Item 1. Business
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 21 years. Our development services include preclinical programs and Phase I to Phase IV clinical development services as well as bioanalytical product testing and clinical laboratory services. We have extensive clinical trial experience including regional, national and global studies across a multitude of therapeutic areas and in various parts of the world. In addition, for marketed drugs, biologics and devices, we offer support such as product launch services, medical information, patient compliance programs, patient and disease registry programs, product safety and pharmacovigilance, Phase IV monitored studies and prescription-to-over-the-counter, or Rx-to-OTC, programs.
With offices in 28 countries and more than 9,100 professionals worldwide, we have provided services to 45 of the top 50 pharmaceutical companies in the world as ranked by 2005 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 2006 annual net revenues generated from contract research organizations.
Building on our outsourcing relationship with pharmaceutical and biotechnology clients, we established our discovery services business in 1997. This business primarily focuses on preclinical evaluations of anticancer and diabetes therapies, biomarker discovery and patient sample analysis services and compound development and commercialization collaborations. We have developed a risk-sharing research and development model to help pharmaceutical and biotechnology clients develop compounds. Through collaborative arrangements based on this model, we assist our clients by sharing the risks and potential rewards of the development and commercialization of drugs at various stages of development.
Our integrated drug discovery and development services offer our clients a way to identify and develop drug candidates more quickly and cost-effectively. In addition, with global infrastructure, we are able to accommodate the multinational drug discovery and development needs of our clients. As a result of having core areas of expertise in discovery and development, we provide integrated services across the drug development spectrum. We use our proprietary informatics technology to support these services.
Industry Overview
Discovering and developing new drugs is an extremely expensive, high-risk and time-consuming process. Multiple industry sources cite fully capitalized drug development costs in excess of $1 billion. In addition, it generally takes between 10 and 15 years to develop a new prescription drug and obtain approval to market it in the United States.
The drug development services industry provides independent product development services to pharmaceutical, biotechnology and medical device companies, and government organizations. This industry has evolved from providing limited clinical trial services in the 1970s to a full-service industry today characterized by broader relationships with clients and by service offerings that encompass the entire drug development process, including preclinical evaluations, study design, clinical trial management, data collection, biostatistical analyses, regulatory consulting, clinical laboratory and diagnostic services, product registration and post-approval support.
Over the past 21 years, technological advances, as well as the emergence of the biotechnology industry, have dramatically changed the drug discovery process. New and improved technologies have evolved such as ultra high-throughput screening, new in vitro and in vivo preclinical profiling techniques, biomarker research and the genetic-based drug research commonly referred to as genomics. The objective of these innovations is to find more drug targets and to screen against targets much more quickly with literally millions of chemical compounds. This process is expected to produce many more molecules having the ability to affect biological activity. These molecules then need to be tested quickly and economically to determine their viability as potentially safe and effective drug candidates. Moreover, many industry participants, including pharmaceutical, biotechnology and contract research companies, have broadened their efforts to collaborate technically and financially to optimize their drug pipelines.
The Drug Discovery and Development Process
Drug discovery and development is the process of creating drugs for the treatment of human disease. The drug discovery process aims to generate safe and effective drug candidates, while the drug development process involves the testing of these drug candidates for safety and efficacy in animals and humans and to meet regulatory requirements.
The Drug Discovery Process
Targets. Historically, scientists have used classical cellular and molecular biology techniques to map biological pathways in cells to provide a cellular basis for understanding disease processes. Based on this information, scientists are now using genomics to pinpoint genes responsible for cellular disease functions. Once genes are identified, they are tested in cellular assays or animals to identify which genes seem to have a causal link between cellular function and occurrence of disease. The preferred genes encode proteins that are used as drug targets in chemical screens.
Screening. After identifying a potential drug target, researchers develop tests, or assays, to screen chemicals for their ability to alter the functional activity of the target. Ones that do so are called “hits.” Thousands of chemicals can be quickly screened when these assays are incorporated into high-throughput screening processes. Hits that have good potency and selectivity are called “leads” and are then tested for their potential as drug candidates.
Lead Generation. Scientists now also design compound libraries to provide a starting point to identify leads in the drug discovery process and to better understand the biochemistry and therapeutic relevance of targets. High quality libraries contain compounds of known purity, structure and weight, and also have diverse structural variations. Once a hit is identified in a functional assay, the compound is profiled for drug characteristics such as solubility, metabolism, stability and feasibility for commercial production.
Lead Optimization. The process of “lead optimization” involves refining the chemical structure of a lead to improve its drug characteristics, with the goal of producing a preclinical drug candidate. Lead optimization typically combines empirical and rational drug design. In empirical design procedures, large numbers of related compounds are screened for selected chemical characteristics. In rational drug design, chemicals are optimized based on the three-dimensional structure of the target. A lead that has been optimized to meet particular drug candidate criteria and is ready for toxicity testing is called a preclinical candidate.
Process Research and Development. Compounds created for screening in lead generation and lead optimization are made in relatively small, milligram quantities. Before a drug candidate can be taken into preclinical and clinical trials, larger quantities must be produced. The goal of process research is to improve the ease with which compounds can be produced in these larger quantities, typically by minimizing the number of production steps, and to determine how to reduce the time and cost of production. Process development refers to the production scale-up and further refinement required for clinical trials and commercial manufacturing.
The Drug Development Process
The drug development process consists of two stages: preclinical and clinical. In the preclinical stage, the new drug is tested in vitro, or in a test tube, and in vivo, or in animals, generally over a one- to three-year period. After successful preclinical testing, the new drug can be advanced to the clinical development stage, which involves testing in humans. The following discussion describes the role of the Food and Drug Administration, or FDA, in the clinical drug development process in the United States. Similar regulatory processes exist in other countries.
Prior to commencing human clinical trials in the United States, a company must file with the FDA an investigational new drug application, or IND, containing details for at least one study protocol and outlines of other planned studies. The company must provide available manufacturing data, preclinical data, information about any use of the drug in humans for other purposes and a detailed plan for the proposed clinical trials. The design of these trials, also referred to as the study protocols, is essential to the success of the drug development effort. The protocols must correctly anticipate the nature of the data to be generated and results that the FDA will require before approving the drug. If the FDA does not comment within 30 days after an IND filing, human clinical trials may begin.
The clinical stage is the most time-consuming and expensive part of the drug development process. The drug undergoes a series of tests in humans, including healthy volunteers as well as patients with the targeted disease or condition. Human trials usually start on a small scale to assess safety and then expand to larger trials to test efficacy. These trials are usually grouped into the following three phases, with multiple trials generally conducted within each phase:
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Phase I trials involve testing the drug on a limited number of healthy individuals, typically 20 to 80 people, to determine the drug’s basic safety data, including tolerance, absorption, metabolism and excretion. This phase lasts an average of six months to one year.
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Phase II trials involve testing a small number of volunteer patients, typically 100 to 200 persons, who suffer from the targeted disease or condition, to determine the drug’s effectiveness and how different doses work. This phase lasts an average of one to two years.
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Phase III trials involve testing large numbers of patients, typically several hundred to several thousand people, to verify efficacy on a large scale, as well as long-term safety. These trials involve numerous sites and generally last two to three years.
After the successful completion of all three clinical phases, a company submits to the FDA a new drug application, or NDA, for a drug or a biologic license application, or BLA, for a biologic, requesting that the product be approved for marketing. The NDA/BLA is a comprehensive, multivolume filing that includes, among other things, the results of all preclinical and clinical studies. The FDA’s review can last from a few months to several years, depending on the drug and the disease state that is being treated. Drugs that successfully complete this review may be marketed in the United States. As a condition to its approval of a drug, the FDA might require additional clinical trials following receipt of approval, in order to monitor long-term risks and benefits, to study different dosage levels or to evaluate different safety and efficacy parameters in target populations. In recent years, the FDA has increased its reliance on these trials, known as Phase IIIb and Phase IV trials.
Trends Affecting the Drug Discovery and Development Industry
The drug discovery and development services industry has been and will continue to be affected by, among others, the following trends:
Rapid Technological Change and Increased Data. Scientific and technological advancements are rapidly changing the drug discovery and development processes. The technology to understand gene function, known as functional genomics, is dramatically increasing the number of identified potential drug targets within the human body. Pharmaceuticals on the market today have historically targeted no more than an estimated 500 human gene products. With an estimated 20,000 to 25,000 human protein-coding genes, an enormous number of targets for therapeutic intervention remain untapped. This number of targets increases the need for companies to use state-of-the-art technologies to effectively validate and optimize promising targets and lead candidates. Industry participants are also looking to applications such as biomarker technology to save development time and costs, as well as enable more precise diagnosis and personalized treatment of disease. These evolving technologies and the expertise to manage them are costly and involve significant investments in capital, intellectual property and sophisticated instrumentation. Thus, drug discovery and development service firms that have the capability and expertise to provide early stage research and development services offer the potential to offset some of these investments and potentially reduce the financial risk of drug discovery efforts. Moreover, industry participants must continue to make significant investments to keep pace with competitive technologies.
Changes in the Regulatory Environment. The drug research and development process is heavily regulated by the FDA and its Center for Drug Evaluation and Research, or CDER. The war on terror, the risk of global vaccine shortages and the threat of new potential pandemics have elevated the FDA’s focus on research in the areas of bioterrorism and vaccine development. In addition, recent product safety concerns, such as cardiovascular and other risks identified as being related to COX 2 inhibitors, increases in drug and general healthcare costs and the emergence of importation issues have placed the FDA and other regulatory agencies under increased scrutiny. As a result of these and other events, drug safety, cost and availability factors are under intense monitoring and review by Congress, the FDA and other government agencies. These events are likely to cause significant changes to the regulatory environment for the drug development process and could have a lasting and pronounced impact on the drug discovery and development industry.
Government-Sponsored Drug Research and Development. Government agencies continue to be a significant source of funding for new drug and vaccine research and development. The total budget of the National Institutes of Health, or NIH, for the fiscal year 2006 was an estimated $29 billion, representing nearly 10% compound annual growth since 1998. The full year 2007 NIH budget estimate is approximately $29 billion and includes significant appropriations for drug research and development initiatives in the areas of cancer, vaccines, AIDS and chronic diseases such as diabetes. As a result, drug research and development service providers and contractors, including CROs, should continue to benefit from government-sponsored research and development initiatives.
Increase in Potential New Drug Candidates. The increase in potential new drug candidates resulting from new and enhanced drug discovery technologies has caused a bottleneck in the drug development industry, particularly in the early stages of drug development. While research and development spending and the number of drug candidates are increasing, the time and cost required to develop a new drug candidate also have increased. Many pharmaceutical and biotechnology companies do not have sufficient internal resources to pursue development of all of these new drug candidates on their own. Consequently, these companies are looking to the drug discovery and development services industry for cost-effective, innovative and rapid means of developing new drugs.
Research and Development Productivity. While the total number of compounds in clinical development has increased in the last several years, thereby increasing the aggregate spending on research and development programs associated with new drug candidates, the number of novel new drugs approved for marketing has remained relatively flat or even declined from 2000 to 2005. Pharmaceutical and biotechnology companies have responded by focusing on efforts to extend the value of existing products, improve clinical success rates, restructure and re-engineer business processes and business units and lower clinical study costs. Furthermore, many pharmaceutical and biotechnology companies have also responded to the productivity challenge by increasing their focus on
licensing and collaborative arrangements to improve new drug pipelines and gain financing for future development and marketing programs. In 2006, the number of new molecular entity (NME) and BLA approvals reported by the FDA increased for the first time since 1999. In addition, the number of NDAs and INDs increased notably compared to 2005.
Biotechnology Industry Growth. The U.S. biotechnology industry has grown rapidly over the last decade or so. This industry is generating significant numbers of new drug candidates that will require development and regulatory approval. Many of these new drug candidates are now moving into clinical development, but many biotechnology companies do not have the necessary staff, operating procedures, experience or expertise to conduct clinical trials on their own. Because of the time and cost involved, these companies rely heavily on contract research organizations to conduct clinical research for their drug candidates. The ability of small and mid-sized biotech companies to attract the funding needed to sustain operations and advance clinical candidates to subsequent stages in the development process can affect the growth of the development services industry.
Need for Large Scale Global Support. Pharmaceutical and biotechnology companies are increasingly filing drug registration packages and recruiting study volunteers in multiple countries and regulatory jurisdictions. The clinical studies to support these registration packages frequently include a combination of multinational and domestic trials. This trend puts an emphasis on global experience and coordination throughout the development process, including the collection, analysis, integration and reporting of clinical trial data.
Cost Pressures of Introducing New Drugs. Market forces and governmental safety initiatives place significant pressures on pharmaceutical and biotechnology companies to reduce drug prices. In addition, increased competition as a result of patent expiration, market acceptance of generic drugs, and governmental and private managed care organization efforts to reduce healthcare costs have added to drug pricing pressures. The industry is responding by consolidating, streamlining operations, decentralizing internal discovery and development processes, and minimizing fixed costs. In addition, increased pressures to differentiate products and justify drug pricing are resulting in an increased focus on healthcare economics, safety monitoring and commercialization services. Moreover, pharmaceutical and biotechnology companies are attempting to increase the speed and efficiency of internal new drug discovery and development processes.
PPD’s Solution
We address the needs of the pharmaceutical, biotechnology and medical device industries and academic and government organizations for drug discovery and development by providing integrated services to help our clients maximize the return on their research and development investments. Our application of innovative technologies, therapeutic expertise and commitment to quality throughout the drug discovery and development process offers our clients a way to identify and develop successful drugs and devices more quickly and cost effectively. We have obtained significant drug development expertise from more than 21 years of operation, and in 2003 we expanded into the medical device industry. We use our proprietary informatics technology across our discovery and development services to support and help accelerate the process. Finally, with global infrastructure and expertise in key regions throughout the world, we are able to accommodate the multinational discovery and development needs of our clients.
Our Strategy
Our corporate mission is to help clients maximize the return on their research and development investments and accelerate the delivery of safe and effective therapeutics to patients. The key parts of our strategy to accomplish this mission include the following:
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Continue to build our core competencies. We are an established company led by professionals with significant discovery and development experience helping major pharmaceutical, biotechnology and medical device companies and academic and government organizations bring successful products to market throughout the world. This experience and expertise constitute our core operational strengths. Our performance in development services has made us one of the largest providers of those services globally. We are continually building our competencies by seeking to hire top professionals in key markets around the world.
