls and Procedures    42
Part II. OTHER INFORMATION   
Item 1. Legal Proceedings    43
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds    43
Item 6. Exhibits    44
Signatures    45

 

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
September 30,
    Nine Months Ended
September 30,
 
     2007     2008     2007     2008  

Net Revenue:

        

Development

   $ 323,769     $ 358,674     $ 940,452     $ 1,077,120  

Discovery Sciences

     4,694       7,773       13,577       31,798  

Reimbursed out-of-pockets

     28,732       32,020       85,388       92,811  
                                

Total net revenue

     357,195       398,467       1,039,417       1,201,729  
                                

Direct Costs:

        

Development

     163,221       173,748       472,651       534,484  

Discovery Sciences

     2,775       2,741       7,595       8,065  

Reimbursable out-of-pocket expenses

     28,732       32,020       85,388       92,811  
                                

Total direct costs

     194,728       208,509       565,634       635,360  
                                

Research and development expenses

     8,353       1,657       14,221       7,911  

Selling, general and administrative expenses

     87,129       101,684       245,016       301,711  

Depreciation and amortization

     14,135       15,332       40,564       45,182  

Impairment of intangible asset

     —         —         —         1,607  
                                

Total operating expenses

     304,345       327,182       865,435       991,771  
                                

Income from operations

     52,850       71,285       173,982       209,958  

Interest income, net

     4,229       4,249       13,017       13,835  

Other income (expense), net

     (5 )     2,386       (219 )     1,072  

Impairment of investments, net

     —         (2,092 )     —         (15,435 )
                                

Income before provision for income taxes

     57,074       75,828       186,780       209,430  

Provision for income taxes

     18,834       24,644       63,906       69,110  
                                

Net income

   $ 38,240     $ 51,184     $ 122,874     $ 140,320  
                                

Net income per common share:

        

Basic

   $ 0.32     $ 0.43     $ 1.04     $ 1.18  
                                

Diluted

   $ 0.32     $ 0.43     $ 1.03     $ 1.16  
                                

Dividends declared per common share

   $ 0.03     $ 0.10     $ 0.09     $ 0.30  
                                

Weighted average number of common shares outstanding:

        

Basic

     118,739       118,704       118,297       119,093  

Dilutive effect of stock options and restricted stock

     1,326       1,448       1,462       1,527  
                                

Diluted

     120,065       120,152       119,759       120,620  
                                

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

 

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Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED BALANCE SHEETS

(unaudited)

(in thousands)

 

     December 31,
2007
   September 30,
2008
 
Assets      

Current assets:

     

Cash and cash equivalents

   $ 171,427    $ 462,489  

Short-term investments

     330,957      47,761  

Accounts receivable and unbilled services, net

     481,477      458,405  

Income tax receivable

     517      4,225  

Investigator advances

     15,318      17,921  

Prepaid expenses and other current assets

     49,835      60,494  

Deferred tax assets

     23,682      24,164  
               

Total current assets

     1,073,213      1,075,459  

Property and equipment, net

     356,189      376,540  

Goodwill

     215,620      214,208  

Long-term investments

     —        101,873  

Equity investments

     23,387      12,433  

Intangible assets

     1,702      2,000  

Deferred tax assets

     11,717      11,720  

Other assets

     2,547      2,688  
               

Total assets

   $ 1,684,375    $ 1,796,921  
               
Liabilities and Shareholders’ Equity      

Current liabilities:

     

Accounts payable

   $ 24,984    $ 26,129  

Payables to investigators

     58,952      53,321  

Accrued income taxes

     16,182      13,304  

Other accrued expenses

     167,235      183,698  

Deferred tax liabilities

     101      204  

Unearned income

     205,779      232,499  
               

Total current liabilities

     473,233      509,155  

Accrued income taxes

     29,223      32,193  

Accrued additional pension liability

     9,763      7,986  

Deferred tax liabilities

     3,814      3,084  

Deferred rent and other

     18,246      28,490  
               

Total liabilities

     534,279      580,908  

Shareholders’ equity:

     

Common stock

     5,955      5,921  

Paid-in capital

     502,898      542,779  

Retained earnings

     626,025      671,357  

Accumulated other comprehensive income

     15,218      (4,044 )
               

Total shareholders’ equity

     1,150,096      1,216,013  
               

Total liabilities and shareholders’ equity

   $ 1,684,375    $ 1,796,921  
               

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

 

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Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)

 

     Nine Months Ended
September 30,
 
     2007     2008  

Cash flows from operating activities:

    

Net income

   $ 122,874     $ 140,320  

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

    

Depreciation and amortization

     40,564       45,182  

Impairment of investments

     —         15,435  

Impairment of intangible asset

     —         1,607  

Stock compensation expense

     15,879       19,182  

(Benefit) provision for doubtful accounts

     (208 )     4,302  

Gain on sale of investments

     (54 )     (521 )

Provision for deferred income taxes

     6,048       (2,403 )

(Gain) loss on disposal of assets, net

     (187 )     60  

Change in operating assets and liabilities

     (38,660 )     35,601  
                

Net cash provided by operating activities

     146,256       258,765  
                

Cash flows from investing activities:

    

Purchases of property and equipment

     (80,089 )     (53,210 )

Proceeds from sale of property and equipment

     1,599       102  

Purchase of intangibles

     —         (1,500 )

Purchases of investments

     (338,903 )     (198,348 )

Maturities and sales of investments

     285,137       370,805  

Purchases of equity investments

     (2,335 )     (2,341 )

Proceeds from sale of equity investments

     979       1,920  
                

Net cash (used in) provided by investing activities

     (133,612 )     117,428  
                

Cash flows from financing activities:

    

Proceeds from revolving credit facility

     24,986       —    

Repayment of revolving credit facility

     (24,986 )     —    

Repayment of construction loan

     (74,833 )     —    

Repayment of capital leases obligations

     (319 )     —    

Repurchases of common stock

     —         (66,612 )

Proceeds from exercise of stock options and employee stock purchase plan

     22,766       25,116  

Income tax benefit from exercise of stock options and disqualifying dispositions of stock

     3,774       3,190  

Cash dividends paid

     (10,673 )     (35,727 )
                

Net cash used in financing activities

     (59,285 )     (74,033 )
                

Effect of exchange rate changes on cash and cash equivalents

     2,504       (11,098 )
                

Net (decrease) increase in cash and cash equivalents

     (44,137 )     291,062  

Cash and cash equivalents, beginning of the period

     179,795       171,427  
                

Cash and cash equivalents, end of the period

   $ 135,658     $ 462,489  
                

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

 

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Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(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. The Company prepared these unaudited consolidated condensed financial statements in accordance with Rule 10-01 of Regulation S-X and, in management’s opinion, has 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, 2007. The results of operations for the three-month and nine-month periods ended September 30, 2008 are not necessarily indicative of the results to be expected for the full year or any other period. The amounts in the December 31, 2007 consolidated condensed balance sheet are derived from the audited financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.

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.

Recent accounting pronouncements

In September 2006, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements”, or SFAS No. 157, which defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In addition, the statement establishes a framework for measuring fair value and expands disclosure about fair value measurements. SFAS No. 157 is effective for fiscal years and interim periods beginning after November 15, 2007. However, in February 2008, the FASB issued FASB Staff Position, or FSP FAS, 157-1 and FSP FAS 157-2, which delay the effective date of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financials statements on a recurring basis (at least annually) and removes certain leasing transactions from the scope of SFAS No. 157. FSP FAS 157-2 partially defers the effective date of SFAS No. 157 to fiscal years and interim periods beginning after November 15, 2008 for items within the scope of the FSP. The Company does not expect the adoption of FSP FAS 157-1 and FSP FAS 157-2 to have a material impact on the Company’s financial statements. See “Fair Value” below, and Note 11 for a discussion of the Company’s fair value accounting.

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106, and 132(R)”, or SFAS No. 158. SFAS No. 158 requires employers to measure the funded status of a plan as of the date of its year-end statement of financial position. The Company currently uses a measurement date of November 30 and will be required to change the measurement date to December 31 for the year ended December 31, 2008. The adoption of this requirement is not expected to have a material impact on the Company’s financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment of FASB Statement No. 115”, or SFAS No. 159. This standard permits, but does not require, all entities to choose to measure eligible items at fair value at specified election dates. For items for which the fair value option has been elected, an entity would report unrealized gains and losses in earnings at each subsequent reporting date. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. The Company has adopted the standard as of January 1, 2008 but has not elected to account for any of its eligible financial assets and liabilities using the guidance of this standard.

 

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Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

1. Significant Accounting Policies (continued)

 

Recent accounting pronouncements (continued)

 

In June 2007, the FASB reached a consensus on Emerging Issues Task Force, or EITF, Issue No. 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards”. EITF 06-11 requires companies to recognize as an increase to additional paid-in capital the income tax benefit realized from dividends or dividend equivalents that are charged to retained earnings and paid to employees for nonvested equity-classified employee share-based payment awards. EITF 06-11 is effective for fiscal years beginning after December 15, 2007. The adoption of this statement did not have an impact on the Company’s financial statements.

In June 2007, the FASB reached a consensus on EITF Issue No. 07-03, “Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities”. EITF 07-03 requires companies to defer and capitalize, until the goods have been delivered or the related services have been rendered, non-refundable advance payments for goods that will be used or services that will be performed in future research and development activities. EITF 07-03 is effective for fiscal years beginning after December 15, 2007. The adoption of this statement did not have an impact on the Company’s financial statements.

In December 2007, the FASB reached a consensus on EITF Issue No. 07-01, “Accounting for Collaborative Arrangements”. EITF 07-01 defines collaborative arrangements and establishes reporting requirements for transactions between participants in a collaborative arrangement and between participants in the arrangement and third parties. EITF 07-01 also establishes the appropriate income statement presentation and classification for joint operating activities and payments between participants, as well as the required disclosures related to these arrangements. EITF 07-01 is effective for fiscal years beginning after December 15, 2008. The Company does not expect EITF 07-01 will have a material impact on its financial statements.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations”, or SFAS 141(R). SFAS 141(R) expands the definitions of a business and a business combination and requires that: the purchase price of an acquisition, including the issuance of equity securities to be determined on the acquisition date, be recorded at fair value at the acquisition date; all assets, liabilities, contingent consideration, contingencies and in-process research and development costs of an acquired business be recorded at fair value at the acquisition date; acquisition costs generally be expensed as incurred; restructuring costs generally be expensed in periods subsequent to the acquisition date; and changes be made in accounting for deferred tax asset valuation allowances and acquired income tax uncertainties after the measurement period to impact income tax expense. SFAS 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The Company does not expect the adoption of this statement to have a significant impact on its current financial statements due to prospective application. However, the adoption of SFAS 141(R) is expected to have a significant effect on reporting of acquisitions in the financial statements after January 1, 2009.

 

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Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

1. Significant Accounting Policies (continued)

 

Recent accounting pronouncements (continued)

 

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51”, or SFAS No. 160. SFAS No. 160 amends ARB No. 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. An ownership interest in subsidiaries held by parties other than the parent should be presented in the consolidated statement of financial position within equity, but separate from the parent’s equity. SFAS No. 160 requires that changes in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary should be accounted for similarly to equity transactions. When a subsidiary is deconsolidated, any retained noncontrolling equity investment should be initially measured at fair value, with any gain or loss recognized in earnings. SFAS No. 160 requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the noncontrolling interest. It also requires disclosure, on the face of the consolidated income statement, of the amounts of consolidated net income attributable to the parent and to the noncontrolling interests. SFAS No. 160 is effective for fiscal years beginning on or after December 15, 2008, including interim periods within those fiscal years. The Company does not expect SFAS No. 160 will have a material impact on its financial statements.

In March 2008, the FASB issued SFAS No. 161, “Disclosures About Derivative Instruments and Hedging Activities”, or SFAS No. 161. SFAS No. 161 requires enhanced disclosures about derivative and hedging activities, including (1) how and why an entity uses derivative instruments, (2) how derivative instruments and related hedged items are accounted for under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, or SFAS No. 133, and its related interpretations, and (3) how derivative instruments and related hedged items affect financial position, financial performance and cash flows. SFAS No. 161 is effective for fiscal years and interim periods beginning on or after November 15, 2008. The Company does not expect SFAS No. 161 will have a material impact on its financial statements.