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Continue to provide a broad range of integrated drug discovery and development services and products. We offer a broad range of integrated services and products that are designed to address our clients’ needs from the preclinical through post-approval phase. By integrating extensive discovery and development services and products across our clients’ product life cycles, we can more effectively serve existing clients and attract new clients. We believe that our range of discovery and development services and products is one of the most extensive available from a single company.
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Continue to incorporate advanced technologies into our service offerings. We have broad experience in the use of technology to improve quality while creating cost efficiencies and accelerating the discovery and development processes. We offer our clients a wide range of technology-based services and products, using a mixture of commercially available third-party systems and internally developed software to help expedite the discovery and development processes for both drugs and devices. As new technologies develop, we equip and train our employees to make use of the innovations. We also plan to continue to leverage and build strategic technology relationships.
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Continue to pursue collaborative drug development relationships. We plan to continue to selectively seek opportunities to in-license and develop earlier stage compounds based on our risk-sharing model. These types of arrangements could provide us opportunities to receive upfront license fees, milestone payments and royalties on sales of drugs successfully developed and commercialized. We also intend to selectively pursue out-licensing arrangements, which might also involve us providing discovery and development services for the continued development of the potential drug candidate.
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Continue to develop intellectual property rights. One of the keys to our long-term performance is the development of our intellectual property rights in a variety of areas, including proprietary clinical development processes, tools and software, as well as rights to the compounds and methods of use developed from risk-sharing arrangements. The former protect our competitive advantage in our core services, and the latter provide revenue opportunities via upfront license fees, milestone payments and royalties on sales of drugs successfully developed and commercialized.
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Continue strategic global expansion to meet client needs. We currently have operations in the Americas, Europe, Africa, the Middle East, Asia and Australia, which positions us to meet our clients’ multinational needs. We intend to further expand globally when we deem it appropriate to meet our existing and prospective clients’ demands.
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Continue to pursue strategic acquisitions and investments. We will continue to actively seek strategic acquisitions and investments, both within and complementary to our current service and product lines. Our criteria for acquisitions and investments include complementary client lists, ability to increase market share within and across clients, complementary therapeutic area and service segment strengths, strategic geographic capabilities, particular process expertise and complementary services, products or technologies.
Our Services
We provide services designed to increase efficiency, reduce time and save costs through our global infrastructure, integrated research and development technologies experience, and client-focused communications. We operate in two segments: Discovery Sciences and Development. See our consolidated statements of operations included elsewhere in this report for segment information regarding revenue and see Note 16 in the Notes to Consolidated Financial Statements for segment information regarding total assets and a measure of profit or loss.
Our Discovery Sciences Group
Our Discovery Sciences Group focuses on the discovery research segment of the biopharmaceutical research and development outsourcing market.
Preclinical Service. Our preclinical biology group integrates pharmacology, metabolism, pharmacokinetic and toxicology expertise to provide preclinical program design and project management services. We provide a broad range of preclinical services including:
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preclinical program design;
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specialized preclinical oncology and diabetes research models;
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toxicology consulting;
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laboratory services; and
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technical writing and regulatory submissions.
Once a potential drug candidate is identified, we offer services that enable our clients to make decisions about whether to advance the drug candidate into a preclinical program both faster and with a greater probability of success. Our experts can provide full preclinical development services and integrate other development services internally.
We offer preclinical consulting as well as a full range of preclinical efficacy, pharmacokinetic, pharmacodynamic and mechanism models for anticancer and diabetes therapeutic candidates. Our experienced preclinical staff designs and performs the studies needed to identify, profile and optimize lead compounds.
Supported by our board-certified toxicologists, we develop and implement preclinical toxicology programs. To support the clinical development program, we write the toxicology study protocols, identify qualified good laboratory practice, or GLP, testing facilities, manage the placement and conduct of studies, and prepare and review pharmacology, toxicology, absorption and metabolism data for regulatory submissions.
We provide non-GLP bioanalytical services in our laboratory located in Middleton, Wisconsin. Our bioanalytical laboratory analyzes biological fluid samples from preclinical animal studies and conducts in vitro discovery/early development experiments to test potential drug candidates.
Our technical writers prepare pharmacology and toxicology summaries for regulatory submissions and work with regulatory authorities to develop preclinical plans. We offer a full range of regulatory support services, including document submission, preparation and review of all preclinical regulatory submissions required by regulatory agencies and facilitation of meetings with regulatory agencies to ensure successful outcomes.
Biomarker Discovery Sciences. We provide biomarker discovery and patient sample analysis at our Menlo Park, California, biomarker discovery sciences laboratory. Biomarkers are components of bodily fluids that indicate the progression or presence of a disease. Our laboratory is equipped with advanced technologies to carry out identification of the different types of proteins, naturally occurring peptides and metabolites, as well as of blood cell populations from a variety of biological samples. Our proprietary mass spectrometry platform that is used for proteomic, peptidomic and metabolomic quantification is at the center of our process. Our technology allows clients to analyze patient samples for novel or known biomarkers in the presence or absence of a drug. The changes in the biomarker profile of a patient can assist in the evaluation of the efficacy of a drug. We were issued a U.S. patent covering our proprietary MassView™ software in 2005. The MassView software helps scientists identify individual components of a biological sample and the amount of each component in the sample.
Compound Collaboration Programs. With increased capacity to screen and develop early lead compounds and candidates, pharmaceutical companies now find themselves without the capacity to develop all of these compounds and take them to market within a reasonable time. Many biotechnology companies have promising drug development candidates but lack the financial resources or the infrastructure to develop them further. These situations provide attractive opportunities for us to use our extensive experience in strategic, global drug development to selectively in-license and develop compounds or jointly develop drug candidates in collaborative
arrangements. Our compound collaborative efforts have created a pipeline of products that leverages our resources, creates new opportunities for growth, and allows us to share the risks and rewards of drug development with our clients and partners.
We entered into our first compound partnering arrangement in 1998 when we acquired an exclusive license, as part of a development collaboration with Eli Lilly & Company, to develop and commercialize the compound dapoxetine for genitourinary indications, including premature ejaculation, or PE. We developed the compound through Phase II proof-of-concept and, in January 2001, out-licensed it to ALZA Corporation, or ALZA, which was subsequently acquired by Johnson & Johnson. Under the terms of the agreement, we granted ALZA worldwide rights to develop and commercialize dapoxetine and ALZA is responsible for all clinical, regulatory, manufacturing, sales and marketing costs associated with the compound. In exchange, we received an upfront payment and are entitled to receive further payments if regulatory milestones are achieved. In addition, we are entitled to receive royalty payments based on sales of dapoxetine, as well as milestone payments when specified sales levels are reached. In December 2003, we acquired Lilly’s patents and remaining rights to develop and commercialize dapoxetine in the field of genitourinary disorders in return for a cash payment of $65.0 million. We also agreed to pay Lilly a royalty of 5% on annual sales of dapoxetine, if any, in excess of $800 million. In December 2004, ALZA submitted an NDA to the FDA for dapoxetine. The FDA accepted the NDA for filing in February 2005, which triggered a $10.0 million milestone payment from ALZA to us. In October 2005, ALZA received a “not approvable” letter from the FDA, but has continued its global development program and has indicated that it may file for approval in Europe as early as late 2007. However, we do not know if or when ALZA will submit applications for or obtain regulatory approval for dapoxetine in the United States or any other country.
In 2003, we made an equity investment in Syrrx, Inc., a privately held drug discovery company, and entered into a collaboration agreement to develop Syrrx’s orally active dipeptidyl peptidase IV, or DPP4, inhibitors to treat type 2 diabetes and other major human diseases. In March 2005, Takeda Pharmaceutical Company Limited acquired Syrrx. In July 2005, Takeda acquired the development and commercialization rights to all DPP4 inhibitors previously granted to us under the collaboration agreement between PPD and Syrrx. Under the new agreement, Takeda paid us a $15.0 million upfront payment in the third quarter of 2005. We will also be entitled to receive potential milestone payments and royalties associated with the future development and commercialization of specified DPP4 inhibitors and will serve as the sole provider of clinical and bioanalytical services to Takeda for Phase II and Phase III trials of DPP4 inhibitors conducted in the United States and Europe. As a result of this agreement, we will have no further material expense associated with the development and commercialization of a DPP4 inhibitor. Takeda commenced Phase III trials for the lead DPP4 inhibitor in January 2006 and we received a $15.0 million milestone payment from Takeda. The Phase III trials for the lead DPP4 inhibitor are on-going.
In 2002, we licensed from Bayer AG the worldwide rights to undertake additional Phase II clinical studies on the compound implitapide for treatment of arteriosclerosis, elevated triglycerides, pancreatitis and hyperlipidemia. During 2004 and 2005, we conducted Phase II proof-of-concept clinical trials for different kinds of elevated cholesterol and triglyceride indications. In the first quarter of 2005, we terminated the implitapide program and our license for various reasons, including the risks associated with continued development and limited market potential. Although, we no longer have a license to this compound, we continue to own the data from the Phase II proof-of-concept trials.
In 2003, we made an equity investment in Chemokine Therapeutics Corp., then a privately held biotechnology company, to continue development of a proprietary peptide that might be useful as a blood recovery therapeutic agent. Chemokine also granted us an exclusive option to license the peptide and the right to first negotiate a license to other Chemokine peptides. We worked closely with Chemokine to scale up the product under good manufacturing practice, or GMP, and to conduct the GLP toxicology studies necessary to advance the program to the clinic. In the second half of 2004, Chemokine initiated a study in healthy volunteers that was completed in the first half of 2005. Chemokine announced the results of this study and subsequently initiated additional Phase I studies. In December 2004, Chemokine completed an initial public offering of its common stock in Canada. In May 2006, we sold our investment in Chemokine for $1.5 million and surrendered our option to license Chemokine’s compound CTCE-0214 to allow Chemokine to assume the development and commercialization of this compound. In return for relinquishing our rights, Chemokine paid us $0.1 million and agreed to make potential future payments up to $2.5 million.
In 2004, we purchased shares of Accentia Biopharmaceuticals, Inc. Series E convertible preferred stock for $5.0 million. Accentia is a specialty biopharmaceutical company focused on the development and commercialization of late-stage clinical products in the areas of respiratory disease and oncology. In 2004, we also entered into a royalty stream purchase agreement with Accentia under which we purchased for $2.5 million a royalty stream based on a percentage of net sales of specified products. We subsequently amended that agreement and agreed to provide specified clinical development services, up to a specified dollar limitation, to Accentia in connection with a Phase III trial for SinuNase®, Accentia’s proprietary compound that it is developing for the treatment of chronic sinusitis. In exchange for providing these services, Accentia agreed to pay us an additional royalty equal to 7% of the net sales of specified SinuNase products if approved for sale by the FDA. Under the amended agreement, either party had the option to terminate the provisions of the agreement related to our obligation to provide clinical development services at any time on or before December 31, 2006. Accentia exercised this option and terminated these provisions of the agreement effective December 28, 2006.
Our Development Group
We have designed our various global services to be flexible and integrated in order to assist our clients in optimizing their research and development spending through the clinical stages of the development process. We provide a broad range of development services, either individually or as an integrated package, to meet clients’ needs.
Phase I Clinical Testing. Having conducted Phase I studies for more than 19 years, we are one of the industry’s most experienced and largest Phase I trial providers. In April 2005, we moved our Phase I clinic to a new 300-bed facility in Austin, Texas, to accommodate the growing demand of our clients. This new facility capitalizes on our strengths in conducting first-in-man studies, cardiac monitoring and large, complex, procedure-intensive Phase I trials. Our professional physician and nursing staff administer general Phase I safety tests, special population studies and bioavailability and bioequivalence testing. Bioavailability and bioequivalence testing involves administration of test compounds and obtaining biological fluids sequentially over time to measure absorption, distribution, metabolism and excretion of the drug. Our Austin, Texas, operations also include a dental research clinic to evaluate the safety and effectiveness of new analgesic compounds in molar extraction models. We manage our Phase I services to maximize scheduling flexibility and efficiency. These services can also be integrated with our other services that we provide, such as bioanalytical, data management, pharmacokinetic and biostatistical services.
Laboratory Services. We offer the following laboratory services:
Austin Central Laboratory: Our Austin central laboratory is located in our Phase I unit and primarily supports the Phase I operations there. This laboratory performs clinical chemistry assays on volunteer specimens to ensure each subject qualifies for the study and is not adversely affected by a drug. Having our laboratory in the same facility as the volunteers speeds our response time to assess unexpected outcomes. This laboratory also serves as a central laboratory for small to medium size Phase II through IV multicenter studies.
Global Central Laboratories: Based in Highland Heights, Kentucky, and Brussels, Belgium, our global central laboratories provide highly standardized efficacy and safety testing services with customized results databases for pharmaceutical and biotechnology companies engaged in clinical drug development as well as government-funded studies. We focus on providing long-term, large-scale studies where laboratory measurement of clinically relevant endpoints is critical. Our global central laboratories can provide these services worldwide within 24 to 48 hours from the time a patient’s blood is drawn.
Bioanalytical Laboratories: We provide bioanalytical services through GLP-compliant laboratories in Richmond, Virginia, and Middleton, Wisconsin. Our bioanalytical laboratories analyze biological fluid samples from animal and human clinical studies. The latter studies include those conducted by our Phase I unit as well as those conducted on behalf of our clients from Phase I-IV for drug and metabolite content and concentration. We currently have more than 2,100 validated assays available for our clients’ use in conducting laboratory analyses. Our laboratories also process fluid samples for preclinical studies. Our bioanalytical methods include gas
chromatography/mass spectrometry (GC/MS), liquid chromatography/mass spectrometry (LC/MS), high performance liquid chromatography (HPLC), gas chromatography (GC), radioimmunoassay (RIA) and enzyme-linked immunosorbent assay (ELISA). Support services include handling HIV-positive samples, managing data for pharmacokinetic studies from multicenter trials, and archiving samples and data. In late 2006, our service offerings expanded to include complex immunologic assays for the vaccine industry.
GMP Laboratory: We provide product analysis laboratory services through our GMP-compliant laboratory in Middleton, Wisconsin. Our product analysis services include inhalation, biopharmaceutics, dissolution, stability and microbiology studies. These studies are necessary to characterize dosage form release patterns and stability under various environmental conditions in the intended package for marketing. These evaluations must be carried out from preclinical testing through Phase IV and the resulting data maintained over the commercial life of a product. New formulations, as well as generics and prescription products going to over-the counter status such that they no longer require physician prescription for consumer use, all require the same set of studies as the original dosage form.