In April 2008, the FASB issued FSP FAS 142-3, “Determination of the Useful Life of Intangible Assets”, or FSP FAS 142-3. FSP FAS 142-3 amends the factors that should be considered in developing a renewal or extension assumptions used for purposes of determining the useful life of a recognized intangible asset under FASB SFAS No. 142, “Goodwill and Other Intangible Assets”, or SFAS No. 142. More specifically, FSP FAS 142-3 removes the requirement under paragraph 11 of SFAS No. 142 to consider whether an intangible asset can be renewed without substantial cost or material modifications to the existing terms and conditions and instead requires an entity to consider its own historical experience in renewing similar arrangements. FSP FAS 142-3 is intended to improve the consistency between the useful life of a recognized intangible asset under SFAS No. 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS 141(R) and other accounting literature. FSP FAS 142-3 is effective for fiscal years beginning after December 15, 2008, including interim periods within those fiscal years. The Company does not expect FSP FAS 142-3 will have a material impact on its financial statements.

In June 2008, the FASB issued FSP EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities”, or FSP EITF 03-6-1. FSP EITF 03-6-1 provides that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of earnings per share pursuant to the two-class method. Upon adoption, a company is required to retrospectively adjust its earnings per share data (including any amounts related to interim periods, summaries of earnings and selected financial data) to conform with the provisions in FSP EITF 03-6-1. The Company’s unvested restricted stock is considered a participating security. FSP EITF 03-6-1 is effective for fiscal years beginning after December 15, 2008, including interim periods within those fiscal years. The Company does not expect FSP EITF 03-6-1 will have a material impact on its financial statements.

 

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Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

1. Significant Accounting Policies (continued)

 

Recent accounting pronouncements (continued)

 

In June 2008, the FASB issued EITF No. 08-3, “Accounting by Lessees for Nonrefundable Maintenance Deposits”, or EITF 08-3. EITF 08-3 requires that nonrefundable maintenance deposits paid by a lessee under an arrangement accounted for as a lease be accounted for as a deposit asset until the underlying maintenance is performed. When the underlying maintenance is performed, the deposit may be expensed or capitalized in accordance with the lessee’s maintenance accounting policy. Upon adoption, entities must recognize the effect of the change as a change in accounting principle. EITF 08-3 is effective for fiscal years beginning after December 15, 2008, including interim periods within those fiscal years. The Company does not expect EITF 08-3 will have a material impact on its financial statements.

In August 2008, the U.S. Securities and Exchange Commission, or SEC, announced that it will issue for comment a proposed roadmap regarding the potential use by U.S. issuers of financial statements prepared in accordance with International Financial Reporting Standards, or IFRS. IFRS is a comprehensive series of accounting standards published by the International Accounting Standards Board, or IASB. Under the proposed roadmap, the Company could be required in fiscal year 2014 to prepare financial statements in accordance with IFRS and the SEC will make a determination in 2011 regarding mandatory adoption of IFRS. The Company is currently assessing the impact that this potential change would have on our consolidated financial statements and will continue to monitor the development of the potential implementation of IFRS.

Earnings per share

The Company computes basic income per share information based on the weighted average number of common shares outstanding during the period. The Company computes diluted income per share information based on the weighted average number of common shares outstanding during the period plus the effects of any dilutive common stock equivalents. The Company excluded 326,566 shares and 1,302,485 shares from the calculation of diluted earnings per share during the three months ended September 30, 2007 and 2008, respectively, and 508,550 shares and 1,238,035 shares from the calculation of diluted earnings per share during the nine months ended September 30, 2007 and 2008, respectively, because they were antidilutive. Included in the calculation of antidilutive shares are the Company’s stock options, employee stock purchase plan subscriptions and restricted stock that are antidilutive for the period.

Fair value

The Company adopted the provisions of SFAS No. 157 as modified by FSP FAS 157-1 and FSP FAS 157-2, effective January 1, 2008. SFAS No. 157 defines fair value, establishes a consistent framework for measuring fair value and expands the disclosure requirements about fair value measurements.

 

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Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

1. Significant Accounting Policies (continued)

 

Fair value (continued)

 

SFAS No. 157 also establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the assumptions market participants would use in pricing the asset or liability based on the best information available in the circumstances. The hierarchy is broken down into three levels based on the inputs as follows:

 

   

Level 1 – Valuations based on quoted prices in active markets for identical assets or liabilities that the Company has the ability to access.

 

   

Level 2 – Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly.

 

   

Level 3 – Valuations based on inputs that are unobservable and significant to the overall fair value measurement.

SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date. Therefore, even when market assumptions are not readily available the Company’s own assumptions are set to reflect those that market participants would use in pricing the asset or liability at the measurement date. Many financial instruments have bid and ask prices that can be observed in the marketplace. Bid prices reflect the highest price that the Company and others are willing to pay for an asset. Ask prices represent the lowest price that the Company and others are willing to accept for an asset. For financial instruments whose inputs are based on bid-ask prices, the Company’s policy is to set fair value at the average of the bid and ask prices.

The availability of observable inputs can vary from product to product and is affected by a wide variety of factors, including, for example, the type of product, whether the product is new and not yet established in the marketplace, and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for instruments categorized in Level 3. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, for disclosure purposes the level in the fair value hierarchy within which the fair value measurement in its entirety falls is based on the lowest level input that is significant to the fair value measurement in its entirety. Transfers between valuation levels are reported at their fair value as of the end of the month in which such changes in the fair value inputs occurs.

Derivatives - The Company’s derivative portfolio consists solely of foreign currency forwards and certain foreign currency structured derivatives. The Company’s derivative positions are valued using generally accepted developed models that use as their basis readily observable market parameters that can be validated to external sources, including industry pricing services. These models reflect the contractual terms of the derivatives, including the period to maturity, and market-based parameters such as interest rates, forward rates, currency exchange rates, and the credit quality of the counterparty and do not require significant judgment. These instruments are classified within Level 2 of the valuation hierarchy.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

1. Significant Accounting Policies (continued)

 

Fair value (continued)

 

Investments, equity investments and cash equivalents - Where quoted prices are available in an active market, securities are classified in Level 1 of the valuation hierarchy. Level 1 securities included highly liquid debt obligations for which there are quoted prices in active markets, money market funds which trade daily based on net asset values or quoted prices in active markets, and exchange-traded equities. If quoted market prices are not available for the specific security, then the Company estimates fair values by using pricing models or quoted prices of securities with similar characteristics. Examples of such instruments are commercial paper, municipal debt obligations (including auction rate securities, variable rate demand notes and fixed maturity obligations), which would generally be classified within Level 2 of the valuation hierarchy. In certain cases where there is limited activity or less transparency around inputs to the valuation, the Company classifies securities within Level 3 of the valuation hierarchy.

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.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

2. Cash and Cash Equivalents, Short-term Investments, Long-term Investments and Equity Investments

Cash and cash equivalents, short-term investments, long-term investments and equity investments were composed of the following as of the dates set forth below:

 

     Cash and
cash
equivalents
   Short-term
investments
   Long-term
investments
   Equity
investments

As of December 31, 2007

           

Cash

   $ 121,326         

Money market funds

     12,474         

Auction rate securities

      $ 209,475      

Municipal debt securities

     23,665      111,230      

Time deposits

     10,177         

Commercial paper

     3,785         

Other investments

        10,252      

Marketable equity securities:

           

BioDelivery Sciences International, Inc.

            $ 1,653

Accentia Biopharmaceuticals, Inc.

              14,006

Cost basis investments:

           

Bay City Capital Funds

              5,449

A.M. Pappas Funds

              1,529

Other equity investments

              750
                           

Total

   $ 171,427    $ 330,957    $ —      $ 23,387
                           

As of September 30, 2008

           

Cash

   $ 225,485         

Money market funds

     237,004         

Auction rate securities

      $ 15,239    $ 101,873   

Municipal debt securities

        22,522      

Time deposits

        10,000      

Marketable equity securities:

           

Accentia Biopharmaceuticals, Inc.

            $ 2,306

Cost basis investments:

           

Bay City Capital Funds

              6,995

A.M. Pappas Funds

              2,382

Other equity investments

              750
                           

Total

   $ 462,489    $ 47,761    $ 101,873    $ 12,433
                           

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

2. Cash and Cash Equivalents, Short-term Investments, Long-term Investments and Equity Investments (continued)

 

Short-term and long-term investments

The Company accounts for its investment in marketable securities in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities”. The Company’s short-term and long-term investments are classified as available-for-sale securities because the Company does not intend to hold these securities to maturity and is not holding them for trading purposes. The Company determines realized and unrealized gains and losses on short-term and long-term investments on a specific identification basis.

As of December 31, 2007 and September 30, 2008, the Company had the following unrealized gains and losses on investments:

 

     December 31,
2007
   September 30,
2008

Unrealized gains on municipal debt securities

   $ 437    $ 12

Unrealized losses on municipal debt securities

     2,145      309

Unrealized losses on auction rate securities

     —        2,963

For the three months and nine months ended September 30, 2007 and 2008, the Company had the following gross realized gains and losses on investments:

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
     2007    2008    2007    2008

Gross realized gains on municipal debt securities

   $ —      $ —      $ —      $ 694

Gross realized losses on other investments

     —        —        —        3,734

Gross realized losses on municipal debt securities

     —        —        —        8

One of the investments in the Company’s short-term investment portfolio incurred a loss of $7.0 million in the first quarter of 2008. The Company elected to liquidate a majority of this investment during the first quarter, leaving a remaining balance of $8.7 million at March 31, 2008. In the second quarter of 2008, the Company incurred an additional loss of $0.3 million, liquidated the balance of this investment and was reimbursed by an investment firm for $3.6 million of its loss that was incurred in the first quarter of 2008.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

2. Cash and Cash Equivalents, Short-term Investments, Long-term Investments and Equity Investments (continued)

 

Short-term and long-term investments (continued)

 

The Company held approximately $209.5 million and $117.1 million in tax-exempt auction rate securities at December 31, 2007 and September 30, 2008, respectively. The Company’s portfolio of investments in auction rate securities consists principally of interests in government-guaranteed student loans, insured municipal debt obligations and municipal preferred auction rate securities. During the nine months ended September 30, 2008, a significant number of auction rate securities auctions failed. If future auctions fail, the Company may not be able to liquidate these securities until a future auction is successful, the issuer redeems the outstanding securities or the securities mature. Due to the uncertainties about the liquidity in the auction rate securities market, the Company classified $101.9 million of its auction rate securities to long-term assets at September 30, 2008. The Company also recorded an unrealized loss on these investments of $3.0 million as of September 30, 2008. The Company concluded that this was a temporary impairment based on the market conditions, the Company’s ability and intent to hold the auction rate securities for a long-term basis and an assessment of credit quality of the underlying collateral. The Company plans to continue to review the classification and valuation of these securities quarterly.

Equity investments

The Company has equity investments in publicly traded entities. The Company classifies investments in marketable equity securities as available-for-sale securities and measures them at market value. The Company determines realized and unrealized gains and losses on equity investments in publicly traded entities on a specific identification basis. 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 until an other-than-temporary decline in market value has occurred. Upon realization or recognition of an other-than-temporary decline in the fair market value of an investment, the Company records an impairment of that investment. 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 on the last trading day of the reporting period. The Company classifies its equity investments as long-term assets due to the Company’s ability to hold its investments long-term, the strategic nature of these investments and the lack of liquidity in the public markets for these securities. As of December 31, 2007 and September 30, 2008, the Company had gross unrealized gains of $0.3 million and $0, respectively, and no gross unrealized losses associated with its investments in marketable securities.

The Company held 564,076 common shares of stock in BioDelivery Sciences International, Inc. at December 31, 2007. In September 2008, the Company sold all of these shares at various prices for total proceeds of $1.9 million, resulting in a gain of $0.5 million.

During the nine months ended September 30, 2008, the Company recorded a charge to earnings of $11.7 million for an other-than-temporary decline in the fair market value of its equity investment in Accentia. The write-down was based on a decrease in the publicly quoted market price that Company management believes was other-than-temporary due to the length of time the stock had been trading below the Company’s cost basis and Accentia’s projected near-term performance based on the results of its Phase III clinical trial for SinuNase, as discussed in Note 5. In future quarters, the Company may need to record additional impairments, which are not expected to be material to the consolidated condensed financial statements.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

2. Cash and Cash Equivalents, Short-term Investments, Long-term Investments and Equity Investments (continued)

 

Equity investments (continued)

 

The Company also has equity investments in privately held entities that are not publicly traded and for which fair values are not readily determinable. The Company records all of its investments in privately held entities at cost. The Company determines realized and unrealized gains and losses on a specific identification basis. 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 the entity, including, among other things, the market condition of its overall industry, historical and projected financial performance, expected cash needs and recent funding events, as well as the Company’s expected holding period and the length of time and the extent to which the fair value of the investment has been less than cost. Upon realization or recognition of an other-than-temporary decline in the fair market value of an investment, the Company records an impairment of that investment.

In November 2003, the Company became a limited partner in A. M. Pappas Life Science Ventures III, L.P., a venture capital fund established for the purpose of making investments in equity securities of privately held companies in the life sciences, healthcare and technology industries. In October 2007, the Company became a limited partner in A. M. Pappas Life Science Ventures IV, L.P. The Company has committed to invest up to a maximum of $4.8 million and $6.0 million, respectively, in these funds. Aggregate capital calls through September 30, 2008 were $2.4 million and $0, respectively. Because no capital call can exceed 10% of the Company’s aggregate capital commitment in each fund and the Company’s capital commitment will expire in May 2009 for Pappas Fund III and the fifth anniversary of the fund’s first investment for Pappas Fund IV, the Company anticipates that its remaining capital commitment of $2.4 million for Pappas Fund III and $6.0 million for Pappas Fund IV will be made through a series of future capital calls over the term of each commitment. The Company owned approximately 4.7% of Pappas Fund III as of September 30, 2008. Pappas Fund IV had not made any capital calls as of September 30, 2008.

In September 2005, the Company became a limited partner in Bay City Capital Fund IV, L.P., a venture capital fund established for the purpose of investing in life sciences companies. In May 2007, the Company became a limited partner in Bay City Capital Fund V, L.P. The Company has committed to invest up to a maximum of $10.0 million in each of these funds. Aggregate capital calls through September 30, 2008 totaled $6.1 million for Bay City Fund IV and $0.9 million for Bay City Fund V. Because no capital call can exceed 20% of the Company’s aggregate capital commitment in each fund and the Company’s capital commitment will expire in September 2009 for Bay City Fund IV and October 2012 for Bay City Fund V, the Company anticipates its remaining capital commitment of $3.9 million for Bay City Fund IV and $9.1 million for Bay City Fund V will be made through a series of future capital calls over the term of each commitment. The Company owned approximately 2.9% and 2.0% of Bay City Fund IV and Bay City Fund V, respectively, as of September 30, 2008.

 

3. Accounts Receivable and Unbilled Services

Accounts receivable and unbilled services consisted of the following amounts on the dates set forth below:

 

     December 31,
2007
    September 30,
2008
 

Billed

   $ 302,429     $ 279,762  

Unbilled

     186,112       189,188  

Provision for doubtful accounts

     (7,064 )     (10,545 )
                

Total accounts receivable and unbilled services, net

   $ 481,477     $ 458,405  
                

 

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

 

4. Property and Equipment

Property and equipment, stated at cost, consisted of the following amounts on the dates set forth below:

 

     December 31,
2007
    September 30,
2008
 

Land

   $ 6,761     $ 6,620  

Buildings and leasehold improvements

     214,842       221,418  

Construction in progress

     18,758       49,029  

Furniture and equipment

     194,187       202,923  

Computer equipment and software

     171,790       183,478  
                

Total property and equipment

     606,338       663,468  

Less accumulated depreciation

     (250,149 )     (286,928 )
                

Total property and equipment, net

   $ 356,189     $ 376,540  
                

Construction in progress as of September 30, 2008, included software licenses purchased from a third-party vendor with annual payment terms as follows:

 

June 1, 2009

   $ 4,212  

June 1, 2010

     4,212  

June 1, 2011

     4,212  

June 1, 2012

     4,212  
        

Total future remaining payments

   $ 16,848  

Present value discount

     (1,184 )
        

Present value of remaining payments

   $ 15,664  
        

The Company classified its liability related to these licenses as $4.0 million in other accrued expense and $11.6 million in deferred rent and other on its consolidated condensed balance sheet as of September 30, 2008.

The Company owns a building and land in Leicester, England, which had a net book value of $2.4 million as of September 30, 2008. The Company used this building to house a Phase I business unit of the Development segment of the Company prior to the closure of that business unit. The Company classified this building as available-for-sale and included it in prepaid expenses and other current assets on its consolidated condensed balance sheet as of September 30, 2008. The net book value at September 30, 2008 was based on indicative offers from external parties. The Company continues to actively market the property.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

5. Goodwill and Intangible Assets

Changes in the carrying amount of goodwill for the 12 months ended December 31, 2007 and the nine months ended September 30, 2008, by operating segment, were as follows:

 

     Development     Discovery
Sciences
   Total  

Balance as of January 1, 2007

   $ 158,766     $ 53,616    $ 212,382  

Translation adjustments

     3,238       —        3,238  
                       

Balance as of December 31, 2007

     162,004       53,616      215,620  

Translation adjustments

     (1,412 )     —        (1,412 )
                       

Balance as of September 30, 2008

   $ 160,592     $ 53,616    $ 214,208  
                       

Information regarding the Company’s other intangible assets follows:

 

     December 31, 2007    September 30, 2008
     Carrying
Amount
   Accumulated
Amortization
   Net    Carrying
Amount
   Accumulated
Amortization
   Net

Backlog and customer relationships

   $ 308    $ 275    $ 33    $ —      $ —      $ —  

License and royalty agreements

     2,500      831      1,669      —        —        —  

Other intangible asset

     —        —        —        2,000      —        2,000
                                         

Total

   $ 2,808    $ 1,106    $ 1,702    $ 2,000    $ —      $ 2,000
                                         

Intangible assets consist of backlog and customer relationships and an other intangible asset. The other intangible asset has an indefinite life and therefore is not amortized. Backlog and customer relationships are subject to amortization, which the Company amortizes on a straight-line basis, based on estimated useful lives of three to five years. The weighted average amortization period is 5.0 years for backlog and customer relationships.

In September 2004, the Company entered into a royalty stream purchase agreement with Accentia Biopharmaceuticals, Inc. under which it paid $2.5 million to Accentia in exchange for the right to receive royalties on sales of specified antifungal products, including SinuNase™, Accentia’s primary compound that it is developing for the treatment of chronic sinusitis. The Company carried this agreement as an intangible asset in the Discovery Sciences segment. During the first quarter of 2008, Accentia announced results of the SinuNase Phase III clinical trial and reported that SinuNase did not meet its goal in treating chronic sinusitis patients, resulting in a significant amount of uncertainty regarding the future clinical development of SinuNase. As a result, the Company determined that the right under its agreement with Accentia to receive royalties on future sales of SinuNase was impaired, and a non-cash charge of $1.6 million was recorded during the first quarter of 2008 for the remaining unamortized value of its royalty interest in SinuNase.

Amortization expense for the three months ended September 30, 2007 and 2008 was $0.1 million and $2,567, respectively. Amortization expense for the nine months ended September 30, 2007 and 2008 was $0.2 million and $0.1 million, respectively. As of September 30, 2008, all backlog and customer relationships have been fully amortized.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

6. Shareholders’ Equity

Share-based compensation

The Company accounts for its share-based compensation plans using the provisions of SFAS No. 123 (revised), “Share-Based Payment”. Accordingly, the Company measures share-based compensation cost at grant date, based on the fair value of the award, and recognizes it as expense over the employee’s requisite service period.

During the nine months ended September 30, 2008, the Company granted options to purchase approximately 1,448,000 shares with a weighted-average exercise price of $44.05. This amount includes options to purchase approximately 1,177,000 shares granted in the Company’s annual grant during the first quarter of 2008. All options were granted with an exercise price equal to the fair value of the Company’s common stock on the grant date. The fair value of the Company’s common stock on the grant date is equal to the Nasdaq closing price of the Company’s stock on the date of grant. Prior to third quarter of 2008, shares granted under the United Kingdom, or U.K., Subplan had a fair value equal to the average of the high and low price of the Company’s common stock on the date of grant as reported by Nasdaq. The weighted-average grant date fair value per share determined using the Black-Scholes option-pricing method and the aggregate fair value of options granted during the nine months ended September 30, 2008 was $11.12 and $16.1 million, respectively. As of September 30, 2008, the Company had 6.6 million options outstanding. In October 2008, the Company granted options to purchase approximately 620,000 shares with an exercise price of $39.01.

Stock repurchase program

In February 2008, the Company’s Board of Directors approved a stock repurchase program authorizing the Company to repurchase up to $350.0 million of its common stock from time to time in the open market. The timing and amount of any share repurchases will be determined by the Company’s management based on its evaluation of the market conditions and other factors. The stock repurchase program was and will continue to be funded from existing cash and future cash flows from operations and may be discontinued at any time.

During the three and nine months ended September 30, 2008, the Company repurchased approximately 769,000 shares and 1,635,000 shares of its common stock, respectively, for an aggregate purchase price, including broker commissions, of $30.1 million and $66.6 million at an average price per share of $39.18 and $40.75, respectively.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

7. Comprehensive Income

Comprehensive income consisted of the following amounts on the dates set forth below:

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2007     2008     2007     2008  

Net income, as reported

   $ 38,240     $ 51,184     $ 122,874     $ 140,320  

Other comprehensive income:

        

Cumulative translation adjustment

     5,864       (26,287 )     9,669       (15,680 )

Change in fair value of hedging transaction, net of taxes of $344, ($2,154), $344 and ($1,143) respectively

     678       (4,857 )     678       (3,258 )

Reclassification adjustment for hedging results included in direct costs, net of taxes of ($77), $197, ($77) and $176 respectively

     (150 )     677       (150 )     847  

Net unrealized gain (loss) on investments, net of taxes of ($68), $756, ($1,433) and ($634), respectively

     (125 )     1,326       (2,533 )     (1,228 )

Reclassification to net income of realized gain on investment, net of tax of $33

     —         57       —         57  
                                

Total other comprehensive income

     6,267       (29,084 )     7,664       (19,262 )
                                

Comprehensive income

   $ 44,507     $ 22,100     $ 130,538     $ 121,058  
                                

Accumulated other comprehensive income consisted of the following amounts on the dates set forth below:

 

     December 31,
2007
    September 30,
2008
 

Translation adjustment

   $ 24,487     $ 8,806  

Pension liability, net of tax benefit of $2,814

     (7,235 )     (7,235 )

Fair value on hedging transaction, net of tax benefit of $439 and $1,406, respectively

     (1,095 )     (3,505 )

Net unrealized loss on investments, net of tax benefit of $513 and $1,150, respectively

     (939 )     (2,110 )
                

Total

   $ 15,218     $ (4,044 )
                

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

8. Accounting for Derivative Instruments and Hedging Activities

The Company enters into foreign exchange forward and option contracts that are designated and qualify as cash flow hedges under SFAS No. 133. The Company recognizes changes in the fair value of the effective portion of these outstanding forward and option contracts in accumulated other comprehensive income, or OCI. The Company reclassifies these amounts from OCI and recognizes them in earnings when either the forecasted transaction occurs or it becomes probable that the forecasted transaction will not occur.

The Company recognizes changes in the ineffective portion of a derivative instrument in earnings in the current period. The Company measures effectiveness for forward cash flow hedge contracts by comparing the fair value of the forward contract to the change in the forward value of the anticipated transaction. When critical terms match, the Company presumes fair market value of the hedged exposure to be the market value of the hedge instrument. The Company’s hedging portfolio ineffectiveness for the three months ended September 30, 2007 and 2008 was $0 and $0.3 million, respectively. The Company had no hedging portfolio ineffectiveness for the nine months ended September 30, 2007 and 2008. The Company records any ineffectiveness as a component of direct costs.

The Company has significant international revenues and expenses, and related receivables and payables, denominated in non-functional currencies in the Company’s foreign subsidiaries. As a result, the Company’s operating results can be affected by movements in foreign currency exchange rates. In an effort to minimize this risk, the Company from time to time purchases currency option and forward contracts as cash flow hedges against anticipated and recorded transactions, and the related receivables and payables denominated in non-functional currencies. The Company only uses currency option and forward contracts as hedges to minimize 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 18 months from their inception. As of September 30, 2008, the Company’s existing hedging contracts will expire over the next 15 months. The Company expects to reclassify the current loss positions of $4.6 million within the next 12 months from OCI into the income statement.