We are one of a few full service companies able to offer our clients the advantages of bioanalytical, biomarker, product analysis and global central laboratory services, as well as Phase I clinical testing.
Phases II through IV Clinical Trial Management. The core of our development business is a comprehensive package of services for Phases II-IV clinical trials which, in conjunction with our other services, allows us to offer our clients an integrated package of clinical management services. We have significant clinical trials experience in the areas of:
General Areas of Expertise
Specific Areas of Expertise
Analgesia
Acute and chronic pain
Cardiovascular disease
Hypertension, angina pectoris, stroke, peripheral arterial disease
Central nervous system disease
Schizophrenia, depression, epilepsy, chronic pain, anxiety, obsessive-compulsive disorders, panic disorders, insomnia, multiple sclerosis
Critical care
Sepsis, ARDS (acute respiratory distress syndrome)
Dermatology
Wound healing, acne, hair loss, psoriasis
Gastroenterology
Duodenal ulcer, gastric ulcer, gastro-esophogeal reflux disease, H.pylori, nonsteroidal anti-inflammatory drug-induced ulcers, inflammatory bowel disease, irritable bowel disease
Genitourinary
Incontinence, sexual dysfunction
Hematology
Leukemia, hemophilia, lymphoma, myeloma, anemia
HIV/AIDS
Primary disease, treatment/prophylaxis of opportunistic infections
Infectious disease
Pneumonia, sinusitis, ear infections, swimmer’s ear, chronic bronchitis, urinary tract infection, skin and soft tissue infection, vaginal infections, thrush, athlete’s foot, ringworm, fungal blood infections, childhood and adult vaccines
Metabolic/endocrine disease
Diabetes, growth hormone
Oncology
Prostate, colorectal, breast, lung, brain and other cancers
Pulmonary/allergy
Asthma, allergic rhinitis
Rheumatology/immunology
Rheumatoid arthritis, osteoarthritis, lupus, gout, psoriasis
Urology
Sexual dysfunction, urinary incontinence, overactive bladder
Virology
Herpes simplex, chronic hepatitis B, chronic hepatitis C, genital herpes, respiratory syncytial virus, influenza
Women’s health
Osteoporosis, hormone replacement therapy
We conduct clinical trials through a project team. A project manager supervises all aspects of the conduct of the clinical trial, while our clinical research associates are in the field monitoring the trial at the various investigational sites. Within this project-oriented structure, we can manage every aspect of Phase II-IV clinical trials. The services that we offer to initiate clinical trials include protocol development, case report form design, feasibility studies, investigator selection, recruitment and training, site initiation and monitoring, patient enrollment strategies, development of training materials for investigators and training of clients’ staff.
We monitor our clinical trials in compliance with government regulations and guidelines. We have adopted global standard operating procedures intended not only to satisfy regulatory requirements in the United States and in many foreign countries, but also to serve as a tool for controlling and enhancing the quality of our clinical trials. All of our standard operating procedures comply with good clinical practices, or GCP, requirements and the International Conference on Harmonisation, or ICH, standards. The FDA has adopted these standards in its guidance documents and, more recently, the members of the European community and Japan have codified these standards into their clinical research regulations. We compile, analyze, interpret and submit data generated during clinical trials to the FDA or other relevant regulatory agencies for purposes of assisting our clients in obtaining regulatory approval. We also provide consulting on the conduct of clinical trials for simultaneous regulatory submissions to multiple countries.
We provide our clients with one or more of the following Phase II-IV clinical trial management services, using parallel processing to accelerate the development process:
Study Design. We serve our clients in the critical area of study design by applying our experience in the preparation of study protocols and case report forms.
Investigator Recruitment. During clinical trials, physicians at hospitals, clinics or other locations supervise administration of the drug to patients. We recruit these physicians, who are also referred to as investigators, to participate in clinical trials. We are continually looking for new investigator sites, particularly those that complement our primary therapeutic areas.
Study Monitoring. We provide study-monitoring services, which involve verifying the accuracy and completeness of medical information. Our services include investigative site initiation, patient enrollment assistance and data collection through subsequent site visits. We have monitored thousands of clinical trials, including a number of very large studies. For example, we have an extensive history of working with the National Institutes of Health, particularly with the National Institute of Allergy and Infectious Diseases, or NIAID. We have more than 15 years experience working as the clinical site monitoring group for the Division of AIDS, or DAIDS, at NIAID. The initial contract requirements were for monitoring services at domestic sites; however, this has been expanded to include both domestic and international sites as well as GCP training for the sites, laboratory audits and GLP training and quality management. In connection with our work with NIAID, since 2000, we have conducted nearly 11,000 interim site visits which involved chart review, pharmacy assessments, site operation assessments, laboratory audits and regulatory file reviews for approximately 900 protocols.
In July 2005, we were awarded a five-year contract with DAIDS for HIV clinical research management support, which includes clinical site assessment; clinical site preparation; clinical trial operational assistance; external quality assurance; training, general, logistical and administrative services to assist the DAIDS/NIAID in the management of its clinical research program; and information management activities. This program involves domestic and international sites.
Clinical Data Management and Biostatistical Analysis. We provide clients with assistance in areas such as sample size determination, case report form design and production, database design and construction, fax-based monitoring and electronic data capture. We also provide statistical analysis and summaries, including interim and final analyses, data safety monitoring board summaries and presentations, NDA preparation, electronic production and presentations, and other regulatory support services.
Medical Writing and Regulatory Services. We provide planning services for product development including preclinical review, consulting and clinical protocol development. These activities are complemented by report writing, program management and other regulatory services designed to reduce overall development time.
Safety/Pharmacovigilance. We provide both pre-approval and post-approval pharmacovigilance services to the pharmaceutical and biotechnology industry. For example, we are now processing an average of more than 3,000 reports per month globally on adverse events that are serious, non-serious or of special interest. We specialize in the real-time processing of event reports necessary for non-biased, independent third-party adjudication, and have managed adjudicated safety studies of up to 25,000 patients.
Post-Approval Services and Market Development Support. We provide custom-designed post-approval services as well as programs to help develop markets for products still under development for pharmaceutical, biotechnology and medical device clients. In 2003, we created a dedicated team of clinical, marketing and health outcomes experts to help companies with pre-launch (Phase II through IIIb) and post-approval (Phase IV) programs to develop products as well as the markets for new products and extend market value of existing products. The portfolio of services we offer in this area includes health outcomes, large-volume Phase IV monitored studies, registries and observational studies, medical information, professional contact center services, writing and editorial services, risk management services, Rx-to-OTC switch programs, and online marketing and education.
Applying advanced technologies and experience, we combine health outcomes such as epidemiology, psychometrics and economics with clinical research to measure and compare risks, benefits and economic and quality-of-life impacts of drug therapies. Our Phase IV monitoring studies can produce valuable safety and efficacy data analyses as well as provide information for patient education programs. Our registries and observational studies collect real-world data on how a product is used once approved and released in the broader patient population and used in a non-controlled setting. Data can be used to determine actual prescriber use or treatment patterns, to collect potential safety signals for further investigation, and to evaluate effectiveness and patient quality of life. Our patient adherence programs can optimize real-world outcomes and indicate ways to help enhance proper use of a drug by the physician and patient. We also provide Rx-to-OTC switch programs, transitioning prescription products to OTC programs. Our online marketing and education services provide our clients proprietary web sites for disseminating medical information to physicians and consumers, online market research and other product marketing services for a variety of clinical specialties.
Device Testing. Through our 2003 acquisition of a medical device testing company, we expanded our service offerings to support clinical trials for the medical device industry, with a focus on cardiovascular stents. Our device services include study design, regulatory consulting, global trial management, data management, biostatistics and documentation development. Using PPD GlobalView, our proprietary web-based software, we have a leading position for long-term registries of permanent implantable cardiovascular devices. This software can also perform electronic data collection, or EDC, for our clients.
eClinical Initiatives. Our eClinical initiatives offer efficiencies, enhanced quality and improved communications with our clients. We utilize a global project milestone and resource management tool that helps project managers provide efficient and cost-effective study management with quality deliverables. We use our clinical trial management system to provide web-based, real-time access to study data from anywhere in the world, across our Phase II to III studies, and are piloting it for use in large-scale Phase IV studies. Enhanced reporting functionality and integration with our interactive voice response, or IVR, and EDC tools should be available in the second quarter of 2007. We have combined our web and IVR technology offerings into a dual-interface solution as well as further improved our modular IVR delivery into a high availability, rapid deployment IVR solution. We also provide remote data capture, or RDC, services using Oracle® Clinical’s RDC platform. Coupled with PPD Patient Profiles and our biostatistical “real time analysis”, we offer our clients graphical display of real-time study data and blinded statistical tables and listings on an ongoing basis. Our PPD DirectConnect™ web portals are now supporting more than 390 client studies across approximately 110 pharmaceutical, biotechnology, clinical laboratory and government clients. This technology has become a core part of how we provide secure, timely access to key study information to our clients. We continue to expand our use of a web-based document management system supporting our data management, safety and clinical operations businesses. This system enables us to flexibly resource project teams worldwide. Now equipped with electronic signature capability, we are able to realize further document workflow efficiencies.
For our registries and observational studies group, especially with a focus on post-approval large global studies, we have continued to grow and enhance our PPD GlobalView EDC system. Not only does this application provide flexible and customized EDC interfaces for sites, it also provides web-based tracking tools and data portals. During 2006, PPD announced PPD GlobalView EventNet™, a customizable global event management and adjudication system for expeditious review of safety and endpoint-driven data from large-scale clinical trials. The secure Internet, network-based system accelerates review of data, particularly when studies with multiple sources of information on individual patients require review by a board of independent physicians. Features of the technology include online tracking of safety events, status reporting for activities and e-mail alerts to prompt and encourage timely review. Providing access to near real-time data and source documents, PPD GlobalView EventNet™ enables adjudication board members to review the information at their own convenience in any location globally.
Informatics. Our informatics division, known as CSS Informatics, delivers specialized software products and technical consulting services to support many aspects of the pharmaceutical research and development process, including drug discovery, clinical trials, regulatory review and pharmacovigilance. Our informatics clients include international and domestic pharmaceutical and biotechnology companies and government agencies, including the FDA. Our current informatics software products include:
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PPD Patient Profiles, which streamlines patient data review and provides graphical displays of complex research data;
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TableTrans®, which automates data transformation and integration;
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eLoader™, which streamlines and automates loading of external data into Oracle Clinical;
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CAVS (Computer Aided Validation System), which streamlines the test development and execution process;
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OC2SDS, which converts trial data to submission-ready data sets that follow standards recently adopted by the FDA; and
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E2B ICSR Browser, which allows companies to configure and create individual case study reports, or ICSRs, for any drug safety software system, transmit them to regulators and partners, and monitor the transmission status, all with real-time e-mail alerts.
A primary focus of our informatics division is to provide consulting services to help pharmaceutical, biotechnology and medical device companies assess and resolve clinical data management and safety system challenges, such as integrating and customizing systems, migrating clinical and safety data, providing computer systems validation services that include compliance evaluation and updating or replacing legacy systems to meet regulatory guidance. We provide expertise on the Oracle Life Sciences and PhaseForward suites of products with a full range of support services including installation, training, validation, technical support and custom development. Also, leveraging the PPD technical infrastructure, we provide application service provider, or ASP, hosting services for the entire Oracle Life Sciences suite of products.
Clients and Marketing
We provide a broad range of discovery and development services and products to help pharmaceutical, biotechnology and medical device companies as well as academic and government organizations develop compounds, drugs and devices, and gain regulatory approval in the markets in which they plan to sell these products. We believe PPD is recognized among our clients as a leading global contract research organization.
Client Identification and Mix
Our Development Group provides Phase I-IV clinical development and post-approval services. We market these services in the Americas, Europe, Africa, the Middle East, Asia and Australia. The key differentiators that help us win development business from pharmaceutical and biotechnology companies and academic and government organizations include our global infrastructure, quality-driven execution based on ongoing training, quality assurance and control practices, and cross-functional groups with dedicated therapeutic expertise. Through our medical device development group, we offer clinical trial services and regulatory expertise to device companies, including a number of the leading cardiovascular device manufacturers and pharmaceutical companies developing adjunct therapies. In
addition, our post-approval services combine clinical, marketing and health outcomes expertise to help pharmaceutical, biotechnology and device companies develop markets for new products and increase the life cycle of existing products.
From a geographic perspective, 66.8% of our Development Group’s net revenues in 2006 were derived from the United States, with the balance primarily coming from Europe and Latin America. For additional information on the geographic distribution of our net revenue, see Note 17 in the Notes to Consolidated Financial Statements included elsewhere in this report.
Our Discovery Sciences Group offers services and technologies to select drug candidates for clinical evaluation. This nonclinical and preclinical group primarily targets clients in the pharmaceutical and biotechnology industries. In addition, we perform research on compounds that we own or license through our compound partnering relationships. For the year ended December 31, 2006, all of our Discovery Sciences Group revenues were generated in the United States.
For the year ended December 31, 2006, total net revenue for all of our services were derived from various industries approximately as follows:
For purposes of classifying net revenue, we define pharmaceutical to include companies with the majority of their research and development related to chemical entities, and biotechnology to include companies with the majority of their research and development related to biologically engineered compounds. Other includes companies primarily focused upon medical devices, diagnostics and generic formulations. We refer to the Standard Industry Classification, or SIC, codes for publicly traded companies to determine their classification.
Concentration of business among large clients is not uncommon in our industry. Our diverse client mix, in which no single client in 2006 accounted for more than 10% of our net revenues, limits our exposure to significant risks associated with industry consolidation and major product cancellations. However, we have experienced higher concentration in the past and might experience it in the future. Approximately 40.5% of our 2006 net revenues were derived from clients headquartered outside the United States, in particular in Europe and Japan. Approximately 32.3% of our 2006 net revenues were generated from services provided by our employees located in countries outside the United States. See Note 17 in the Notes to Consolidated Financial Statements included elsewhere in this report for the breakdown of this revenue.
Marketing Strategy
With a primary focus on large pharmaceutical and biotechnology companies, we promote our nonclinical and preclinical work through concentrated business development efforts, localized scientist-to-scientist communications and our centralized corporate marketing programs. In addition, we believe our reputation assists in securing repeat business and new clients for our specialized nonclinical and preclinical oncology and diabetes services.