The Company’s hedging contracts are intended to protect against the impact of changes in the value of the U.S. dollar against other currencies and their impact on operating results. Accordingly, for forecasted transactions, subsidiaries incurring expenses in foreign currencies seek to hedge U.S. dollar revenue contracts. The Company reclassifies OCI associated with hedges of foreign currency revenue into direct costs upon recognition of the forecasted transaction in the statement of operations. At September 30, 2008, the face value of these foreign exchange hedging contracts was $114.0 million.

At September 30, 2008, the Company’s foreign currency derivative portfolio resulted in the Company recognizing an asset of $0.1 million as a component of prepaid expenses and other current assets and a liability of $5.3 million as a component of other accrued expenses.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

9. Pension Plan

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. pension 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. pension plan included the following components on the dates set forth below:

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2007     2008     2007     2008  

Service cost

   $ 431     $ 369     $ 1,271     $ 1,139  

Interest cost

     665       778       1,961       2,401  

Expected return on plan assets

     (692 )     (762 )     (2,040 )     (2,354 )

Amortization of gains and losses

     140       112       412       345  
                                

Net periodic pension cost

   $ 544     $ 497     $ 1,604     $ 1,531  
                                

For the nine months ended September 30, 2008, the Company made contributions totaling $2.3 million and anticipates contributing an additional $0.2 million to fund this plan during the remainder of 2008.

 

10. 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 $10.0 million.

The Company is self-insured for health insurance for the majority of its employees located within the United States, but maintains stop-loss insurance on a “claims made” basis for expenses in excess of $0.28 million per member per year. As of December 31, 2007 and September 30, 2008, the Company maintained a reserve of approximately $4.0 million and $3.2 million, respectively, included in other accrued expenses on the consolidated condensed balance sheets, to cover open claims and estimated claims incurred but not reported.

As of September 30, 2008, the Company had commitments to invest up to an aggregate additional $21.4 million in four venture capital funds. For further details, see Note 2.

As of September 30, 2008, the total gross unrecognized tax benefits were $25.0 million, of which $10.7 million, if recognized, would reduce the Company’s effective tax rate. The Company does not anticipate a significant change in total unrecognized tax benefits or its effective tax rate due to the settlement of audits and the expiration of statute of limitations within the next 12 months.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

10. Commitments and Contingencies (continued)

 

The Company has been involved in compound development and commercialization collaborations since 1997. The Company developed a risk-sharing research and development model to help pharmaceutical and biotechnology clients develop compounds. Through collaborative arrangements based on this model, the Company assists its clients by sharing the risks and potential rewards associated with the development and commercialization of drugs at various stages of development. As of September 30, 2008, the Company had four such arrangements that involve the potential future receipt of one or more of the following forms of revenue: payments upon the achievement of specified development and regulatory milestones; royalty payments if the compound is approved for sale; sales-based milestone payments; and a share of net sales up to a specified dollar limit. The compounds that are the subject of these collaborations are either still in development or are awaiting regulatory approvals in certain countries. None of the compounds have been approved for sale in any country in the world. As a result of the risks associated with drug development, including poor or unexpected clinical trial results and obtaining regulatory approval to sell in any country, the Company might not receive any further milestone payments, royalties or other payments with respect to any of the drug development collaborations.

As of September 30, 2008, the Company had two collaborations that involved potential future expenditures. The first is the Company’s collaboration with ALZA Corporation, subsequently acquired by Johnson & Johnson, for dapoxetine. In connection with this collaboration, the Company has an obligation to pay a royalty to Eli Lilly and Company of 5% on annual net sales of the compound in excess of $800 million. Johnson & Johnson received a “not approvable” letter from the United States Food and Drug Administration, or FDA, in October 2005, but continued its global development program. In December 2007, Johnson & Johnson submitted a marketing authorization application for dapoxetine to regulatory authorities in seven countries in the European Union. Although this regulatory application has been submitted, the Company does not know if or when Johnson & Johnson will obtain regulatory approval for dapoxetine in these or any other countries.

The second collaboration involving future expenditures is with Ranbaxy Laboratories Ltd. In February 2007, the Company exercised an option to license from Ranbaxy a statin compound that the Company is developing as a potential treatment for dyslipidemia, a metabolic disorder characterized by high cholesterol levels. Under the agreement, the Company has an exclusive license to make, use, sell, import and sublicense the compound and any licensed product anywhere in the world for any human use. The Company is solely responsible, and will bear all costs and expenses, for the development, manufacture, marketing and commercialization of the compound and licensed products. In addition to the one-time license fee, the Company is obligated to pay Ranbaxy milestone payments upon the occurrence of specified clinical development events. If a licensed product is approved for sale, the Company must also pay Ranbaxy royalties based on sales of the product, as well as commercial milestone payments based on the achievement of specified worldwide sales targets. If all criteria are met, the total amount of potential clinical and sales-based milestones that the Company is obligated to pay Ranbaxy would be $44.0 million. As previously announced, the Company completed a high dose comparator study in healthy volunteers. The drug was well-tolerated and a preliminary review of results suggests the statin compound compares favorably to currently marketed statins. The Company continues to review the data from this trial, identify potential development and commercialization partners and evaluate the future clinical development of this compound.

In September 2007, the Company entered into a contract with a client to construct a laboratory within a leased building, to supply laboratory equipment and to provide specified laboratory services. The client has agreed to reimburse the Company for the costs of the construction of the laboratory and related equipment over a two-year period. The Company completed the construction and up-fit for this laboratory in the second quarter of 2008 and incurred construction and equipment costs of $5.0 million.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

10. Commitments and Contingencies (continued)

 

Under most of the agreements for Development services, the Company typically 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. For example, beginning in early 2007 the Company was named as a co-defendant in various lawsuits involving claims relating to sanofi-aventis’ FDA-approved antibiotic Ketek, for which the Company provided certain clinical trial services to sanofi-aventis’ predecessor prior to FDA approval. The Company records a reserve for pending and threatened litigation matters when an adverse outcome is probable and the amount of the potential liability is reasonably estimable. Although the ultimate outcome of pending and threatened litigation matters is currently not determinable and litigation costs can be material, 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.

 

11. Fair Value

The Company’s assets and liabilities recorded at fair value have been categorized based upon a fair value hierarchy in accordance with SFAS No. 157. See “Fair Value” under Note 1 for a discussion of the Company’s policies regarding this hierarchy.

The following table presents information about the Company’s assets and liabilities measured at fair value on a recurring basis as of September 30, 2008:

 

     Level 1    Level 2    Level 3    Total

Assets

           

Cash and cash equivalents

   $ 237,004    $ —      $ —      $ 237,004

Short-term investments

     —        47,761      —        47,761

Long-term investments

     —        —        101,873      101,873

Derivative contracts

     —        140      —        140

Equity investments in marketable securities

     2,306      —        —        2,306
                           

Total assets

   $ 239,310    $ 47,901    $ 101,873    $ 389,084
                           

Liabilities

           

Derivative contracts

   $ —      $ 5,348    $ —      $ 5,348
                           

Total liabilities

   $ —      $ 5,348    $ —      $ 5,348
                           

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

11. Fair Value (continued)

 

The following table provides a reconciliation of the beginning and ending balances for assets and liabilities measured at fair value using significant unobservable inputs (Level 3) for the three and nine months ended September 30, 2008:

 

     Long-term
investments
 

Balance as of January 1, 2008

   $ —    

Transfers into Level 3

     110,000  
        

Balance as of March 31, 2008

   $ 110,000  

Liquidation of investments

     (950 )

Reclassification to short-term investments

     (4,225 )

Unrealized loss on investments included in other comprehensive income

     (3,986 )
        

Balance as of June 30, 2008

   $ 100,839  

Liquidation of investments

     (1,025 )

Unrealized gain on investments included in other comprehensive income

     2,059  
        

Balance as of September 30, 2008

   $ 101,873  
        

Transfers into Level 3 result from changes in the observability of fair value inputs used in determining fair values for different types of financial assets that were previously categorized at a higher level. As a result of failed auctions of auction rate securities and the lack of liquidity in this market, the Company transferred $110.0 million of its auction rate securities into Level 3 during the first quarter of 2008.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

12. Business Segment Data

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

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
     2007     2008    2007     2008

Income (loss) from operations:

         

Development

   $ 61,179     $ 69,292    $ 187,485     $ 200,303

Discovery Sciences

     (8,329 )     1,993      (13,503 )     9,655
                             

Total

   $ 52,850     $ 71,285    $ 173,982     $ 209,958
                             
     December 31,
2007
    September 30,
2008
          

Identifiable assets:

         

Development

   $ 1,596,616     $ 1,713,905     

Discovery Sciences

     87,759       83,016     
                   

Total

   $ 1,684,375     $ 1,796,921     
                   

 

13. Subsequent Event

In October 2008, the Company completed its acquisition of InnoPharm, an independent contract research organization, for total consideration of $9.0 million. With offices in Russia and Ukraine, the acquisition of InnoPharm will strengthen our presence in Eastern Europe and will serve as the foundation for continued growth in a region the Company has targeted for expansion while enhancing our ability to conduct global studies for clients. This acquisition will be included in the Company’s Development segment.

 

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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 performance, expectations, predictions, assumptions and other statements that are not statements of historical facts. In some cases, you can identify forward-looking statements by terminology such as “might”, “will”, “should”, “expect”, “plan”, “anticipate”, “believe”, “estimate”, “predict”, “intend”, “potential” or “continue”, or the negative of these terms, or other comparable terminology. These statements are only predictions. These statements rely on a number of assumptions and estimates that could be inaccurate and that are subject to risks and uncertainties. Actual events or results might differ materially due to a number of factors, including those listed in “Potential Volatility of Quarterly Operating Results and Stock Price” below and in “Item 1A. Risk Factors” included in our Annual Report on Form 10-K for the year ended December 31, 2007. 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 contract research organization providing drug discovery and development services, post-approval expertise and compound partnering programs. Our clients and partners include pharmaceutical, biotechnology, medical device, academic and government organizations. Our corporate mission is to help clients and partners maximize returns on their research and development investments and accelerate the delivery of safe and effective therapeutics to patients.

We have been in the drug development business for more than 22 years. Our development services include preclinical programs and Phase I to Phase IV clinical development services as well as bioanalytical product testing and clinical laboratory services. We have extensive clinical trial experience, including regional, national and global studies across a multitude of therapeutic areas and in various parts of the world. In addition, for marketed drugs, biologics and devices, we offer support such as product launch services, medical information, patient compliance programs, patient and disease registry programs, product safety and pharmacovigilance, Phase IV monitored studies and prescription-to-over-the-counter programs.

With 72 offices in 33 countries and more than 10,500 professionals worldwide, we have provided services to 46 of the top 50 pharmaceutical companies in the world as ranked by 2007 healthcare research and development spending. We also work with leading biotechnology and medical device companies and government organizations that sponsor clinical research. We are one of the world’s largest providers of drug development services to pharmaceutical, biotechnology and medical device companies, and government organizations based on 2007 annual net revenue generated from contract research organizations.

Building on our outsourcing relationship with pharmaceutical and biotechnology clients, we established our Discovery Sciences segment in 1997. This segment primarily focuses on preclinical evaluations of anticancer therapies, biomarker discovery and patient sample analysis services, and compound development and commercialization collaborations. We have developed a risk-sharing research and development model to help pharmaceutical and biotechnology clients develop compounds. Through collaborative arrangements based on this model, we assist our clients by sharing the risks and potential rewards of the development and commercialization of drugs at various stages of development.

Our integrated drug discovery and development services offer our clients a way to identify and develop drug candidates more quickly and cost-effectively. In addition, with global infrastructure, we are able to accommodate the multinational drug discovery and development needs of our clients. As a result of having core areas of expertise in discovery and development, we provide integrated services across the drug development spectrum. We use our

 

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proprietary informatics technology to support these services. For more detailed information on PPD, see our Annual Report on Form 10-K for the year ended December 31, 2007.

Executive Overview

Our revenues are dependent on a relatively small number of industries and clients. As a result, we closely monitor the market for our services. For a discussion of the trends affecting the market for our services, see “Item 1. Business – Industry Overview – Trends Affecting the Drug Discovery and Development Industry” in our Annual Report on Form 10-K for the year ended December 31, 2007. Although we cannot forecast with certainty the demand for CRO services for the remainder of 2008, particularly in light of current general economic conditions and uncertainties, the global financial crisis and FDA regulatory developments, the overall market for these services appears to be solid. This is supported by, among other factors, the increase in the volume and size of requests for proposals for our Phase II-IV clinical development services. For the remainder of 2008, we plan to continue our focus on operational performance and sales execution.

We believe there are specific opportunities for growth and improvement in certain areas of our core development business. In total, the four Phase II-IV geographic regions showed continued strength in the third quarter of 2008 demonstrated by a 35.3% increase in authorizations and a 20.0% increase in backlog compared to the third quarter of 2007. In addition, as we expand our global footprint, we expect our ex-United States Phase II-IV units to continue to grow at a higher rate than our overall revenue growth. Our central laboratory’s net revenue was 14.3% above the third quarter of 2007. In October 2008, we announced plans to expand our global central lab services into Southeast Asia in response to growing client demand, which should provide an opportunity for future growth in this business unit.

We review various metrics to evaluate our financial performance, including period-to-period changes in backlog, new authorizations, cancellation rates, revenue, margins and earnings. In the third quarter of 2008, we had new authorizations of $705.1 million, an increase of 23.6% over the third quarter of 2007. The cancellation rate for the third quarter of 2008 was 29.5% of new authorizations. Excluding a foreign currency adjustment to backlog, the cancellation rate for the quarter was 24.2%. Backlog grew to $3.0 billion as of September 30, 2008, up 20.0% over September 30, 2007. The average length of our contracts continued to increase, reaching 35 months as of September 30, 2008 up from 32 months as of September 30, 2007 due to several new contracts with longer than average duration. In the third quarter of 2008, selling, general and administrative costs, or SG&A, as a percentage of net revenue was 25.5% compared to 24.4% in the third quarter of 2007. Included in SG&A costs is an additional $2.5 million of bad debt expense, which equates to 0.6% of net revenue in the third quarter of 2008. While a significant portion of the SG&A cost is related to growth in mature and emerging markets, we are focused on decreasing SG&A as a percentage of net revenue in the future. In addition, our operating margin improved sequentially as income from operations as a percentage of net revenue increased from 17.4% in the second quarter of 2008 to 17.9% in the third quarter of 2008.

Backlog by client type as of September 30, 2008 was 54.1% pharmaceutical, 35.0% biotech and 10.9% government/other, as compared to 51.1% pharmaceutical, 35.9% biotech and 13.0% government/other as of September 30, 2007. This change in the composition of our backlog was primarily a result of an increase in authorizations from pharmaceutical companies. Net revenue by client type for the quarter ended September 30, 2008 was 56.0% pharmaceutical, 30.8% biotech and 13.2% government/other compared to 58.9% pharmaceutical, 29.3% biotech and 11.8% government/other for the quarter ended September 30, 2007.

For the third quarter of 2008, net revenue contribution by service area was 80.3% for Phase II-IV services, 14.3% for laboratory services, 3.3% for the Phase I clinic and 2.1% for Discovery Sciences, compared to net revenue contribution for the year ended December 31, 2007 of 81.0% for Phase II-IV services, 14.1% for laboratory services, 3.3% for the Phase I clinic and 1.6% for Discovery Sciences. Top therapeutic areas by net revenue for the quarter ended September 30, 2008 were oncology, infectious diseases, circulatory/cardiovascular, endocrine/metabolic and central nervous system. For a detailed discussion of our revenue, margins, earnings and other financial results for the quarter ended September 30, 2008, see “Results of Operations – Three Months Ended September 30, 2007 versus Three Months Ended September 30, 2008” below.

Capital expenditures for the three months ended September 30, 2008 totaled $18.4 million. These capital expenditures were primarily for our new building in Scotland and various other leasehold improvements, computer software and hardware, and scientific equipment for our laboratory units. We expect our capital expenditures for 2008

 

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to be approximately $80 million to $90 million, primarily associated with facility expansion and improvements, as well as investments in information technology and new laboratory equipment.

As of September 30, 2008, we had $612.1 million of cash and cash equivalents and short- and long-term investments. In the third quarter of 2008, we generated $81.8 million in cash from operations. The number of days’ revenue outstanding in accounts receivable and unbilled services, net of unearned income, also known as DSO, for the third quarter of 2008 was 42 days, bringing it to 44 days for the nine months ended September 30, 2008, compared to 51 days for the year ended December 31, 2007. DSO decreased during the first nine months of 2008 due to improved cash collections, the mix of contracts performed and their payment terms. We plan to continue to monitor DSO and the various factors that affect it. However, we expect DSO will continue to fluctuate from quarter to quarter depending on contract terms, the mix of contracts performed and our success in collecting receivables.

With regard to our compound partnering arrangements, Johnson & Johnson’s marketing authorization application for dapoxetine is under regulatory review in seven European countries. The dipeptidyl peptidase, or DPP-4, program in type 2 diabetes with Takeda is also under regulatory review in several countries. Takeda submitted the new drug application, or NDA, for alogliptin to the FDA in December 2007. In February 2008, the alogliptin NDA was accepted for filing by the FDA, triggering a $15.0 million milestone payment to us. In October 2008, the FDA notified Takeda that it would not be able to complete its review of the alogliptin NDA before the Prescription Drug Use Fee Act date of October 27, 2008 due to the lack of internal resources. The FDA did not provide any timelines for its ongoing review of the alogliptin NDA. In September 2008, Takeda submitted an NDA for alogliptin in Japan, triggering an additional $3.0 million milestone payment to us. Takeda also submitted an NDA for a single tablet product with alogliptin and Actos with the FDA in September 2008. If additional filings/approvals and launch occur for alogliptin, we will receive additional regulatory milestones, sales-based milestones and royalties.

With regard to our collaboration on the statin compound, PPD10558, as previously announced, we have completed a high dose comparator study in healthy volunteers. The drug was well-tolerated and a preliminary review of results suggests the statin compound compares favorably to currently marketed statins. We continue to review the data from this trial, identify potential development and commercialization partners and evaluate the future development of this compound. We continue to conduct limited development activities with respect to the statin compound and expect to incur additional R&D expenses in future periods, but the level of expenditures should be lower than in prior periods.

We believe these drug development collaborations allow us to leverage our resources and global drug development expertise to create new opportunities for growth and to share the risks and potential rewards of drug development with our collabrators. For a background discussion of our compound partnering arrangements, see “Item 1. Business – Our Services – Our Discovery Sciences Group – Compound Collaboration Programs” in our Annual Report on Form 10-K for the year ended December 31, 2007. We believe our compound partnering strategy uses our cash resources and drug development expertise to drive mid- to long-term shareholder value. For the remainder of 2008, we plan to continue advancing our existing collaborations and evaluate new potential strategies and opportunities in this area.

New Business Authorizations and Backlog

New business authorizations, which are sales of our services, are added to backlog when we enter into a contract or letter of intent or receive a verbal commitment. Authorizations can vary significantly from quarter to quarter and contracts generally have terms ranging from several months to several years. We recognize revenue on these authorizations as services are performed. Our new authorizations for the three months ended September 30, 2007 and 2008 were $570.6 million and $705.1 million, respectively.

Our backlog consists of new business authorizations for which the work has not started but is anticipated to begin in the future and contracts in process that have not been completed. As of September 30, 2008, the remaining duration of the contracts in our backlog ranged from one to 111 months, with a weighted average duration of 35 months. We expect the weighted average duration of the contracts in our backlog to fluctuate from quarter to quarter in the future, based on the contracts constituting our backlog at any given time. Amounts included in backlog represent potential future revenue and exclude revenue that we have recognized. We adjust backlog on a monthly basis to account for fluctuations in exchange rates. Our backlog as of September 30, 2007 and 2008 was $2.5 billion and $3.0 billion, respectively. For various reasons discussed in “Item 1. Business – Backlog” in our Annual Report on Form 10-K for the

 

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year ended December 31, 2007, our backlog might never be recognized as revenue and is not necessarily a meaningful predictor of future performance.

Results of Operations

Revenue Recognition

We record revenue from contracts, other than time-and-material contracts, on a proportional performance basis in our Development and Discovery Sciences segments. To measure performance on a given date, we compare direct costs through that date to estimated total direct costs to complete the contract. Direct costs relate primarily to the amount of labor and labor related overhead costs for the delivery of services. We believe this is the best indicator of the performance of the contractual obligations. Changes in the estimated total direct costs to complete a contract without a corresponding proportional change to the contract value result in a cumulative adjustment to the amount of revenue recognized in the period the change in estimate is determined. For time-and-material contracts in both our Development and Discovery Sciences segments, we recognize revenue as hours are worked, multiplied by the applicable hourly rate. For our Phase I, laboratory and biomarker businesses, we recognize revenue from unitized contracts as subjects or samples are tested, multiplied by the applicable unit price. We offer volume discounts to our large customers based on annual volume thresholds. We record an estimate of the annual volume rebate as a reduction of revenue throughout the period based on the estimated total rebate to be earned for the period.

In connection with the management of clinical trials, we pay, on behalf of our clients, fees to investigators and test subjects as well as other out-of-pocket costs for items such as travel, printing, meetings and couriers. Our clients reimburse us for these costs. 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 September 30, 2007 and 2008, fees paid to investigators and other fees we paid as an agent and the associated reimbursements were approximately $83.9 million and $75.2 million, respectively.

Most of our contracts can be terminated by our clients either immediately or after a specified period following notice. These contracts typically require the client to pay us the fees earned to date, the fees and expenses to wind down the study and, in some cases, a termination fee or some portion of the fees or profit that we could have earned under the contract if it had not been terminated early. Therefore, revenue recognized prior to cancellation generally does not require a significant adjustment upon cancellation. If we determine that a loss will result from the performance of a contract, the entire amount of the estimated loss is charged against income in the period in which such determination is made.

The Discovery Sciences segment also generates revenue from time to time in the form of milestone payments in connection with licensing of compounds. We only recognize milestone payments as revenue if the specified milestone is achieved and accepted by the client, and continued performance of future research and development services related to that milestone is not required.

Recording of Expenses

We generally record our operating expenses among the following categories:

 

   

direct costs;

 

   

research and development;

 

   

selling, general and administrative; and

 

   

depreciation and amortization.

Direct costs consist of amounts necessary to carry out the revenue and earnings process, and include direct labor and related benefit charges, other costs directly related to contracts, an allocation of facility and information technology costs, and reimbursable out-of-pocket expenses. Direct costs, as a percentage of net revenue, tend to and are expected to fluctuate from one period to another as a result of changes in labor utilization and the mix of service offerings involved in the hundreds of studies being conducted during any period of time.

Research and development, or R&D, expenses consist primarily of patent expenses, labor and related benefit charges associated with personnel performing internal research and development work, supplies associated with this work, consulting services and an allocation of facility and information technology costs.

 

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SG&A expenses consist primarily of administrative payroll and related benefit charges, sales, advertising and promotional expenses, recruiting and relocation expenses, training costs, administrative travel, an allocation of facility and information technology costs and costs related to operational employees performing administrative tasks.

We record depreciation expense on a straight-line method, based on estimated useful lives of 40 years for buildings, five years for laboratory equipment, two to five years for software, computers and related equipment, and five to ten years for furniture and equipment, except for aircraft, which we depreciate over 30 years. We depreciate leasehold improvements over the shorter of the life of the relevant lease or the useful life of the improvement. We depreciate property under capital leases over the life of the lease or the service life, whichever is shorter. We record amortization expense on intangible assets on a straight-line method over the life of the intangible assets.

 

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Three Months Ended September 30, 2007 versus Three Months Ended September 30, 2008

The following table sets forth amounts from our consolidated condensed financial statements along with the dollar and percentage change for the three months ended September 30, 2007 compared to the three months ended September 30, 2008.