For our development services and products, we use corporate marketing to support the efforts of our centralized business development staff calling on pharmaceutical, biotechnology and device companies. Our sales teams focus on client segments and service areas. In addition, while service area representatives call on particular buying groups within a given biopharmaceutical or device client, our general account managers are responsible for coordinating our provision of services to the client across our portfolio of services.
The top 25 publicly traded pharmaceutical companies ranked by research and development expenses in 2005 accounted for 96% of pharmaceutical research and development spending in 2005, so we concentrate on these
companies. The top 50 publicly traded biotechnology companies accounted for nearly 47% of the biotechnology research and development expenditures in 2005. To appropriately focus our sales and marketing efforts among biotechnology companies, we consider additional factors such as the stage of a drug’s development and the financial stability of a potential client’s business.
Our business development personnel consult with potential pharmaceutical and biotechnology clients early in the project consideration stage in order to determine their requirements. Along with the appropriate operational, technical or scientific personnel, our business development representatives invest significant time to determine the optimal means to design and execute the potential client’s program requirements. As an example, recommendations we make to a potential client with respect to a drug development study design and implementation are an integral part of our bid proposal process and an important aspect of the integrated services we offer. Our preliminary efforts relating to the evaluation of a proposed clinical protocol and implementation plan enhance the opportunity for accelerated initiation and overall success of the trial.
Our core global marketing and corporate communications activities continue to be primarily web-based. Our initiatives include online advertising and directory listings on predominant industry web sources; interactive web-based education and information programs, including web conferences and web casts; direct e-mail campaigns; and electronic newsletters. In 2006, we initiated a redesign of the services section of our web site for improved navigation and use, and continued to add new search optimization tools to help drive traffic to the site. In addition, we integrate client presentations and sales materials, a global speakers bureau, media relations, marketing at professional trade shows and corporate materials to reinforce key messages and selling points. We encourage and sponsor the participation of our personnel in a variety of professional endeavors, including the presentation of papers at national and international professional trade meetings and the publication of scientific articles in medical and pharmaceutical journals. Through these presentations, publications and additional promotion via our web site, we seek to further our reputation for professional excellence.
Backlog
Our backlog consists of anticipated net revenue from contracts, letters of intent and verbal commitments that either have not started but are anticipated to begin in the near future, or are in process and have not been completed. Amounts included in backlog represent future revenue and exclude revenue that has been recognized previously in our statement of operations. Net revenue is defined as professional fee income, or gross revenue, less fees and associated reimbursements. Once contracted work begins, net revenue is recognized over the life of the contract. Our backlog was $2.238 billion in net revenues at December 31, 2006, compared to $1.799 billion in net revenues at December 31, 2005.
Our backlog as of any date is not necessarily a meaningful predictor of future results because backlog can be affected by a number of factors, including the size and duration of contracts, many of which are performed over several years, and the changes in labor utilization that typically occur during a study. Additionally, contracts relating to our clinical development business are often subject to early termination by the client and clinical trials can be delayed or canceled for many reasons, including unexpected test results, safety concerns or regulatory developments. Also, the scope of a contract can change significantly during the course of a study. If the scope of a contract is revised, the adjustment to backlog occurs when the revised scope is approved by the client. For these and other reasons, we might not fully realize our entire backlog as net revenue.
Intellectual Property
Patents, trademarks, copyrights and other proprietary rights are important to our business. We also rely on trade secrets, know-how, continuing technological innovations and licensing opportunities to develop and maintain our competitive position.
We actively seek patent protection both in the United States and abroad. As of December 31, 2006, we owned or co-owned 29 issued U.S. patents and 25 pending U.S. patent applications. Our issued U.S. patents primarily relate to our proprietary antitumor compounds, dapoxetine and methods of its use, and our biomarkers and
methods of their use. Our pending U.S. patent applications primarily relate to proprietary biomarker discovery information, chemical compounds, clinical development business methods and software. We have filed or plan to file applications in other countries corresponding to most of our U.S. applications. As of December 31, 2006, we had 53 granted and 38 pending foreign filings.
We also have obtained licenses to other patents from academic institutions and pharmaceutical companies. As of December 31, 2006, we had exclusive license rights to two issued U.S. patents and two granted foreign filings, as well as one pending foreign filing.
Pursuant to the terms of the Uruguay Round Agreements Act, patents issued from applications filed on or after June 8, 1995, have a term of 20 years from the date of filing, no matter how long it takes for the patent to issue. Because patent applications in the pharmaceutical industry often take a long time to issue, this method of patent term calculation can result in a shorter period of patent protection afforded to us compared to the prior method of term calculation, which was 17 years from the date of issue. Under the Drug Price Competition and Patent Term Restoration Act of 1984 and the Generic Animal Drug and Patent Term Restoration Act of 1988, a patent that claims a product, use or method of manufacture covering drugs may be extended for up to five years to compensate the patent holder for a portion of the time required for FDA review. However, we might not be able to take advantage of the patent term extension provisions of this law.
In addition, we rely on trade secrets and continuing technological innovation, which we try to protect with reasonable business procedures for maintaining trade secrets, including confidentiality agreements with our collaborators, employees and consultants. We also have numerous trademark registration applications pending in the United States and other jurisdictions throughout the world.
Employees
At December 31, 2006, we employed approximately 9,150 professionals, of whom approximately 8,900 were in the Development Group, approximately 100 were in the Discovery Sciences Group and the remainder served in corporate operations functions. Of our staff, approximately 700 hold Ph.D., M.D., Pharm.D. or D.V.M. degrees and approximately 1,500 hold other master’s or other postgraduate degrees. None of our employees are subject to a collective bargaining agreement. We believe that our relations with our employees are good.
We believe that our success is based on the quality and dedication of our employees. We strive to hire the best available people in terms of ability, experience, attitude and fit with our performance philosophy and standard operating procedures. We train new employees extensively and we believe we are an industry leader in the thoroughness of our training programs. In addition, we encourage our employees to continually grow and broaden their skills through internal and external training programs.
Available Information
Our web site address is www.ppdi.com. Information on our web site is not incorporated by reference herein. We make available free of charge through our web site our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission.
Competition
The drug and medical device development outsourcing industry consists of hundreds of smaller, limited-service providers and a number of full-service global development companies. In the past, the industry experienced some consolidation and a group of large, full-service competitors emerged. For example, in 2004, consolidation continued with the merger of PharmaNet, Inc. into SFBC International, Inc. and the merger of Inveresk Research Group, Inc. into Charles River Laboratories International, Inc. In 2006, Covance acquired Radiant Research, a multi-site domestic Phase I/IIA business, and PRA International, Inc. acquired Pharma Bio-Research (PBR), a Phase I/IIA clinical development company based in the Netherlands. Also in 2006, Kendle International, Inc. acquired the Phase II-IV clinical business of Charles River Laboratories International, Inc., and PAREXEL International
Corporation acquired California Clinical Trials Medical Group, Inc. and Behavioral and Medical Research, adding a broad range of Phase I-IV clinical research services. These recent consolidations, among other factors, continue to generate intense competition among industry competitors for clients, experienced clinical personnel, geographic markets and acquisition candidates. Additional business combinations by competitors or clients could have a significant impact on the competitive landscape of the drug development outsourcing industry.
In addition to competing with a number of other global, full-service companies, our Development Group and Discovery Sciences Group also compete against some medium-sized companies, in-house research and development departments of pharmaceutical and biotechnology companies, universities and teaching hospitals. Newer, smaller entities with specialty focuses, such as those aligned to a specific disease or therapeutic area, compete aggressively against larger companies for clients. Increased competition might lead to price and other forms of competition that could adversely affect our operating results.
Providers of outsourced drug and medical device development services and products compete on the basis of a number of factors, including reputation for on-time quality performance; expertise and experience in specific therapeutic areas; scope of service offerings; staff expertise and qualifications; price; strengths in various geographic markets; technological expertise and systems; data management capabilities; ability to acquire, process, analyze and report data in a time-saving, accurate manner; and ability to manage large-scale clinical trials both domestically and internationally. Over the past few years, our clients have increasingly pursued preferred provider agreements under which development services providers compete for selection as a vendor, with only a limited number of providers being chosen and therefore eligible to win business from the client. While selection under such agreements is no guarantee of business, larger, established service providers have benefited significantly from these arrangements. In addition, providing clinical development services can be labor-intensive and we compete for a limited pool of professionals to provide these services. Although there can be no assurance that we will continue to do so, we believe we compete favorably in these areas.
Despite recent consolidation, this industry remains highly fragmented, with several hundred smaller, limited-service providers and a small number of full-service companies with global capabilities. Although there are few barriers to entry for smaller, limited-service providers, there are significant barriers to becoming a global provider offering a broad range of services and products. These barriers include:
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the cost and experience necessary to develop broad therapeutic expertise;
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the ability to manage large, global, complex clinical trials;
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the ability to deliver high quality services consistently for large drug development projects;
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the experience to prepare regulatory submissions throughout the world; and
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the infrastructure and knowledge to respond to the global needs of clients.
For specialty areas such as drug information and post-marketing services, informatics and analytical laboratory services, our Development Group competes in a market that has a myriad of niche providers as well as larger, established firms. For the most part, these niche providers offer specialty services and products with a focus on a specific geographic region, a particular service or function and/or a specific stage or phase of drug development. By contrast, we provide our services on a global basis across functional areas.
The outsourced preclinical research industry consists of a number of large providers and numerous smaller niche companies. Our Discovery Sciences Group faces significant competition from these companies, as well as competition from research teams funded internally by pharmaceutical and biotechnology companies. Our compound risk-sharing initiatives seek to help our clients increase the return on their research and development investments by sharing development costs and risks as well as potential future revenue streams from successful product launches. Many of these clients search for a collaborative partner through a competitive bidding process, which can include pharmaceutical, biotechnology and discovery platform and services companies, as well as venture capital and private equity firms and financial institutions. As such, there is significant competition for these opportunities and our success will depend on our ability to identify and competitively bid for risk-sharing programs that are likely to be productive.
Government Regulation
Our clients are subject to extensive regulations by government agencies. Consequently, the services we provide for these clients must comply with relevant laws and regulations.
Prior to commencing human clinical trials in the United States, a company developing a new drug must file an IND with the FDA. The IND must include information about animal toxicity and distribution studies, manufacturing and control data, stability data and a clinical development plan for the product, and a study protocol for the initial proposed clinical trial of the drug or biologic in humans. If the FDA does not object within 30 days after the IND is filed, human clinical trials may begin. The study protocol must be reviewed and approved by the institutional review board, or IRB, in each institution in which a study is conducted and each IRB may impose additional requirements on the way in which the study is conducted in its institution.
Human trials usually start on a small scale to assess safety and then expand to larger trials to test both efficacy and safety in the target population. The trials are generally conducted in three phases, which sometimes overlap, although the FDA may require a fourth phase as a condition of approval. After the successful completion of the first three clinical phases, a company requests approval for marketing its product by submitting an NDA for a drug or a BLA for a biologic. The NDA/BLA is a comprehensive, multivolume filing that includes, among other things, the results of all preclinical and clinical studies, information about how the product will be manufactured and tested, additional stability data and proposed labeling. The FDA’s review can last from several months to multiple years, with the median approval time lasting approximately 13 months. Once the NDA/BLA is approved, the product may be marketed in the United States subject to any conditions imposed by the FDA.
Laboratories such as ours that provide information included in IND applications and NDAs must conform to regulatory requirements that are designed to ensure the quality and integrity of the testing process. For example, our bioanalytical laboratories in Richmond, Virginia, and Middleton, Wisconsin, follow the FDA’s GLPs. These GLPs have also been adopted by the Ministry of Health in the United Kingdom and by similar regulatory authorities in other countries. Our product analysis lab in Middleton, Wisconsin, also follows the FDA’s GMPs. Both GLPs and GMPs require standardization procedures for all equipment, processes and analytical tests, for recording and reporting data, and for retaining appropriate records. To help ensure compliance with GLPs and GMPs, we have established quality assurance at our laboratory facilities to audit test data and we conduct regular inspections of testing procedures and our laboratory facilities.
In addition, laboratories that analyze human blood or other biological samples for the diagnosis and treatment of study subjects must comply with the Clinical Laboratory Improvement Act, or CLIA. CLIA requires laboratories to meet staffing, proficiency and quality standards. The laboratory in our Austin, Texas, facility and our central laboratory located in Kentucky are CLIA-certified. Both of these laboratories and our central laboratory in Europe are accredited by the College of American Pathologists.
The industry standard for the conduct of clinical research is embodied in the FDA’s regulations for IRBs, investigators and sponsor/monitors, which collectively are termed good clinical practices, or GCPs, by industry and the GCP guidelines issued by ICH, which have been agreed upon by industry and regulatory representatives from the United States, European Union, or EU, and Japan. Our global standard operating procedures are written in accordance with all FDA and ICH requirements. This enables our work to be conducted locally, regionally and globally to standards that meet all currently applicable regulatory requirements.
In the past several years, both the U.S. and foreign governments have become more concerned about the disclosure of confidential personal data. The EU prohibits the disclosure of personal confidential information, including medical information, to any entity that does not comply with certain security safeguards. Companies in the United States can satisfy these requirements by filing for safe harbor status according to a self-certification procedure agreed to by the EU and the United States. We registered for and have obtained this safe harbor status.
The Department of Health and Human Services has promulgated final regulations under the Health Insurance Portability and Accountability Act of 1996, or HIPAA, which governs the disclosure of confidential medical information in the United States. We have had a global privacy policy in place since January 2001, which
includes a designated privacy officer, and we comply with the current EU and HIPAA requirements. We will continue to monitor our compliance with these regulations and will take necessary steps to ensure continued compliance with these and other privacy regulations.
We are also subject to regulations enforced by the following agencies, among others:
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Occupational Safety and Health Administration;
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Nuclear Regulatory Commission;
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Environmental Protection Agency;
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Department of Transportation;
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International Civil Aviation Organization; and
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Drug Enforcement Administration.
We also must comply with other related international, federal, state and local regulations that govern the use, handling, disposal, packaging, shipment and receipt of certain drugs or unknown compounds, chemicals and chemical waste, toxic substances, bloodborne pathogens and bloodborne pathogen waste, and radioactive materials and radioactive waste. In order to comply with these regulations, we have provided procedures, necessary equipment and ongoing training for our employees involved in these activities. To date, we have had no citations or fines from the above agencies.
The failure on our part to comply with applicable regulations could result in the termination of ongoing research or the disqualification of data for submission to regulatory authorities. Furthermore, the issuance of a notice of finding by a governmental authority against either us or our clients, based upon a material violation by us of any applicable regulation, could materially and adversely affect our business.
Item 1A.
Item 1A. Risk Factors
Risks Related to Our Discovery and Development Businesses
Changes in trends in the pharmaceutical and biotechnology industries could adversely affect our operating results.
Industry trends and economic and political factors that affect pharmaceutical, biotechnology and medical device companies and academic and government entities that sponsor clinical research, also affect our business. For example, the practice of many companies in these industries and government organizations has been to hire companies like us to conduct large development projects. If these industries reduce their tendency to outsource those projects, our operations, financial condition and growth rate could be materially and adversely affected. In the past, mergers, product withdrawal and liability lawsuits, and other factors in the pharmaceutical industry appear to have slowed decision-making by pharmaceutical companies and delayed drug development projects. Continuation or increases in these trends could have an adverse effect on our business. In addition, numerous governments have undertaken efforts to control growing healthcare costs through legislation, regulation and voluntary agreements with medical care providers and pharmaceutical companies. If future regulatory cost-containment efforts limit the profits that can be derived on new drugs, our clients might reduce their drug discovery and development spending, which could reduce our revenue and have a material adverse effect on our results of operations.
Our revenue depends on a small number of industries and clients.
We provide services to the pharmaceutical, biotechnology and medical device industries and academic and government organizations that sponsor clinical trials, and our revenue is highly dependent on expenditures by these clients. Accordingly, our operations could be materially adversely affected by consolidation in these industries or other factors resulting in a decrease in the number of our potential clients. For example, if the number of our potential clients declines even further, they might be able to negotiate price discounts or other terms for our services and products that are less favorable to us than has historically been the case. We have experienced client concentration in the past and could again in the future. The loss of business from a significant client could have a material adverse effect on our results of operations.
The majority of our clients’ contracts can be terminated upon short notice.
Most of our contracts for discovery and development services are terminable by the client upon 30 to 90 days’ notice. Clients terminate or delay their contracts for a variety of reasons, including but not limited to:
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products being tested fail to satisfy safety requirements;
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products have undesired clinical results;
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the client decides to forego a particular study;
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inability to enroll enough patients in the study;
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inability to recruit enough investigators;
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production problems cause shortages of the drug; and
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actions by regulatory authorities.
The loss or delay of a large contract or multiple smaller contracts could adversely affect our operating results.
We might not be able to recruit and retain the experienced personnel we need to compete in the drug discovery and development industry.
Our future success depends on our ability to attract, retain and motivate highly skilled personnel.
Management
Our future success depends on the personal efforts and abilities of the principal members of our senior management and scientific staff to provide strategic direction, develop business, manage our operations, and maintain a cohesive and stable work environment. For example, we rely on the services of Fredric N. Eshelman, Pharm.D., our chief executive officer. Although we have employment agreements with Dr. Eshelman and other executives, they are generally only for one year and do not assure that Dr. Eshelman or any other executive with whom we have an employment agreement will remain with us. Fred B. Davenport, Jr., who was our President, did not renew his contract and his employment ended December 31, 2006. We have allocated his duties among the existing management team, increasing their workload and importance to our success. We do not have employment agreements with all of our key personnel.
Healthcare Providers
Our ability to maintain, expand or renew existing business with our clients and to get business from new clients, particularly in the drug development sector, depends on our ability to hire and retain healthcare providers with the skills necessary to keep pace with continuing changes in drug development technologies. Competition for experienced healthcare providers is intense. We compete with pharmaceutical and biotechnology companies, including our clients and collaborators, other contract research companies, and academic and research institutions, to recruit healthcare providers.
Scientists
Our ability to maintain, expand or renew existing business with our clients and to get business from new clients in both the drug development and the drug discovery areas also depends on our ability to hire and retain scientists with the skills necessary to keep pace with continuing changes in drug discovery and development technologies. We face the same risks, challenges and competition in attracting and retaining experienced scientists as we do with healthcare providers.
Our inability to hire additional qualified personnel might also require an increase in the workload for both existing and new personnel. We might not be successful in attracting new healthcare providers, scientists or management, or in retaining or motivating our existing personnel. The shortage of experienced healthcare providers and scientists, or other factors, might lead to increased recruiting, relocation and compensation costs for these professionals, which might exceed our forecasts. These increased costs might reduce our profit margins or make hiring new healthcare providers or scientists impracticable. If we are unable to attract and retain any of these personnel, our ability to execute our business plan will be adversely affected.
Our future success depends on our ability to keep pace with rapid technological changes that could make our services and products less competitive or obsolete.
The biotechnology, pharmaceutical and medical device industries generally and drug discovery and development more specifically are subject to increasingly rapid technological changes, such as the genomics revolution. Our competitors or others might develop technologies, services or products that are more effective or commercially attractive than our current or future technologies, services or products, or that render our technologies, services or products less competitive or obsolete. If competitors introduce superior technologies, services or products and we cannot make enhancements to ours to remain competitive, our competitive position, and in turn our business, revenues and financial condition, would be materially and adversely affected.
Any failure by us to comply with existing regulations could harm our reputation and operating results.
Any failure on our part to comply with existing regulations could result in the termination of ongoing research or the disqualification of data for submission to regulatory authorities. This would harm our reputation, our prospects for future work and our operating results. For example, if we were to fail to verify that informed consent is obtained from patient participants in connection with a particular clinical trial or grant deviations from the inclusion or exclusion criteria in a study protocol, the data collected from that trial could be disqualified and we might be required to conduct the trial again at no further cost to our client, but at a substantial reputational and financial cost to us. Furthermore, the issuance of a notice from the FDA based on a finding of a material violation by us of good clinical practice, good laboratory practice or good manufacturing practice requirements could similarly materially and adversely affect us.
Proposed and future legislation or regulations might increase the cost of our business or limit our service or product offerings.
Federal or state authorities might adopt healthcare legislation or regulations that are more burdensome than existing regulations. For example, recent product safety concerns and the creation of the Drug Safety Oversight Board could change the regulatory environment for drug products, including the process for FDA product approval and post-approval safety surveillance. These and other changes in regulation could increase our expenses or limit our ability to offer some of our services or products. For example, the confidentiality of patient-specific information and the circumstances under which it may be released for inclusion in our databases or used in other aspects of our business are subject to substantial government regulation. Additional legislation or regulation governing the possession, use and dissemination of medical record information and other personal health information might require us to implement new security measures that require substantial expenditures or limit our ability to offer some of our services and products. These regulations might also increase costs by creating new privacy requirements for our informatics business and mandating additional privacy procedures for our clinical research business.
We might lose business opportunities as a result of healthcare reform.
Numerous governments have undertaken efforts to control growing healthcare costs through legislation, regulation and voluntary agreements with healthcare providers and drug companies. Healthcare reform could reduce demand for our services and products, including potential drug candidates that are being developed by us or with others under our risk-sharing agreements, and, as a result, our revenue. In recent years, the U.S. Congress has reviewed several comprehensive health care reform proposals. The proposals are intended to expand healthcare coverage for the uninsured and reduce the growth of total healthcare expenditures. The U.S. Congress has also considered and may adopt legislation that could have the effect of putting downward pressure on the prices that pharmaceutical and biotechnology companies can charge for prescription drugs. The Democratic party having taken control of Congress in the 2006 elections increases the possibility of healthcare reform. Any such legislation could cause our discovery and development clients to spend less on research and development. If this were to occur, we would have fewer business opportunities for our development and discovery service businesses, which could reduce our earnings, and the development of particular compounds might be discontinued. Similarly, pending or future healthcare reform proposals outside the United States could negatively impact our revenues from our international operations.
The drug discovery and development services industry is highly competitive.
The drug discovery and development services industry is highly competitive. We often compete for business not only with other drug discovery and development companies, but also with internal discovery and development departments within our clients, some of which are large pharmaceutical and biotechnology companies with greater resources than we have. We also compete with universities and teaching hospitals. If we do not compete successfully, our business will suffer. The industry is highly fragmented, with numerous smaller specialized companies and a handful of full-service companies with global capabilities similar to ours. Increased competition might lead to price and other forms of competition that might adversely affect our operating results. As a result of competitive pressures, our industry experienced consolidation in recent years. This trend is likely to produce more competition among the larger companies for both clients and acquisition candidates. In addition, there are few barriers to entry for smaller specialized companies considering entering the industry. Because of their size and focus, these companies might compete effectively against larger companies such as us, which could have a material adverse impact on our business.
Our business has experienced substantial expansion in the past and we might not properly manage that expansion in the future.
Our business has expanded substantially in recent years. Rapid expansion could strain our operational, human and financial resources and facilities. If we fail to properly manage our expansion, our results of operations and financial condition might be negatively affected. In order to manage expansion, we must, among other things, do the following:
•
continue to improve our operating, administrative and information systems;
•
accurately predict our future personnel, resource and facility needs to meet our commitments;
•
track the progress of ongoing projects; and
•
attract and retain qualified management, sales, professional, scientific and technical operating personnel.
In addition, we have numerous business groups, subsidiaries and divisions. If we cannot properly manage these groups, subsidiaries or divisions, it will disrupt our operations. We also face additional risks in expanding our foreign operations. Specifically, we might find it difficult to:
•
assimilate differences in foreign business practices;
•
hire and retain qualified personnel; and
•
overcome language and cultural barriers.
Future acquisitions or investments could disrupt our ongoing business, distract our management and employees, increase our expenses and adversely affect our business.
We anticipate that a portion of any future growth of our business might be accomplished by acquiring existing businesses, products or technologies. The success of any acquisition will depend upon, among other things, our ability to integrate acquired personnel, operations, products and technologies into our organization effectively, to retain and motivate key personnel of acquired businesses and to retain their clients. In addition, we might not be able to identify suitable acquisition opportunities or obtain any necessary financing on acceptable terms. We might also spend time and money investigating and negotiating with potential acquisition or investment targets, but not complete the transaction. Any future acquisition could involve other risks, including the assumption of additional liabilities and expenses, issuances of potentially dilutive equity securities or interest-bearing debt, transaction costs, reduction in our stock price as a result of any of these or because of market reaction to a transaction and diversion of management’s attention from other business concerns.
We have made and plan to continue to make investments in other companies. In many cases, there is no public market for the securities of these companies and we might not be able to sell these securities on terms acceptable to us, if at all. In addition, if these companies encounter financial difficulties, we might lose all or part of our investment. For example, in 2004 and 2005 we recorded impairments of equity investments, net, totaling $2.0 million and $5.9 million, respectively, to write down the carrying value of our investments for other-than-temporary declines in value. See Note 6 in the Notes to Consolidated Financial Statements included elsewhere in this report for a more detailed discussion of these impairments.
The fixed price nature of our development contracts could hurt our operating results.
The majority of our contracts for the provision of development services are at fixed prices or have set limits on the amounts we can charge for our services. As a result, variations in the timing and progress of large contracts can materially affect our operating results. In addition, we bear the risk of cost overruns unless the scope of activity is revised from the contract specifications and we are able to negotiate a contract modification with the client shifting the additional cost to the client. If we fail to adequately price our contracts, or if we experience significant cost overruns, our operating results could be materially adversely affected. From time to time, we have had to commit unanticipated resources to complete projects, resulting in lower gross margins on those projects. We might experience similar situations in the future, which could have a material adverse impact on our operating results.
If we are unable to attract suitable willing investigators and volunteers for our clinical trials, our development business might suffer.
The clinical research studies we run in our Development Group rely upon the ready accessibility and willing participation of physician investigators and volunteer subjects. Investigators are typically located at hospitals, clinics or other sites and supervise administration of the study drug to patients during the course of a clinical trial. Volunteer subjects generally include people from the communities in which the studies are conducted, including our Phase I clinic in Austin, Texas, which to date has provided a substantial pool of potential subjects for research studies. Our clinical research development business could be adversely affected if we were unable to attract suitable and willing investigators or volunteers on a consistent basis.
Our business exposes us to potential liability for personal injury claims that could affect our financial condition.
Our business involves the testing of new drugs and medical devices on human volunteers and, if marketing approval is received for any of our drug candidates, their use by patients. This exposes us to the risk of liability for personal injury or death to patients resulting from, among other things, possible unforeseen adverse side effects or improper administration of a drug or device. Many of these volunteers and patients are already seriously ill and are at risk of further illness or death. We could be materially and adversely affected both financially and reputationally if we were required to pay damages or incur defense costs in connection with a claim that is outside the scope of indemnification agreements we have with clients and collaborative partners, if any indemnification agreement is not performed in accordance with its terms or if our liability exceeds the amount of any applicable indemnification limits or available insurance coverage. We might also not be able to get adequate insurance for these risks at reasonable rates in the future.
Our business uses biological and hazardous materials, which could injure people or violate laws, resulting in liability that could hurt our financial condition and business.
Our drug discovery and development activities involve the controlled use of potentially harmful biological materials, as well as hazardous materials, chemicals and various radioactive compounds. We cannot completely eliminate the risk of accidental contamination or injury from the use, storage, handling or disposal of these materials. In the event of contamination or injury, we could be held liable for damages that result, and any liability could exceed our ability to pay. Any contamination or injury could also damage our reputation, which is critical to getting new business. In addition, we are subject to federal, state and local laws and regulations governing the use, storage, handling and disposal of these materials and specified waste products. The cost of compliance with these laws and regulations is significant and if changes are made to impose additional requirements, these costs could increase and have an adverse impact on our financial condition and results of operations.
Our business is subject to international economic, currency, political and other risks that could negatively affect our revenue and results of operations.
Because we provide our discovery and development services worldwide, our business is subject to risks associated with doing business internationally. Our revenue from our non-U.S. operations represented approximately 32.3% of our total revenues for the year ended December 31, 2006. We anticipate that revenue from international operations will grow in the future. Accordingly, our future results could be harmed by a variety of factors, including:
•
changes in foreign currency exchange rates, which could result in foreign currency losses;
•
changes in a specific country or region’s political or economic conditions;
•
potential negative consequences from changes in tax laws affecting our ability to expatriate profits;
•
difficulty in staffing and managing widespread operations, including risks of violations of local laws or the U.S. Foreign Corrupt Practices Act by employees overseas; and
•
unfavorable labor regulations, including specifically those applicable to our European operations.
For example, in 2006 our income from operations was negatively impacted by approximately $3.6 million, net of hedging loss, due to the effect of the weakening of the U.S. dollar relative to the euro, British pound and Brazilian real. Although we attempt to manage this risk through provisions in our contracts with our clients and other methods, including foreign currency hedging contracts, we might not be able to eliminate or manage these risks in the future and our income from operations could be materially and adversely affected by a significant decline in the value of the U.S. dollar.