 

     Three Months Ended
September 30,
             
(in thousands, except per share data)    2007    2008     $ Inc (Dec)     % Inc (Dec)  

Net revenue:

         

Development

   $ 323,769    $ 358,674     $ 34,905     10.8 %

Discovery Sciences

     4,694      7,773       3,079     65.6  

Reimbursed out-of-pockets

     28,732      32,020       3,288     11.4  
                         

Total net revenue

     357,195      398,467       41,272     11.6  

Direct costs:

         

Development

     163,221      173,748       10,527     6.5  

Discovery Sciences

     2,775      2,741       (34 )   (1.2 )

Reimbursable out-of-pocket expenses

     28,732      32,020       3,288     11.4  
                         

Total direct costs

     194,728      208,509       13,781     7.1  

Research and development expenses

     8,353      1,657       (6,696 )   (80.2 )

Selling, general and administrative expenses

     87,129      101,684       14,555     16.7  

Depreciation and amortization

     14,135      15,332       1,197     8.5  
                         

Income from operations

     52,850      71,285       18,435     34.9  

Impairment of investments

     —        (2,092 )     (2,092 )   (100.0 )

Interest and other income, net

     4,224      6,635       2,411     57.1  
                         

Income before provision for income taxes

     57,074      75,828       18,754     32.9  

Provision for income taxes

     18,834      24,644       5,810     30.9  
                         

Net income

   $ 38,240    $ 51,184     $ 12,944     33.9  
                         

Net income per diluted share

   $ 0.32    $ 0.43     $ 0.11     34.4  
                         

Total net revenue increased $41.3 million to $398.5 million in the third quarter of 2008. The increase in total net revenue resulted primarily from an increase in our Development segment revenue. The Development segment generated net revenue of $358.7 million, which accounted for 90.0% of total net revenue for the third quarter of 2008. The 10.8% increase in Development segment net revenue was primarily attributable to an increase in the level of Phase II-IV services and an increase in net revenue from our laboratory units in the third quarter of 2008 as compared to the same period in 2007.

The Discovery Sciences segment generated net revenue of $7.8 million in the third quarter of 2008, an increase of $3.1 million from the third quarter of 2007. The higher 2008 Discovery Sciences segment net revenue was mainly attributable to the $3.0 million milestone payment we earned in the third quarter of 2008 as a result of Takeda’s submission of the alogliptin NDA in Japan.

Total direct costs increased $13.8 million to $208.5 million in the third quarter of 2008 primarily as the result of an increase in Development segment direct costs. Development segment direct costs increased $10.5 million to $173.7 million in the third quarter of 2008 primarily due to an increase in personnel costs of $9.6 million.

R&D expenses decreased $6.7 million to $1.7 million in the third quarter of 2008. The decrease in R&D expense was primarily due to a decrease in development costs associated with the statin compound we licensed from Ranbaxy and are developing as a potential treatment for dyslipidemia. We are solely responsible for all costs and expenses for the development, manufacture, marketing and commercialization of this compound. We continue to

 

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conduct limited development activities with respect to the statin compound and expect to incur additional R&D expenses in future periods, but at lower levels than in prior periods. We also plan to continue evaluating other compound partnering strategies and opportunities, which could result in additional R&D expenses in future periods.

SG&A expenses increased $14.6 million to $101.7 million in the third quarter of 2008. As a percentage of total net revenue, SG&A expenses increased to 25.5% in the third quarter of 2008 as compared to 24.4% for the same quarter in 2007. The increase in SG&A expenses in absolute terms was primarily related to additional personnel costs of $13.3 million and higher bad debt costs of $2.5 million, partially offset by a $1.4 million decrease in recruitment and relocation costs.

Depreciation and amortization expense increased $1.2 million to $15.3 million in the third quarter of 2008. The increase was related to property and equipment we acquired to accommodate our growth. Capital expenditures were $18.4 million in the third quarter of 2008. Our capital expenditures in the third quarter of 2008 primarily consisted of $3.5 million for our new building in Scotland and various other leasehold improvements, $11.4 million for computer software and hardware and $2.9 million for additional scientific equipment for our laboratory units.

Impairment of investments of $2.1 million in the third quarter of 2008 consisted of a write-down for an other-than-temporary decline in the fair market value of our equity investment in Accentia. The write-down was based on a decrease in the publicly quoted market price of Accentia’s common stock on September 30, 2008. For further details, see Note 2 in the notes to the consolidated condensed financial statements.

Interest and other income, net increased $2.4 million to $6.6 million in the third quarter of 2008. This increase was due primarily to gains from intercompany long-term loan settlements offset by the change in foreign currency exchange rates from the time invoices are prepared until payment is received from the client, resulting in a net gain on foreign currency transactions of $1.1 million. Interest and other income, net increased an additional $0.9 million from the sale of our institutional review board unit and $0.4 million from gain on the sale of investments.

Our provision for income taxes increased $5.8 million to $24.6 million in the third quarter of 2008. Our effective income tax rate for the third quarter of 2008 was 32.5% compared to 33.0% for the third quarter of 2007. The decrease in tax rate for the third quarter of 2008 compared to the third quarter of 2007 was primarily caused by the change in the geographic distribution of our pretax earnings among locations with varying tax rates.

Net income of $51.2 million in the third quarter of 2008 represents an increase of 33.9% from $38.2 million in the third quarter of 2007. Net income per diluted share of $0.43 in the third quarter of 2008 represents a 34.4% increase from $0.32 net income per diluted share in the third quarter of 2007.

 

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Nine Months Ended September 30, 2007 versus Nine Months Ended September 30, 2008

The following table sets forth amounts from our consolidated condensed financial statements along with the dollar and percentage change for the nine months ended September 30, 2007 compared to the nine months ended September 30, 2008.

 

     Nine Months Ended
September 30,
             
(in thousands, except per share data)    2007    2008     $ Inc (Dec)     % Inc (Dec)  

Net revenue:

         

Development

   $ 940,452    $ 1,077,120     $ 136,668     14.5 %

Discovery Sciences

     13,577      31,798       18,221     134.2  

Reimbursed out-of-pockets

     85,388      92,811       7,423     8.7  
                         

Total net revenue

     1,039,417      1,201,729       162,312     15.6  

Direct costs:

         

Development

     472,651      534,484       61,833     13.1  

Discovery Sciences

     7,595      8,065       470     6.2  

Reimbursable out-of-pocket expenses

     85,388      92,811       7,423     8.7  
                         

Total direct costs

     565,634      635,360       69,726     12.3  

Research and development expenses

     14,221      7,911       (6,310 )   (44.4 )

Selling, general and administrative expenses

     245,016      301,711       56,695     23.1  

Depreciation and amortization

     40,564      45,182       4,618     11.4  

Impairment of intangible asset

     —        1,607       1,607     100.0  
                         

Income from operations

     173,982      209,958       35,976     20.7  

Impairment of investments, net

     —        (15,435 )     (15,435 )   (100.0 )

Interest and other income, net

     12,798      14,907       2,109     16.5  
                         

Income before provision for income taxes

     186,780      209,430       22,650     12.1  

Provision for income taxes

     63,906      69,110       5,204     8.1  
                         

Net income

   $ 122,874    $ 140,320     $ 17,446     14.2  
                         

Net income per diluted share

   $ 1.03    $ 1.16     $ 0.13     12.6  
                         

Total net revenue increased $162.3 million to $1.2 billion in the first nine months of 2008. The increase in total net revenue resulted primarily from an increase in our Development segment revenue. The Development segment generated net revenue of $1.1 billion, and accounted for 89.6% of total net revenue for the first nine months of 2008. The 14.5% increase in Development segment net revenue was primarily attributable to an increase in the level of Phase II-IV services we provided in the first nine months of 2008 as compared to the same period in 2007. Net revenue from our laboratory units and Phase I clinic increased in the first nine months of 2008 as compared to 2007 and contributed to the overall increase in net revenue in the Development segment.

The Discovery Sciences segment generated net revenue of $31.8 million in the first nine months of 2008, an increase of $18.2 million from the first nine months of 2007. The higher 2008 Discovery Sciences segment net revenue was mainly attributable to the $15.0 million milestone payment we earned in the first quarter of 2008 as a result of the FDA’s acceptance of the alogliptin NDA and a $3.0 million milestone payment we earned in the third quarter of 2008 as a result of Takeda’s submission of the alogliptin NDA in Japan.

Total direct costs increased $69.7 million to $635.4 million in the first nine months of 2008, primarily as the result of an increase in Development segment direct costs. Development segment direct costs increased $61.8 million to $534.5 million in the first nine months of 2008 primarily due to an increase in personnel costs of $45.9 million. The

 

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remaining increase in Development segment direct costs was primarily due to increased facility and information technology costs of $9.0 million as a result of headcount growth and an increase in subcontractor costs of $4.5 million.

SG&A expenses increased $56.7 million to $301.7 million in the first nine months of 2008. As a percentage of total net revenue, SG&A expenses increased to 25.1% in the first nine months of 2008 compared to 23.6% in the first nine months of 2007. The increase in SG&A expenses in absolute terms was primarily due to additional personnel costs of $47.5 million, higher facility and information technology costs of $2.2 million and higher bad debt expense of $4.5 million.

Depreciation and amortization expense increased $4.6 million to $45.2 million in the first nine months of 2008. The increase was related to property and equipment we acquired to accommodate our growth. Capital expenditures were $53.2 million in the first nine months of 2008. Our capital expenditures in the first nine months of 2008 primarily consisted of $15.7 million for our new building in Scotland and various other leasehold improvements, $20.2 million for computer software and hardware and $11.2 million for additional scientific equipment for our laboratory units.

In March 2008, Accentia announced the results of its SinuNase Phase III clinical trial and reported that SinuNase failed to meet its goal in treating chronic sinusitis patients, resulting in a significant amount of uncertainty regarding the future clinical development of SinuNase. As a result, we wrote off the $1.6 million of remaining unamortized value of our royalty interest in SinuNase during the first nine months of 2008.

Income from operations increased $36.0 million to $210.0 million in the first nine months of 2008. Income from operations in the first nine months of 2008 included $18.0 million in milestone payments under our DPP-4 collaboration agreement with Takeda.

Impairment of investments, net of $15.4 million in the first nine months of 2008 consisted of a net impairment of an investment in our short-term investment portfolio of $3.7 million and a $11.7 million write-down for an other-than-temporary decline in the fair market value of our equity investment in Accentia. The write-down on Accentia was based on a decrease in the publicly quoted market price of Accentia’s common stock on September 30, 2008. The net impairment of investments consisted of an impairment of $7.0 million that occurred in the first quarter of 2008 followed by a net reimbursement of $3.3 million that occurred in the second quarter of 2008 on an investment in a AAA-rated tax-advantaged investment fund. For further details, see Note 2 in the notes to consolidated condensed financial statements.

Interest and other income, net increased $2.1 million to $14.9 million in the first nine months of 2008. This increase was due primarily to an increase on the gain on the sale of investments of $1.1 million, the sale of our institutional review board unit for $0.9 million and an increase in interest income of $0.7 million.

Our provision for income taxes increased $5.2 million to $69.1 million in the first nine months of 2008. Our effective income tax rate for the first nine months of 2008 was 33.0% compared to 34.2% for the first nine months of 2007. The decrease in tax rate for the first nine months of 2008 was impacted by a 0.9% reduction due to a tax benefit realized from the disposal of certain assets during the first quarter of 2008. The remaining difference in our effective tax rates for the first nine months of 2008 compared to the first nine months of 2007 was due to the change in the geographic distribution of our pretax earnings among locations with varying tax rates.

Net income of $140.3 million in the first nine months of 2008 represents an increase of 14.2% from $122.9 million in the first nine months of 2007. Net income per diluted share of $1.16 in the first nine months of 2008 represents a 12.6% increase from net income per diluted share of $1.03 in the first nine months of 2007. Diluted earnings per share for the first nine months of 2008 included $18.0 million in milestone payments from Takeda under our DPP-4 collaboration agreement with Takeda, a $1.6 million impairment of an intangible asset and a $15.4 million impairment of investments, net, all discussed above.

Liquidity and Capital Resources

As of September 30, 2008, we had $462.5 million of cash and cash equivalents and $47.8 million of short-term investments. We also had $101.9 million of long-term investments, consisting of auction rate securities. We have classified these auction rate securities as long-term due to uncertainties about the liquidity in the auction rate securities market. Our cash and cash equivalents and short-term investments are invested in financial instruments that are rated A or better by Standard & Poor’s or Moody’s and earn interest at market rates. Our expected primary cash needs on both a short- and long-term basis are for capital expenditures, expansion of services, possible acquisitions, investments and compound partnering collaborations, geographic expansion, dividends, our stock repurchase program, working capital

 

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and other general corporate purposes. We have historically funded our operations, dividends and growth, including acquisitions, primarily with cash flow from operations.