Our inability to adequately protect our intellectual property rights could hurt our business.
Our success will depend in part on our ability to protect the proprietary software, compositions, processes and other technologies we develop during the drug development process. In addition, one of our business strategies is to in-license and/or out-license rights to drug candidates and enter into collaborations with pharmaceutical and biotechnology companies for the development of proprietary drug candidates. Any inability to protect our intellectual property rights could materially and adversely affect our business.
Any patents that we own or license might not provide valuable protection in the future for the covered technology or products. Our patent applications might never result in the issuance of a patent. Competitors might develop similar products or methods that are not covered by our issued patent claims. In addition, an issued patent might be narrowed or invalidated by a court challenge. The value of an issued patent could also be diminished if a patent is issued to a competitor that blocks our ability to use our patented technology. If blocked, we might be forced to stop using some or all of the technology or to license technology from third parties on unfavorable terms.
In addition to patent protection, we also rely on copyright, trademark and trade secret protection. In an effort to maintain the confidentiality and ownership of our intellectual property, we require our employees, consultants and advisors to execute confidentiality and proprietary information agreements. These agreements and other procedures, however, might not provide us with adequate protection against improper use or disclosure of confidential information. Also, there might not be adequate remedies in the event of unauthorized use or disclosure. Furthermore, from time to time we hire scientific personnel formerly employed by other companies involved in one or more areas similar to the activities we conduct. In some situations, our confidentiality and proprietary information agreements might conflict with, or be subject to, the rights of third parties with whom our employees, consultants or advisors have prior employment or consulting relationships. Although we require our employees and consultants to maintain the confidentiality of all confidential information of previous employers, both the company and these individuals might be subject to allegations of trade secret misappropriation or other similar claims as a result of their prior affiliations. Finally, others might independently develop substantially equivalent proprietary information or otherwise gain access to our trade secrets. Our failure to protect our proprietary information and techniques might inhibit or limit our ability to exclude competitors from the market and to execute our business strategies.
The drug discovery and development industry has a history of patent and other intellectual property litigation, and we might be involved in costly intellectual property lawsuits.
The drug discovery and development industry has a history of patent and other intellectual property litigation and these lawsuits will likely continue. Because we provide many different services and products in this industry and have rights to compounds, we face potential patent infringement suits by companies that have patents for similar products and methods used in business or other suits alleging infringement of their intellectual property rights. In addition to the possibility of having to defend an infringement claim asserted against us, in order to protect or enforce our intellectual property rights, we might have to initiate legal proceedings against third parties. Legal proceedings relating to intellectual property could be expensive, take significant time and divert management’s attention from other business concerns, whether we win or lose. The cost of this kind of litigation could affect our profitability. Further, if we do not prevail in an infringement lawsuit brought against us, we might have to pay substantial damages, including treble damages, and we could be required to stop the infringing activity or obtain a license to use technology on unfavorable terms.
We have relatively limited experience in the drug discovery business, and our prospects for success in this business remain uncertain and are dependent on third parties with whom we collaborate.
It takes many years for a drug discovery business like ours to generate revenue and income. We established our drug discovery group in 1997 and have relatively limited experience with these activities and might not be successful in our drug discovery efforts. Generating revenue and income from our drug discovery business will depend on our ability to:
•
develop products internally or obtain rights to them from others on favorable terms;
•
successfully complete laboratory testing and human studies;
•
obtain and maintain intellectual property rights to these products;
•
obtain and maintain regulatory approvals related to the efficacy and safety of these products;
•
enter into agreements with third parties to continue the development and commercialization of drug candidates; and
•
enter into arrangements with third parties to manufacture products on our behalf and to provide sales and marketing functions.
Since 1997, we have entered into collaborative agreements to develop and commercialize drugs with others. Our ability to succeed in our drug discovery business will depend on successfully executing existing and new arrangements we enter into for the development and commercialization of drug candidates. The third parties that we collaborate with might not perform their obligations as expected or they might breach or terminate their agreements with us or otherwise fail to conduct their collaborative activities successfully and in a timely manner. For example, the FDA sent ALZA a “not approvable” letter for dapoxetine and we terminated the implitapide program (see “Our Discovery Sciences Group - Compound Collaboration Programs” above). Further, parties collaborating with us might elect not to develop the product candidates or not to devote sufficient resources to the development, manufacture, regulatory strategy and approvals, marketing or sale of these product candidates. If the parties to our collaborative agreements do not fulfill their obligations, elect not to develop a candidate or fail to devote sufficient resources to it, we could be materially and adversely affected.
We are dependent on third parties for essential business functions for our risk-sharing arrangements and failures of these third party providers could materially adversely affect our business, financial condition and results of operations.
We and some of our collaborative partners are dependent on third parties for functions associated with the development and commercialization of our potential drug candidates, including manufacturing and marketing and sales. Our dependence on third parties for these services might adversely affect us and our ability to develop and
commercialize a drug candidate on a timely and competitive basis. If we or our collaborative partners are unable to retain or replace third-party providers of required services on commercially acceptable terms, our potential drug candidates might be delayed and might not be developed and commercialized as planned, if at all. If we encounter delays or failures by these third parties to perform, we might have to seek alternative sources of supply, lose sales or abandon a drug candidate, and our business, financial condition and results of operations could be materially and adversely affected.
We might not be able to obtain government approval for our product candidates.
The development and commercialization of pharmaceutical products are subject to extensive governmental regulation in the United States and foreign countries. Government approvals are required to develop, market and sell the potential drug candidates we are developing alone or with others under our risk-sharing arrangements. Obtaining government approval to develop, market and sell drug candidates is time-consuming and expensive, and the clinical trial results for a particular drug candidate might not satisfy requirements to obtain government approvals. For example, in late 2005, ALZA Corporation, our collaborator on dapoxetine, received a “not approvable” letter from the FDA. In addition, governmental approvals might not be received in a timely manner, if at all, and we and our collaborative partners might not be able to meet other regulatory requirements for our products. Even if we are successful in obtaining all required approvals to market and sell a drug candidate, post-approval requirements and the failure to comply with other regulations could result in suspension or limitation of government approvals.
In connection with drug discovery activities outside the United States, we and our collaborators will be subject to foreign regulatory requirements governing the testing, approval, manufacture, labeling, marketing and sale of pharmaceutical products. These requirements vary from country to country. Even if approval has been obtained for a product in the United States, approvals in foreign countries must be obtained prior to marketing the product in those countries. The approval process in foreign countries may be more or less rigorous and the time required for approval may be longer or shorter than that required in the United States. Clinical studies conducted outside of any particular country may not be accepted by that country, and the approval of a pharmaceutical product in one country does not assure that the product will be approved in another country.
We might incur substantial expense to develop products that are never successfully developed and commercialized.
We have incurred and expect to continue to incur substantial research and development and other expenses in connection with our compound partnering agreements. The potential drug candidates to which we devote resources might never be successfully developed or commercialized by us or our collaborative partners for numerous reasons, including:
•
preclinical and clinical trial results;
•
delays in manufacturing, or the inability to manufacture product for use in clinical trials or for sale following regulatory approval, if any;
•
competitive products with superior safety and efficacy profiles;
•
patent conflicts or unenforceable intellectual property rights;
•
failures or delays in obtaining regulatory approvals;
•
demand for the particular product; and
•
other factors that could make the product uneconomical.
Incurring significant expenses for a potential drug candidate that is not successfully developed and/or commercialized could have a material adverse effect on our business, financial condition, prospects and stock price.
Our operations might be affected by the occurrence of a natural disaster or other catastrophic event.
We depend on our clients, investigators, collaboration partners, our own laboratories and other facilities for the continued operation of our business. Although we have contingency plans in effect for natural disasters or other catastrophic events, these events, including terrorist attacks, pandemic flu, hurricanes and ice storms, could still disrupt our operations or those of our clients, investigators and collaboration partners, which could also affect us. Even though we carry business interruption insurance policies and typically have provisions in our contracts that protect us in certain events, we might suffer losses as a result of business interruptions that exceed the coverage available under our insurance policies or for which we do not have coverage. Any natural disaster or catastrophic event affecting us or our clients, investigators or collaboration partners could have a significant negative impact on our operations and financial performance.
Our development operations might be affected if there was a disruption to the air travel system.
Our global central laboratories and some of our other discovery and development services rely heavily on air travel for transport of clinical trial kits, other materials and people, and disruption to the air travel system could have a material adverse effect on our business. While we have developed contingency plans for a variety of events that could disrupt or limit available air transportation, these plans might not be effective or sufficient to avert such a material adverse effect.
Risks Related to Owning Our Stock
You might not receive any dividends, and the reduction or elimination of dividends might negatively affect the market price of our common stock.
We only began paying dividends as a public company in late 2005. Future dividend payments are not guaranteed and are within the absolute discretion of our Board of Directors. You might not receive any dividends as a result of any of the following factors:
•
we are not obligated to pay dividends;
•
while our dividend policy contemplates the distribution of a portion of the excess cash generated by our business each fiscal quarter, our Board of Directors could modify or revoke the policy at any time and for any reason;
•
even if the dividend policy is not modified or revoked, our Board of Directors could decide to reduce dividends or not to pay any dividends at all, at any time and for any reason;
•
the amount of dividends distributed is subject to state law restrictions;
•
new credit facilities or other agreements could limit the amount of dividends we are permitted to pay; and
•
our stockholders have no contractual or other legal right to dividends.
Our dividend policy is based upon our current assessment of the cash needs of our business and the environment in which it operates. That assessment could change due to, among other things, changes in our results of operations, cash requirements, financial condition, contractual restrictions, growth opportunities, acquisitions, competitive or technological developments, provisions of applicable law and other factors that our Board of Directors might deem relevant. The reduction or elimination of dividends might negatively affect the market price of our common stock.
Our dividend policy might limit our ability to pursue other growth opportunities.
Our Board of Directors has adopted a dividend policy which reflects an intention to distribute to our stockholders a portion of the cash generated by our business that exceeds our operating needs and capital expenditures as regular quarterly dividends. In developing the dividend policy, we have made assumptions for and judgments about our expected results of operations, anticipated levels of capital expenditures, income taxes and working capital. As a result of any payment made under the dividend policy, our ability to finance any material expansion of our business, including through acquisitions, investments or increased capital spending, or to fund our operations might be more limited than if we had retained all of our cash flow from operations.
Because our stock price is volatile, our stock price could experience substantial declines.
The market price of our common stock has historically experienced and might continue to experience volatility. Our quarterly operating results, changes in general conditions in the economy or the financial markets and other developments affecting us or our competitors could cause the market price of our common stock to fluctuate substantially. In addition, in recent years, the stock market has experienced significant price and volume fluctuations. The stock market, and in particular the market for pharmaceutical and biotechnology company stocks,
has also experienced significant decreases in value in the past. This volatility and valuation decline have affected the market prices of securities issued by many companies, often for reasons unrelated to their operating performance, and might adversely affect the price of our common stock.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
As of February 15, 2007, we had 63 offices located in 28 countries on six continents. All locations relate to our Development services, and the Morrisville, North Carolina and Menlo Park, California locations also house Discovery Sciences services. Our principal executive offices are located in Wilmington, North Carolina. We own and operate four facilities, including a building in Leicester, England, a building in Bellshill, Scotland, a laboratory building in Brussels, Belgium and a building in Durham, North Carolina. We lease all of our other facilities. We own land in Wilmington, North Carolina, on which we are constructing a new corporate headquarters building and related parking facilities that we have started to occupy. We believe that our facilities are adequate for our operations and that suitable additional space will be available when needed. The locations, approximate square footage and lease expiration dates of our operating facilities comprising more than 10,000 square feet as of February 15, 2007 were as follows:
Item 3.
Item 3. Legal Proceedings
In the normal course of business, we are a party to various claims and legal proceedings. Although the ultimate outcome of these matters is not yet determined, after consultation with legal counsel we do not believe that the resolution of these matters will have a material effect upon our financial condition or results of operations in any interim or annual period.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matter was submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 2006.
Executive Officers
The following table contains information concerning our executive officers as of February 15, 2007:
Name
Age
Position(s)
Fredric N. Eshelman., Pharm.D.
Vice Chairman, Chief Executive Officer
Paul S. Covington, M.D.
Executive Vice President - Development
Linda Baddour
Chief Financial Officer, Treasurer, Assistant Secretary
Colin Shannon
Executive Vice President - Global Clinical Operations
William W. Richardson
Senior Vice President - Global Business Development
Fredric N. Eshelman, Pharm.D. has served as Chief Executive Officer and as a director since July 1990, and as Vice Chairman of the Board of Directors since 1993. Dr. Eshelman founded our company’s predecessor in 1985 and served as its Chief Executive Officer until 1989. Prior to rejoining us in 1990, Dr. Eshelman served as Senior Vice President, Development and as a director of Glaxo Inc., a subsidiary of Glaxo Holdings plc.
Paul S. Covington, M.D. is our Executive Vice President - Development. Dr. Covington joined us in September 1991 as a Medical Director. He was promoted from Senior Vice President to his current position in January 2002. He is board certified in internal medicine and licensed in North Carolina and Alabama. Prior to joining us, Dr. Covington was in private practice in Clanton, Alabama from 1985 to 1990 where he served as Chief of Staff and Director of Critical Care and Cardiopulmonary Disease for the local hospital. From 1991 to 1992, he was Medical Director for the Birmingham site of Future Healthcare Research Centers.
Linda Baddour is our Chief Financial Officer, Treasurer and Assistant Secretary. Ms. Baddour joined us in December 1995. Ms. Baddour was promoted to Chief Accounting Officer in 1997 and to Chief Financial Officer in 2002. Prior to her employment by us, Ms. Baddour was the Controller for Cooperative Bank from 1980 to 1995. Ms. Baddour is a Certified Public Accountant.
Colin Shannon is our Executive Vice President - Global Clinical Operations. Mr. Shannon joined us in 1995. He has served in numerous management positions, including Chief Operating Officer, Europe and Chief Financial and Administration Officer, Europe. Prior to his employment by us, Mr. Shannon spent more than 15 years in a variety of financial and accounting positions in the utility and multimedia industries.
William W. Richardson is our Senior Vice President - Global Business Development. Prior to joining us in November 2005, Mr. Richardson served as Executive Vice President of Sales for Mylan Bertek Pharmaceuticals Inc. from 2000 to 2005. He was President and Chief Executive Officer of Bertek Pharmaceuticals Inc. from 1996 to 2000. He began his career as Sales Manager for Dow Hickam Pharmaceuticals and rose through its ranks to serve as President and CEO from 1992 to 1996.
PART II
Item 5.
Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
Our common stock is traded under the symbol “PPDI” and is quoted on the Nasdaq Global Select Market. The following table sets forth the high and low prices, adjusted to give effect to our two-for-one stock split in February 2006, for shares of our common stock, as reported by Nasdaq for the periods indicated.
Holders
As of February 15, 2007, there were approximately 47,000 holders of our common stock.
Dividends
Prior to the fourth quarter of 2005, we had never declared or paid cash dividends as a public company. On October 3, 2005, our Board of Directors declared a special one-time cash dividend for our shareholders in the amount of $0.50, as adjusted to give effect to our February 2006 two-for-one stock split, on each outstanding share of common stock. This special one-time cash dividend was paid in the fourth quarter of 2005. Our Board of Directors also adopted an annual cash dividend policy to pay an aggregate annual cash dividend of $0.10 on each outstanding share of common stock, payable quarterly at a rate of $0.025 per share, as adjusted to give effect to our February 2006 two-for-one stock split. We paid the first quarterly cash dividend under our annual dividend policy in the fourth quarter of 2005. Beginning in the fourth quarter of 2006, our Board of Directors amended the annual cash dividend policy to increase the annual dividend rate by 20 percent, from $0.10 to $0.12 per share, or $0.03 per share quarterly. The annual cash dividend policy and the payment of future quarterly cash dividends under that policy are not guaranteed and are subject to the discretion of and continuing determination by our Board of Directors that the policy remains in the best interests of our shareholders and in compliance with applicable laws and agreements.
Equity Compensation Plans
The information required by Item 5 of Form 10-K regarding equity compensation plans is incorporated herein by reference to “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters”.
Item 6.
Item 6. Selected Financial Data
The following table represents selected historical consolidated financial data. The statement of operations data for the years ended December 31, 2004, 2005 and 2006 and balance sheet data at December 31, 2005 and 2006 are derived from our audited consolidated financial statements included elsewhere in this report. The statement of operations data for the years ended December 31, 2002 and 2003, and the balance sheet data at December 31, 2002, 2003 and 2004 are derived from audited consolidated financial statements not included in this report. The historical results are not necessarily indicative of the operating results to be expected in the future. The selected financial data should be read together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and notes to the financial statements included elsewhere in this report.
Consolidated Statement of Operations Data (in thousands, except per share data):
Consolidated Balance Sheet Data (in thousands):
(1)
Effective January 1, 2006, we adopted SFAS No. 123 (revised) using the modified retrospective application method. In accordance with the modified retrospective application method, we have adjusted our financial statements for all periods prior to January 1, 2006 to give effect to the fair-value based method of accounting for all awards granted in fiscal years beginning after December 15, 1994.
(2)
For 2002, 2003 and 2005, results of operations for acquisitions that occurred during the year are included in our consolidated results of operations as of and since the effective date of the acquisitions. For further details, see Note 2 in Notes to Consolidated Financial Statements.
(3)
For 2003, operating expenses include a $65.0 million cash payment to Eli Lilly & Company to acquire Lilly’s patents to dapoxetine.
(4)
For 2003, gain on sale of assets related to the restructuring of our Discovery Sciences segment. For 2005, gain on exchange of assets related to the acquisition of substantially all the assets of SurroMed, Inc.’s biomarker business. For further details regarding the 2005 transaction, see “Restructuring Charges” in Note 1 in Notes to Consolidated Financial Statements.
(5)
For 2003 and 2004, restructuring charges related to the restructuring of our Discovery Sciences segment. For further details, see “Restructuring Charges” in Note 1 in Notes to Consolidated Financial Statements.
(6)
For 2002, 2003, 2004 and 2005, impairment of equity investments includes charges to earnings for other-than-temporary declines in the fair market value of our investments. For further details, see Note 6 in Notes to Consolidated Financial Statements.
(7)
Working capital equals current assets minus current liabilities.
(8)
For 2005 and 2006, long-term debt includes $17.1 million and $74.8 million, respectively, which we borrowed to finance the construction of our new headquarters building and related parking facility in Wilmington, North Carolina.
(9)
The Board of Directors declared a special one-time cash dividend in the amount of $0.50, as adjusted to give effect to our February 2006 two-for-one stock split, on each outstanding share of common stock in the fourth quarter of 2005. The Board of Directors also adopted an annual dividend policy in the fourth quarter of 2005 and paid the first quarterly cash dividend in that quarter.
Item 7.
Item 7. 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 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-K contains forward-looking statements within the meaning of the federal securities laws. These statements relate to future events or our future financial performance. Forward-looking statements include statements concerning plans, objectives, goals, strategies, future events or performance, expectations, predictions, assumptions and other statements that are not statements of historical facts. In some cases, you can identify forward-looking statements by terminology such as “might”, “will”, “should”, “expect”, “plan”, “anticipate”, “believe”, “estimate”, “predict”, “intend”, “potential” or “continue”, or the negative of these terms, or other comparable terminology. These statements are only predictions. These statements rely on a number of assumptions and estimates that could be inaccurate and that are subject to risks and uncertainties. Actual events or results might differ materially due to a number of factors, including those listed in “Potential Volatility of Quarterly Operating Results and Stock Price” and in “Item 1A. Risk Factors”. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements.
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 our market, see “Item 1. Business - Trends Affecting the Drug Discovery and Development Industry”. Although we cannot predict the demand for CRO services for 2007, we continue to believe that the traditional market drivers for our industry are intact. In the first half of 2006, the market opportunity was robust and we experienced a new high for our global Phase II through IV business from a proposal volume standpoint. During the second half of 2006, proposal volume declined from the record levels in the first half of the year, but our proposal volume remained strong and ahead of 2005 levels. For 2007, we plan to focus our efforts on managing our recent growth and delivering timely, high quality services to our clients, which is fundamental to our business and future growth. We also intend to improve our business development efforts by focusing on the core markets for our services.
We believe there are specific opportunities for continued growth in certain areas of our business. Our Global Phase II through IV units had strong operating and financial performance in 2006, and we expect to see continued revenue growth in these units in 2007. Our global central laboratory also achieved strong revenue growth in 2006. We are expanding our service offerings, especially in the area of infectious disease, and investing in new equipment for 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 2006, we had new authorizations of $1.971 billion, an increase of 11.6% over 2005. The cancellation rate for 2006 was 19.4%, which is higher than the 16.8% cancellation rate for 2005, but lower than our projected cancellation rate for 2006. The cancellation rate for 2006 was also below our average cancellation rate over the past five years. Backlog grew to $2.238 billion as of December 31, 2006, up 24.4% over December 31, 2005. The average length of our contracts increased to 32.8 months as of December 31, 2006 from 32.1 months as of December 31, 2005.
Backlog by client type as of December 31, 2006 was 54.5% pharmaceutical, 32.3% biotech and 13.2% government/other as compared to 49.5% pharmaceutical, 33.3% biotech and 17.2% government/other as of December 31, 2005. The change in the composition of our backlog from 2005 to 2006 is primarily the result of an increase in authorizations from pharmaceutical companies in 2006. Net revenue by client type for the year ended December 31, 2006 was 58.5% pharmaceutical, 29.5% biotech and 12.0% government/other compared to 62.2% pharmaceutical, 27.6% biotech and 10.2% government/other as of December 31, 2005.
For 2006, net revenue contribution by service area was 78.0% for Phase II-IV services, 15.3% for laboratory services, 3.8% for Phase I clinic and 2.9% for discovery sciences compared to net revenue contribution for the year ended December 31, 2005 of 76.7% for Phase II-IV services, 15.0% for laboratory services, 4.2% for discovery sciences and 4.1% for Phase I clinic. Top therapeutic areas by net revenue for the year ended December 31, 2006 were anti-infective/anti-viral, oncology, endocrine/metabolic, circulatory/cardiovascular and central nervous system. For a detailed discussion of our revenue, margins, earnings and other financial results for the year ended December 31, 2006, see “Results of Operations - Year Ended December 31, 2005 versus Year Ended December 31, 2006” below.
Capital expenditures for the year ended December 31, 2006 totaled $148.0 million. These capital expenditures were primarily for construction costs for our new corporate headquarters building and related parking facility in Wilmington, North Carolina, computer software and hardware, scientific equipment for our laboratory units, and various building improvements throughout the company. We made these investments to support our growing businesses and to improve the efficiencies of our operations. For 2007, we expect to spend between $105 million and $110 million for capital expenditures, of which approximately $30 million will be related to the ongoing construction of our new headquarters building. The majority of the remaining forecasted capital expenditures will be related to up-fit costs for facilities, information technology related expenditures and additional laboratory equipment.
As of December 31, 2006, we had $435.7 million of cash, cash equivalents and short-term investments and $75.2 million of debt primarily related to amounts borrowed to finance the construction of our new headquarters building. In 2006, we generated $187.4 million in cash from operations, which was impacted by an increase in accounts receivable and unbilled services of $99.1 million. The number of days’ revenue outstanding in accounts receivable and unbilled services, net of unearned income, also known as DSO, was 44.0 and 34.1 days as of December 31, 2006 and 2005, respectively. While DSO increased in part due to the increase in accounts receivable, more than 90% of our accounts receivable balance as of December 31, 2006 was less than 60 days old. DSO also rose in 2006 due to longer payment terms with some clients and a decrease in unearned income as a percentage of accounts receivable and unbilled services at December 31, 2006 compared to December 31, 2005. We expect DSO and unbilled services will continue to fluctuate in the future depending on contract terms, the mix of contracts performed within a quarter, the levels of investigator advances and unearned income, and our success in collecting receivables.
Because of our cash position and free cash flow, in late 2005 our Board of Directors declared a special one-time cash dividend and adopted a policy to pay annual cash dividends. In October 2006, our Board of Directors amended the annual cash dividend policy to increase the annual dividend rate by 20 percent, from $0.10 to $0.12 per
share. The new dividend rate became effective in the fourth quarter of 2006. The cash dividend policy and the payment of future cash dividends are not guaranteed and are subject to the discretion of and continuing determination by our Board of Directors that the policy remains in the best interests of our shareholders and in compliance with applicable laws and agreements.
With regards to our Discovery Sciences segment, our preclinical oncology facility had a solid performance in 2006, and is now offering models to support diabetes drug development. Our Discovery Sciences segment also includes our compound partnering arrangements. The DPP4 development program with Takeda Pharmaceuticals continues to progress. With regard to our collaboration on dapoxetine with ALZA Corporation, ALZA has indicated that it may file for approval in Europe as early as late 2007. In February 2007, we exercised an option to license a statin compound from Ranbaxy Laboratories Ltd. which we intend to develop as a treatment for dyslipidemia. We are solely responsible, and will bear all costs and expenses, for the development, manufacture, marketing and commercialization of the compound and licensed products. 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 clients. For a background discussion of our compound partnering arrangements, see “Item 1. Business - Our Services - Our Discovery Sciences Group - Compound Collaboration Programs”. We are committed to our compound partnering strategy and believe it is an innovative way to use our cash resources and drug development expertise to drive mid- to long-term shareholder value. In 2007, we plan to continue advancing our existing collaborations and evaluate new potential opportunities in this area.
Acquisitions
In February 2005, we completed our acquisition of substantially all of the assets of SurroMed, Inc.’s biomarker business. The biomarker business is part of the Discovery Sciences segment. In exchange for the assets, we surrendered to SurroMed for cancellation all shares of preferred stock of SurroMed we held. As additional consideration for the acquisition, we assumed approximately $3.4 million of SurroMed liabilities under capital leases and additional operating liabilities, and guaranteed repayment of up to $1.5 million under a SurroMed bank loan. Our guarantee of this loan expired on December 31, 2006. We recognized a pre-tax gain on the exchange of assets with Surromed in the amount of $5.1 million. For further details regarding this acquisition, see Note 2 in the Notes to Consolidated Financial Statements.
New Business Authorizations and Backlog
New business authorizations, which are sales of our services, are added to backlog when we enter into a contract or letter of intent or receive a verbal commitment. Authorizations can vary significantly from quarter to quarter and contracts generally have terms ranging from several months to several years. We recognize revenue on these authorizations as services are performed. Our new authorizations for the years ended December 31, 2004, 2005 and 2006 were $1.212 billion, $1.766 billion and $1.971 billion, respectively.
Our backlog consists of new business authorizations for which the work has not started but is anticipated to begin in the future and contracts in process that have not been completed. As of December 31, 2006, the remaining duration of the contracts in our backlog ranged from one month to 142 months, with an average duration of 32.8 months. Amounts included in backlog represent future revenue and exclude revenue that we have previously recognized. Once work begins on a project included in backlog, we recognize net revenue over the life of the contract as services are performed. Our backlog as of December 31, 2004, 2005 and 2006 was $1.293 billion, $1.799 billion and $2.238 billion, respectively. For various reasons discussed in “Item 1. Business - Backlog”, our backlog might never be recognized as revenue and is not necessarily a meaningful predictor of future performance.
Results of Operations
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 effort expended through that date to estimated total effort to complete the contract. We believe this is the best indicator of the performance of the contractual obligations because the costs relate primarily to the amount of labor incurred to perform the service. Changes to the estimated total contract direct costs result in a cumulative adjustment to the amount of revenue recognized. For time-and-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. Revenue is reported net of volume discounts provided to clients.
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 and our clients reimburse us for these costs. As required by Emerging Issues Task Force 01-14, amounts paid by us as a principal for out-of-pocket costs are included in direct costs as reimbursable out-of-pocket expenses and the reimbursements we receive as a principal are reported as reimbursed out-of-pocket revenue. In our statements of operations, we combine amounts paid by us as an agent for out-of-pocket costs with the corresponding reimbursements, or revenue, we receive as an agent. During the years ended December 31, 2004, 2005 and 2006, fees paid to investigators and other fees we paid as an agent and the associated reimbursements were approximately $226.9 million, $279.8 million and $292.6 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 payment to us of expenses to wind down a study, fees earned to date and, in some cases, a termination fee or some portion of the fees or profit that we could have earned under the contract if it had not been terminated early. Therefore, revenue recognized prior to cancellation does not generally require a significant adjustment upon cancellation. If we determine that a loss will result from the performance of a fixed-price contract, the entire amount of the estimated loss is charged against income in the period in which 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:
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direct costs;
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research and development;
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selling, general and administrative;
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depreciation; and
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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.