We held approximately $209.5 million and $117.1 million in tax-exempt auction rate securities at December 31, 2007 and September 30, 2008, respectively. Our portfolio of investments in auction rate securities consists principally of interests in government-guaranteed student loans, insured municipal debt obligations and municipal preferred auction rate securities. During the nine months ended September 30, 2008, a significant number of auction rate securities auctions failed. If future auctions fail, we may not be able to liquidate these securities until a future auction is successful, the issuer redeems the outstanding securities or the securities mature. During the first quarter of 2008, due to the uncertainties about the liquidity in the auction rate securities market, we classified $110.0 million of our auction rate securities to long-term assets. Liquidation of these investments, reclassification to short-term assets and recognition of unrealized gains and losses during the nine months ended September 30, 2008 result in a remaining balance of $101.9 million. We also recorded an unrealized loss on these investments of $3.0 million as of September 30, 2008. We concluded that this was a temporary impairment based on the market conditions, our ability and intent to hold the auction rate securities for a long-term basis and an assessment of credit quality of the underlying collateral. The Company plans to continue to review the classification and valuation of these securities quarterly.

In the first nine months of 2008, our operating activities provided $258.8 million in cash as compared to $146.3 million for the same period last year. The change in cash flow was due primarily to (1) a $29.3 million increase in noncash items relating to investing or financing activities, including an impairment of investments, net of $15.4 million, an increase in depreciation and amortization of $4.6 million, an increase in the provision for doubtful accounts of $4.5 million and an increase in stock compensation expense of $3.3 million, and (2) deferrals of past, and accruals of expected future, operating cash receipts and payments totaling $65.8 million. The change in adjustments for accruals of expected future operating cash receipts and payments includes accounts receivable and unbilled services of $59.7 million, prepaid expenses and investigator advances of $8.2 million and unearned income of $43.1 million. The change in adjustments for deferrals of past operating cash receipts and payments includes accounts payable and other accrued expenses and deferred rent of ($13.1) million, accrued and deferred income taxes of ($17.7) million and payables to investigators of ($13.5) million. Fluctuations in receivables and unearned income occur on a regular basis as we perform services, achieve milestones or other billing criteria, send invoices to clients and collect outstanding accounts receivable. This activity varies by individual client and contract. We attempt to negotiate payment terms that provide for payment of services prior to or soon after the provision of services, but the levels of unbilled services and unearned revenue can vary significantly from quarter to quarter.

In the first nine months of 2008, our investing activities provided $117.4 million in cash. We used cash to purchase investments of $198.3 million, make capital expenditures of $53.2 million and purchase equity investments of $2.3 million. These amounts were offset by maturities and sales of investments of $370.8 million. Our capital expenditures in the first nine months of 2008 primarily consisted of $15.7 million for our new building in Scotland and various other leasehold improvements, $20.2 million for computer software and hardware and $11.2 million for additional scientific equipment for our laboratory units. We expect our capital expenditures for 2008 to be approximately $80 million to $90 million, primarily associated with facility expansions and improvements, as well as investments in information technology and new laboratory equipment.

In the first nine months of 2008, our financing activities used $74.0 million of cash. We used $66.6 million of cash to repurchase shares of our common stock and $35.7 million to pay dividends, which was partially offset by proceeds of $25.1 million from stock option exercises and purchases under our employee stock purchase plan and $3.2 million in income tax benefits from the exercise of stock options and disqualifying dispositions of stock.

 

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The following table sets forth amounts from our consolidated balance sheet affecting our working capital, along with the dollar amount of the change from December 31, 2007 to September 30, 2008.

 

(in thousands)    December 31,
2007
   September 30,
2008
   $ Inc (Dec)  

Current assets:

        

Cash and cash equivalents

   $ 171,427    $ 462,489    $ 291,062  

Short-term investments

     330,957      47,761      (283,196 )

Accounts receivable and unbilled services, net

     481,477      458,405      (23,072 )

Income tax receivable

     517      4,225      3,708  

Investigator advances

     15,318      17,921      2,603  

Prepaid expenses and other current assets

     49,835      60,494      10,659  

Deferred tax assets

     23,682      24,164      482  
                      

Total current assets

   $ 1,073,213    $ 1,075,459    $ 2,246  
                      

Current liabilities:

        

Accounts payable

   $ 24,984    $ 26,129    $ 1,145  

Payables to investigators

     58,952      53,321      (5,631 )

Accrued income taxes

     16,182      13,304      (2,878 )

Other accrued expenses

     167,235      183,698      16,463  

Deferred tax liabilities

     101      204      103  

Unearned income

     205,779      232,499      26,720  
                      

Total current liabilities

   $ 473,233    $ 509,155    $ 35,922  
                      

Working capital

   $ 599,980    $ 566,304    $ (33,676 )

Working capital as of September 30, 2008 was $566.3 million compared to $600.0 million at December 31, 2007. The decrease in working capital was due primarily to a decrease in short-term investments and increases in unearned income and other accrued expenses partially offset by an increase in cash and cash equivalents. In addition, due to the uncertainties about the liquidity in the auction rate securities market, we reclassified $101.9 million of our auction rate securities to long-term assets at September 30, 2008 due to our ability and intent to hold these securities on a long-term basis until the auction rate securities market improves.

For the third quarter of 2008 DSO was 42 days, bringing it to 44 days for the nine months ended September 30, 2008, compared to 51 days for the year ended December 31, 2007. We calculate DSO by dividing accounts receivable and unbilled services less unearned income by average daily gross revenue for the applicable period. We expect DSO will continue to fluctuate in the future depending on contract terms, the mix of contracts performed within a quarter, the levels of investigator advances and unearned income, and our success in collecting receivables.

Effective July 1, 2008, we reduced our $50.0 million revolving credit facility with Bank of America, N. A. to $25.0 million. Indebtedness under the facility is unsecured and subject to covenants relating to financial ratios and restrictions on certain types of transactions. This credit facility does not expressly restrict or limit the payment of dividends. We were in compliance with all loan covenants as of September 30, 2008. Outstanding borrowings under the facility bear interest at an annual fluctuating rate equal to the one-month London Interbank Offered Rate, or LIBOR, plus a margin of 0.6%. Borrowings under this credit facility are available to provide working capital and for general corporate purposes. This credit facility is currently scheduled to expire in June 2009, at which time any outstanding balance will be due. As of September 30, 2008, no borrowings were outstanding under this credit facility, although the aggregate amount available for borrowing had been reduced by $1.8 million due to outstanding letters of credit issued under this facility.

In October 2007, our Board of Directors amended the annual cash dividend policy to increase the annual dividend rate from $0.12 to $0.40 per share, payable quarterly at a rate of $0.10 per share. The new dividend rate was effective beginning in the fourth quarter of 2007. In September 2008, our Board of Directors further amended the annual dividend policy to increase the annual dividend rate from $0.40 to $0.50 per share, payable quarterly at a rate of $0.125 per share. The new dividend rate will be effective beginning in the fourth quarter of 2008. The cash dividend policy and the payment of future quarterly cash dividends under that policy are not guaranteed and are subject to the

 

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discretion of and continuing determination by our Board of Directors that the policy remains in the best interests of our shareholders and in compliance with applicable laws and agreements.

In February 2008, we announced our plan to begin a stock repurchase program whereby up to $350.0 million of our common stock may be purchased from time to time in the open market. We decided to adopt a share repurchase program in view of the current price at which stock was trading at the time of the adoption of the program, the strength of our balance sheet and our ability to generate cash, as well as to minimize earnings dilution from future equity compensation awards. We expect to finance potential repurchases of stock, if any, from existing cash and cash flows from operations. During the three and nine months ended September 30, 2008, we repurchased approximately 769,000 shares and 1,635,000 shares of our common stock, respectively, for an aggregate purchase price, including broker commissions, of $30.1 million and $66.6 million at an average price per share of $39.18 and $40.75, respectively. As of September 30, 2008, $283.4 million remained available for share repurchases under the stock repurchase program.

We have commitments to invest up to an aggregate additional $21.4 million in four venture capital funds. For further details, see Note 2 in the notes to consolidated condensed financial statements.

As of September 30, 2008, the total gross unrecognized tax benefits were $25.0 million, of which $10.7 million, if recognized, would reduce our effective tax rate. We do not anticipate a significant change in total unrecognized tax benefits or our effective tax rate due to the settlement of audits and the expiration of statute of limitations within the next 12 months.

We have been involved in compound development and commercialization collaborations since 1997. We developed a risk-sharing research and development model to help pharmaceutical and biotechnology clients develop compounds. Through collaborative arrangements based on this model, we assist our clients by sharing the risks and potential rewards associated with the development and commercialization of drugs at various stages of development. As of September 30, 2008, we had four such arrangements that involve the potential future receipt of one or more of the following forms of revenue: payments upon the achievement of specified development and regulatory milestones; royalty payments if the compound is approved for sale; sales-based milestone payments; and a share of net sales up to a specified dollar limit. The compounds that are the subject of these collaborations are either still in development or are awaiting regulatory approvals in certain countries. None of the compounds have been approved for sale in any country in the world. As a result of the risks associated with drug development, including poor or unexpected clinical trial results and obtaining regulatory approval to sell in any country, we might not receive any further milestone payments, royalties or other payments with respect to any of our drug development collaborations.

As of September 30, 2008, we had two collaborations that involved potential future expenditures. The first is our collaboration with ALZA Corporation, subsequently acquired by Johnson & Johnson, for dapoxetine. In connection with this collaboration, we have an obligation to pay a royalty to Eli Lilly and Company of 5% on annual net sales of the compound in excess of $800 million. Johnson & Johnson received a “not approvable” letter from the FDA in October 2005, but continued its global development program. In December 2007, Johnson & Johnson submitted a marketing authorization application for dapoxetine to regulatory authorities in seven countries in the European Union. Although this regulatory application has been submitted, we do not know if or when Johnson & Johnson will obtain regulatory approval for dapoxetine in these or any other countries.

The second collaboration involving future expenditures is with Ranbaxy. In February 2007, we exercised an option to license from Ranbaxy a statin compound that we are developing as a potential treatment for dyslipidemia. Under the agreement, we have an exclusive license to make, use, sell, import and sublicense the compound and any licensed product anywhere in the world for any human use. We are solely responsible, and will bear all costs and expenses, for the development, manufacture, marketing and commercialization of the compound and licensed products. In addition to the one-time license fee, we are obligated to pay Ranbaxy milestone payments upon the occurrence of specified clinical development events. If a licensed product is approved for sale, we must also pay Ranbaxy royalties based on sales of the product, as well as commercial milestone payments based on the achievement of specified worldwide sales targets. If all criteria are met, the total amount of potential clinical and sales-based milestones that we are obligated to pay Ranbaxy would be $44.0 million. As previously announced, we have completed a high dose comparator study in healthy volunteers. The drug was well-tolerated and a preliminary review of results suggests the statin compound compares favorably to currently marketed statins. We continue to review the data from this trial, identify potential development and commercialization partners and evaluate the future clinical development of this compound.

 

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In September 2007, we entered into a contract with a client to construct a laboratory within a leased building, to supply laboratory equipment and to provide specified laboratory services. The client has agreed to reimburse us for the costs of the construction of the laboratory and related equipment over a two-year period. We completed the construction and up-fit for this laboratory in the second quarter of 2008 and incurred construction and equipment costs of $5.0 million.

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

We expect to continue expanding our operations through internal growth, strategic acquisitions and investments. We expect to fund these activities, the payment of future cash dividends and potential repurchases of stock, if any, from existing cash, cash flows from operations and, if necessary or appropriate, borrowings under our existing or future credit facilities. We believe that these sources of liquidity will be sufficient to fund our operations, dividends and stock repurchases, if any, for the foreseeable future. From time to time, we evaluate potential acquisitions, investments and other growth and strategic opportunities that might require additional external financing, and we might seek funds from public or private issuances of equity or debt securities. While we believe we have sufficient liquidity to fund our operations for the foreseeable future, our sources of liquidity and ability to pay dividends or repurchase our stock could be affected by our dependence on a small number of industries and clients; compliance with regulations; reliance on key personnel; breach of contract, personal injury or other tort claims; international risks; environmental or intellectual property claims; or other factors described below under “Potential Liability and Insurance”, “Potential Volatility of Quarterly Operating Results and Stock Price” and “Quantitative and Qualitative Disclosures about Market Risk”. In addition, see “Risk Factors,” “Contractual Obligations” and “Critical Accounting Policies and Estimates” in our Annual Report on Form 10-K for the year ended December 31, 2007.

Contractual Obligations

There have been no significant changes to the Contractual Obligation table included in our Annual Report on Form 10-K for the year ended December 31, 2007.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect reported amounts and related disclosures. We have discussed those estimates that we believe are critical and require the use of complex judgment in their application in our 2007 Annual Report on Form 10-K. There were no material changes to our critical accounting policies and estimates in the first nine months of 2008. For detailed information on our critical accounting policies and estimates, see our Annual Report on Form 10-K for the year ended December 31, 2007.

 

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Recent Accounting Pronouncements

Recently issued accounting standards relevant to our financial statements, which are described in “Recent Accounting Pronouncements” in Note 1 in the notes to our consolidated condensed financial statements are:

 

Date

  

Title

  

Effective Date

September 2006    SFAS No. 157, “Fair Value Measurements”    Fiscal years beginning after November 15, 2007 and interim periods within those years except those specified in FAS 157-1 and FAS 157-2 which are effective for fiscal years beginning after November 15, 2008
September 2006    SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106, and 132(R)”    Measurement date provision – fiscal years ending after December 15, 2008
February 2007    SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment of FASB Statement No. 115”    Fiscal years beginning after November 15, 2007
June 2007    EITF Issue 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards”    Fiscal years beginning after December 15, 2007
June 2007    EITF Issue 07-03, “Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities”    Fiscal years beginning after December 15, 2007
December 2007    EITF Issue 07-01, “Accounting for Collaborative Arrangements”    Fiscal years beginning after December 15, 2008
December 2007    SFAS No. 141 (revised 2007), “Business Combinations”    Fiscal years beginning after December 15, 2008
December 2007    SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements - an Amendment of ARB No. 51”    Fiscal years beginning after December 15, 2008
March 2008    SFAS No. 161, “Disclosure about Derivative Instruments and Hedging Activities”    Fiscal years beginning after November 15, 2008
April 2008    FSP FAS 142-3, “Determination of the Useful Life of Intangible Assets”    Fiscal years beginning after December 15, 2008
June 2008    FSP EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities”    Fiscal years beginning after December 15, 2008
June 2008    EITF 08-3, “Accounting by Lessees for Nonrefundable Maintenance Deposits”    Fiscal years beginning after December 15, 2008

 

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August 2008    U.S. SEC will issue for comment a proposed roadmap regarding the potential use by U.S. issuers of financial statements prepared in accordance with IFRS published by the IASB.    Fiscal years ending on or after December 15, 2014

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 tax jurisdictions. In particular, as the geographic mix of our pretax earnings among various tax jurisdictions changes, our effective tax rate might vary from period to period. The effective rate will also change due to the discrete recognition of tax benefits when tax positions are effectively settled or as a result of specific transactions, such as the disposal of certain assets in the first quarter of 2008.

Inflation

Our long-term contracts, those in excess of one year, generally include an inflation or cost of living adjustment for the portion of the services to be performed beyond one year from the contract date. In the event that actual inflation rates are greater than our contractual inflation rates or cost of living adjustments, inflation could have a material adverse effect on our operations or financial condition.

Potential Liability and Insurance

Drug development services involve the testing of potential drug candidates on human volunteers pursuant to a study protocol. This testing exposes us to the risk of liability for personal injury or death to volunteers and patients resulting from, among other things, possible unforeseen adverse side effects or improper administration of the study drug or use of the drug following regulatory approval. For example, we have been named as a defendant in a number of lawsuits relating to the antibiotic Ketek, as described below in Part II, Item 1 – “Legal Proceedings”. We attempt to manage our risk of liability for personal injury or death to volunteers and patients from administration of study products through standard operating procedures, patient informed consent, contractual indemnification provisions with clients and insurance. We monitor clinical trials in compliance with government regulations and guidelines. We have established global standard operating procedures intended to satisfy regulatory requirements in all countries in which we have operations and to serve as a tool for controlling and enhancing the quality of drug development services. The contractual indemnifications generally do not protect us against all our own actions, such as gross negligence. We currently maintain professional liability insurance coverage with limits we believe are adequate and appropriate.

Potential Volatility of Quarterly Operating Results and Stock Price

Our quarterly and annual operating results have fluctuated in the past, and we expect that they will continue to fluctuate in the future. Factors that could cause these fluctuations to occur include:

 

   

the timing and level of new business authorizations;

 

   

the timing of our Discovery Sciences segment milestone payments or other revenue, if any;

 

   

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

 

   

our ability to properly manage our growth;

 

   

our ability to recruit and retain experienced personnel;

 

   

impairment of investments or intangible assets;

 

   

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

 

   

litigation costs;

 

   

the timing of the opening of new offices;

 

   

the timing of other internal expansion costs;

 

   

exchange rate fluctuations between periods;

 

   

our dependence on a small number of industries and clients;

 

   

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

 

   

pricing pressure in the market for our services;

 

   

rapid technological change;

 

   

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

 

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products and services;

 

   

the timing and extent of new government regulations;

 

   

intellectual property risks; 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 clients or regulatory authorities, and are not typically controllable by us. Because a large percentage of our operating costs are relatively fixed while revenue is subject to fluctuation, variations in the timing and progress of large contracts can materially affect our quarterly operating results. For these reasons, we believe that comparisons of our quarterly financial results are not necessarily meaningful and should not be relied upon as an indication of future performance.

Fluctuations in quarterly results, actual or anticipated changes in our dividend policy or stock repurchase plan or other factors, including recent general economic and financial market conditions, could affect the market price of our common stock. These factors include ones beyond our control, such as changes in revenue and earnings estimates by analysts, market conditions in our industry, disclosures by product development partners and actions by regulatory authorities with respect to potential drug candidates, changes in pharmaceutical, biotechnology and medical device industries and the government sponsored clinical research sector, and general economic conditions. Any effect on our common stock could be unrelated to our longer-term operating performance. For further details, see “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2007.

 

Item 3. Quantitative and Qualitative Disclosures about Market Risk

We are exposed to foreign currency risk by virtue of our international operations. We derived approximately 36.2% and 39.8% of our net revenue for the three months ended September 30, 2007 and 2008, respectively, from operations outside the United States. Our operations in the United Kingdom generated 37.7% and 41.7% of our net revenue from international operations during the three months ended September 30, 2007 and 2008. We generally reinvest funds generated by each subsidiary in the country where they are earned. Accordingly, we are exposed to adverse movements in foreign currencies, predominately in the pound sterling, euro and Brazilian real.

The vast majority of our contracts are entered into by our U.S. or U.K. subsidiaries. The contracts entered into by the U.S. subsidiaries are almost always denominated in U.S. dollars. Contracts entered into by our U.K. subsidiaries are generally denominated in U.S. dollars, pounds sterling or euros, with the majority in U.S. dollars. Although an increase in exchange rates for the pound sterling or euro relative to the U.S. dollar increases net revenue from contracts denominated in these currencies, income from operations is negatively affected due to an increase in operating expenses that occurs when we convert our expenses from local currencies into the U.S. dollar equivalent.

We also have currency risk resulting from the passage of time between the invoicing of clients under contracts and the collection of client payments against those invoices. If a contract is denominated in a currency other than the 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 client will result in our receiving either more or less in local currency than the local currency equivalent of the receivable. We recognize this difference as a foreign currency transaction gain or loss, as applicable, and report it in other income, net. If the exchange rate on accounts receivable balances denominated in pounds sterling and euros had increased by 10%, our foreign currency transaction loss would have increased by $3.9 million in the quarter ended September 30, 2008.

Our strategy for managing foreign currency risk relies primarily on receiving payment in the same currency used to pay expenses. From time to time, we also enter into foreign currency hedging activities in an effort to manage our potential foreign exchange exposure. At September 30, 2008, the face amount of these foreign exchange hedging contracts was $114.0 million. If the U.S. dollar had weakened an additional 10% relative to the pound sterling, euro and Brazilian real in the third quarter of 2008, income from operations would have been approximately $1.6 million lower excluding the impact of hedging for the quarter based on revenues and the costs related to our foreign operations.

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;

 

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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. We report translation adjustments with accumulated other comprehensive income (loss) as a separate component of shareholders’ equity. During the third quarter of 2008, several foreign currencies had a large decrease in value relative to the U.S. dollar. This resulted in a larger than normal change in translation adjustment. For further details, see Note 7 in the notes to the consolidated condensed financial statements. To date, cumulative translation adjustments have not been material to our consolidated financial position. However, future translation adjustments could materially and adversely affect us.

Currently, there are no material exchange controls on the payment of dividends or otherwise prohibiting the transfer of funds out of any country in which we conduct operations. Although we perform services for clients located in a number of jurisdictions, we have not experienced any material difficulties in receiving funds remitted from foreign countries. However, new or modified exchange control restrictions could have an adverse effect on our financial condition. If the Company were to repatriate dividends from the cumulative amount of undistributed earnings in foreign entities, the Company would incur a tax liability which is not currently provided for in the Company’s balance sheet.

We are exposed to changes in interest rates on our cash, cash equivalents, investments and amounts outstanding under notes payable and lines of credit. We invest our cash and investments in financial instruments with interest rates based on market conditions. If the interest rates on cash, cash equivalents and investments decreased by 10%, our interest income would have decreased by approximately $0.4 million in the third quarter of 2008.

We are also exposed to market risk related to our investments in auction rate securities. For further details, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources”.

 

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 were effective as of the end of the period covered by this report to provide the reasonable assurance discussed above.

Internal Control Over Financial Reporting

No change to our internal control over financial reporting occurred during the third quarter of 2008 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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Part II. OTHER INFORMATION

 

Item 1. Legal Proceedings

Beginning in early 2007, we were named as a co-defendant in lawsuits involving claims relating to patients who took sanofi-aventis’ FDA-approved antibiotic Ketek, for which we provided certain clinical trial services to sanofi-aventis’ predecessor prior to FDA approval. Lawsuits are pending in New Jersey, North Carolina, Alabama, Wisconsin and New York. These suits allege multiple causes of action, including negligence, fraud, misrepresentation, breach of warranty, conspiracy, wrongful death and violations of various state and federal statutes, including unfair and deceptive trade practices acts. Generally, the plaintiffs are seeking unspecified damages from alleged injuries from the ingestion of Ketek, and in some of the cases claim damages of at least $20.0 million. It is possible that additional suits will be filed. While there can be no assurance of a successful outcome and litigation costs can be material, we do not believe that these claims against us have merit and intend to vigorously defend ourself in these matters.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

In February 2008, we announced our Board of Directors approved a stock repurchase program authorizing us to repurchase up to $350 million of our common stock. Purchases under this repurchase program may be made from time to time in the open market. The timing and amount of any share repurchases will be determined by our management based on its evaluation of the market conditions and other factors. The following table provides information with respect to purchases made by us of our common stock pursuant to the share repurchase program during the three months ended September 30, 2008:

 

     Total Number
of Shares
Purchased
   Average
Price Paid
Per Share (1)
   Total Value
Paid by

the Company (1)
   Maximum Dollar
Value of Shares

That May Yet
Be Purchased
Under the Share
Repurchase Program

Period

           

July 1, 2008 to July 30, 2008

   322,900    $ 37.53    $ 12,118,933    $ 301,391,569

August 1, 2008 to August 31, 2008

   446,000      40.37      18,003,612      283,387,957

September 1, 2008 to September 30, 2008

   —        —        —        —  

 

(1) Includes broker commissions.

 

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Item 6. Exhibits

 

(a) Exhibits

 

10.263    Third Amendment dated July 7, 2008 to Lease Agreement, dated July 1, 2001, by and between Brandywine Grande C, L.P., and PPD Development, LP
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

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly 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/ Daniel G. Darazsdi

  Chief Financial Officer
  (Principal Financial Officer)
By  

/s/ Peter Wilkinson

  Chief Accounting Officer
  (Principal Accounting Officer)

Date: November 5, 2008

 

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