Selling, general and administrative, or SG&A, expenses consist primarily of administrative payroll and related benefit charges, sales, advertising and promotional expenses, recruiting and relocation expenses, training costs, administrative travel, an allocation of facility and information technology costs, and costs related to operational employees performing administrative tasks.
Depreciation expenses consist of depreciation costs recorded on a straight-line method, based on estimated useful lives of 40 to 50 years for buildings, five years for laboratory equipment, two to five years for software, computers and related equipment, and five to ten years for furniture and equipment, except for aircrafts, which we depreciate over 30 years. We depreciate leasehold improvements over the shorter of the life of the relevant lease or the useful life of the improvement. We depreciate property under capital leases over the life of the lease or the service life, whichever is shorter.
Amortization expenses consist of amortization costs recorded on intangible assets on a straight-line method over the life of the intangible assets.
Year Ended December 31, 2005 versus Year Ended December 31, 2006
The following table sets forth amounts from our consolidated financial statements along with the dollar and percentage change for the full year of 2005 compared to the full year of 2006.
Total net revenue increased $210.6 million to $1.248 billion in 2006. The increase in total net revenue resulted primarily from an increase in our Development segment revenue. The Development segment generated net revenue of $1.113 billion, which accounted for 89.2% of total net revenue for 2006. The 20.8% increase in Development net revenue was primarily attributable to an increase in the level of global CRO Phase II through IV services we provided in 2006 as compared to 2005.
The Discovery Sciences segment generated net revenue of $33.2 million in 2006, a decrease of $7.0 million from 2005. The higher 2005 Discovery Sciences net revenue was mainly attributable to the $10.0 million milestone payment from ALZA Corporation we received in 2005 for the filing of the dapoxetine NDA. This was partially offset by increased revenue generated by our preclinical oncology division in 2006 as compared to 2005. We received a $15.0 million milestone from Takeda in connection with the DPP4 collaboration in both 2005 and 2006. We do not expect to receive any milestone payments related to either of these collaborations in 2007.
Total direct costs increased $120.0 million to $670.5 million in 2006 primarily as the result of an increase in the Development segment direct costs. Development direct costs increased $92.8 million to $559.8 million in 2006. The primary reason for this was an increase in personnel costs of $80.8 million due to over 1,000 additional employees in our global Phase II through IV division. The remaining increase in the development direct costs is primarily due to increased facility costs of $11.2 million related to the increase in personnel.
R&D expenses decreased $18.0 million to $5.4 million in 2006. R&D expenses decreased primarily as a result of decreased spending in connection with the DPP4 program, which was transferred to Takeda. Under the DPP4 agreement with Takeda that we entered into in July 2005, Takeda assumed the obligation to fund all future development and commercialization costs of the DPP4 inhibitor program. In February 2007, we exercised an option to license a statin compound from Ranbaxy Laboratories Ltd. which we intend to develop as a treatment for dyslipidemia. We are solely responsible, and will bear all costs and expenses, for the development, manufacture, marketing and commercialization of the compound and licensed products. We plan to continue evaluating other compound partnering opportunities to drive mid- and long-term shareholder value. As a result of this new collaboration and any other compound partnering transaction that we might enter into in 2007, our R&D expense could increase.
SG&A expenses increased $51.4 million to $302.5 million in 2006. As a percentage of total net revenue, SG&A expenses were 24.2% in both 2005 and 2006. The increase in SG&A expenses includes additional personnel costs of $40.7 million. The increase in personnel costs related mainly to an increased level of new hires of both operations infrastructure and administrative personnel to support expanding operations and revenue growth. The increase in SG&A costs also includes an additional $3.2 million related to additional provisions for bad debt expense. In addition, SG&A costs include an increase of $2.0 million in accounting and legal fees.
Depreciation expense increased $8.0 million to $47.2 million in 2006. The increase was related to property and equipment we acquired to accommodate our growth, a significant portion of which related to information technology system investments we made in 2005. Capital expenditures were $148.0 million in 2006. Capital expenditures included $73.5 million for our new corporate headquarters building and related parking facility in Wilmington, North Carolina, $23.4 million for computer software and hardware, $16.1 million related to leasehold improvements at various sites, $8.9 million for additional scientific equipment for our Phase I and laboratory units and $8.7 million for our new building in Scotland. We expect depreciation to increase in 2007 as a result of substantial investments over the past couple years in information technology systems to support our global Phase II-IV business and the additional depreciation related to our new corporate headquarters building.
Income from operations increased $43.3 million to $220.0 million in 2006. As a percentage of net revenue, income from operations increased from 17.0% in 2005 to 17.6% in 2006. Income from operations in 2006 included a significant decrease in R&D expenses as discussed above and a $1.5 million loss on disposal of assets, mostly composed of $0.8 million related to disposal of assets in our biomarker business, $0.2 million related to the disposal of an intangible asset and a $0.4 million impairment related to the value of our building in Leicester, United Kingdom, which was the site of our former U.K. Phase I operations. Income from operations in 2006 was negatively impacted by approximately $3.3 million due to foreign currency fluctuation, primarily the weakening of the U.S. dollar relative to the pound sterling, euro and Brazilian real. Although these currency movements increased net revenue in the aggregate, the negative impact on income from operations is attributable to dollar-denominated contracts for services rendered in countries other than the United States. In these cases, revenue is not impacted by the weakening of the U.S. dollar, but the costs associated with performing these contracts and maintaining the foreign infrastructure, which are paid in local currency, increase when translated to U.S. dollars, resulting in lower operating profits. During 2006, we recorded a foreign currency hedging loss of $0.3 million, resulting in a net impact to income from operations of $3.6 million attributable to foreign currency transactions. Income from operations in 2005 included a $5.1 million gain on exchange of assets associated with the acquisition of SurroMed’s biomarker business. Income from operations in 2005 also included a $10.0 million milestone payment related to the filing of the dapoxetine NDA.
During 2005, we recorded charges to earnings for other-than-temporary declines in the fair market value of our cost basis investments of $5.6 million, which included $1.6 million related to the outstanding balance of a revolving line of credit that was guaranteed by us, and our marketable equity securities of $0.3 million. The write-downs were due to a business failure, current fair market values, historical and projected performance and liquidity needs of the investees.
Interest and other income, net increased $6.5 million to $15.5 million in 2006. This was due primarily to increased interest income due to higher interest rates and a 28.2% increase in our average cash, cash equivalents and short-term investment balance.
Our provision for income taxes increased $18.9 million to $78.9 million in 2006. Our effective income tax rate for 2005 was 33.3% compared to 33.5% for 2006. The effective tax rate for 2006 was positively impacted by 1.8% by the recognition of benefit for state economic development tax credits as well as a decrease in liabilities for tax contingencies and a decrease in the valuation allowance due to the closing of certain state tax statutes and audits. The effective tax rate for 2005 was positively impacted by a $6.9 million reduction in our valuation allowance provided for the deferred tax asset relating to capital loss carryforwards. The reduction was a result of the utilization of capital loss carryforwards that previously had a valuation allowance recorded against them as well as the recognition of capital gains for the dapoxetine NDA milestone payment from ALZA Corporation received in the first quarter of 2005 and the $15.0 million up-front payment received from Takeda during the third quarter of 2005 with respect to the DPP4 program. This reduction in the valuation allowance decreased the effective tax rate in 2005 by 3.5%. The remaining difference in our effective tax rates for 2006 compared to 2005 is due to the tax on the repatriation of foreign earnings in 2005 and the change in the geographic distribution of our pretax earnings among locations with varying tax rates.
Net income of $156.7 million in 2006 represents an increase of 30.7% from $119.9 million in 2005. Net income per diluted share of $1.32 in 2006 represents a 28.2% increase from $1.03 net income per diluted share in 2005. Net income per diluted share for 2005 included $0.03 per share, net of tax, for the gain on exchange of assets associated with the acquisition of SurroMed’s biomarker business which was offset by $0.03 per share, net of tax, for impairment of equity investments.
Year Ended December 31, 2004 versus Year Ended December 31, 2005
The following table sets forth amounts from our consolidated financial statements along with the dollar and percentage change for the full year of 2004 compared to the full year of 2005.
Total net revenue increased $195.8 million to $1.037 billion in 2005. The increase in total net revenue resulted primarily from an increase in our Development segment revenue. The Development segment generated net revenue of $921.8 million, which accounted for 88.9% of total net revenue for 2005. The 21.3% increase in Development net revenue was primarily attributable to an increase in the level of global CRO Phase II through IV services we provided in 2005 as compared to 2004.
The Discovery Sciences segment generated net revenue of $40.2 million in 2005, an increase of $25.9 million from 2004. The increase in the Discovery Sciences net revenue was mainly attributable to the $15.0 million up-front payment we received from Takeda in connection with the DPP4 agreement we entered into in July 2005 and the $10.0 million milestone payment we received from ALZA for the filing of the dapoxetine NDA. The remaining increase was primarily due to revenue generated by our biomarker business that we acquired from SurroMed. In 2004, we received a $5.0 million payment from ALZA in connection with an amendment to the dapoxetine out-license agreement.
Total direct costs increased $97.8 million to $550.5 million in 2005 primarily as the result of an increase in the Development segment direct costs. Development direct costs increased $87.8 million to $467.0 million in 2005. The primary reason for this increase was an increase in personnel costs of $67.6 million due to hiring additional employees in our global CRO Phase II through IV division and increased costs in our foreign operations due to the weakening of the U.S. dollar. The remaining $20.2 million of this increase in Development direct costs primarily consisted of increased facility costs and higher subcontractor costs to support the growth in the global CRO Phase II through IV division.
Discovery Sciences direct costs increased $2.2 million to $8.4 million in 2005. The higher costs in 2005 related primarily to additional direct costs associated with the biomarker business acquired from SurroMed in February 2005.
R&D expenses increased $7.5 million to $23.4 million in 2005. R&D expenses increased primarily as a result of increased spending in the first half of the year in connection with the DPP4 program with Takeda, including a $2.5 million milestone payment made by us as a result of the commencement of the Phase II studies in April 2005. Based on the new DPP4 agreement with Takeda entered into in July 2005, Takeda is responsible for future development and commercialization costs for the DPP4 program. Thus, we do not expect to incur any material future R&D expense for the DPP4 program.
SG&A expenses increased $47.9 million to $251.1 million in 2005. As a percentage of total net revenue, SG&A expenses were 24.2% in both 2004 and 2005. The increase in SG&A expenses includes additional personnel costs of $31.0 million. The increase in personnel costs related mainly to training costs for new personnel, higher levels of operations infrastructure to manage direct personnel and changes in utilization levels. The increase in SG&A costs also includes an increase of $5.1 million in travel costs due to training initiatives for new and existing operations personnel and higher administrative travel expense. In addition, SG&A costs include $4.7 million in recruiting costs to hire additional personnel and an increase of $2.8 million in facility costs related to the increase in personnel.
Depreciation expense increased $10.5 million to $39.1 million in 2005. The increase was related to the depreciation of the property and equipment we acquired to accommodate our growth. Capital expenditures were $109.9 million in 2005. Capital expenditures included $30.5 million for our new corporate aircraft, $18.0 million for our new corporate headquarters facility in Wilmington, North Carolina, $20.6 million for computer software and hardware and $14.7 million for additional scientific equipment for our Phase I and laboratory units.
In 2004, we recorded a $2.6 million restructuring charge associated with exiting our chemistry facility in Research Triangle Park, North Carolina. These charges include lease payments and termination costs, net of sublease rentals, of approximately $2.1 million and a loss on sale of assets used in our chemistry services of approximately $0.5 million. The lease termination liability will be paid over the remaining life of the lease, which expires in 2015.
Income from operations increased $39.9 million to $176.7 million in 2005. As a percentage of net revenue, income from operations increased from 16.3% in 2004 to 17.0% in 2005. Income from operations in 2005 included a $15.0 million up-front payment from Takeda in connection with the DPP4 agreement, a $10.0 million milestone payment related to the filing of the dapoxetine NDA and a $5.1 million gain on exchange of assets associated with the acquisition of SurroMed’s biomarker business. Income from operations in 2005 was negatively impacted by the increase in R&D expenses discussed above and by approximately $3.3 million due to foreign currency fluctuation, primarily the weakening of the U.S. dollar relative to the euro and Brazilian real. Although these currency movements increased net revenue in the aggregate, the negative impact on income from operations is attributable to dollar-denominated contracts for services rendered in countries other than the United States. In these cases, revenue is not impacted by the weakening of the U.S. dollar, but the costs associated with performing these contracts and maintaining the foreign infrastructure, which are paid in local currency, increase when translated to U.S. dollars resulting in lower operating profits. During 2005, we recorded a foreign currency hedging loss of $1.7 million, resulting in a net impact to income from operations of $5.0 million attributable to foreign currency transactions. Income from operations in 2004 includes a $5.0 million dapoxetine milestone payment from ALZA and the $2.6 million restructuring charge discussed above.
During 2005, we recorded charges to earnings for other-than-temporary declines in the fair market value of our cost basis investments of $5.6 million, which included $1.6 million related to the outstanding balance of a revolving line of credit that was guaranteed by us, and our marketable equity securities of $0.3 million. The write-downs were due to a business failure, current fair market values, historical and projected performance and liquidity needs of the investees.
During 2004, we recorded a charge to earnings for an other-than-temporary decline in the fair market value of an investment of $2.0 million. We deemed our investment to be impaired as a result of the issuance of shares to new investors at a lower valuation than our original investment.
Our provision for income taxes increased $13.0 million to $59.9 million in 2005. Our effective income tax rate for 2004 was 33.8% compared to 33.3% for 2005. The effective tax rate for 2005 was positively impacted by a $6.9 million reduction in our valuation allowance provided for the deferred tax asset relating to capital loss carryforwards. The reduction was a result of the utilization of capital loss carryforwards that previously had a valuation allowance recorded against them as well as the recognition of capital gains for the dapoxetine NDA milestone payment from ALZA Corporation received in the first quarter of 2005 and the $15.0 million up-front payment received from Takeda during the third quarter of 2005 with respect to the DPP4 program. This reduction in the valuation allowance decreased the effective tax rate in 2005 by 3.5%. During 2004, our effective tax rate was positively impacted by the $3.7 million tax benefit which we recorded as a result of the utilization of capital loss carryforwards that previously had a valuation allowance recorded against them. The remaining difference in our effective rates for 2004 and 2005 is due to the change in the geographic distribution of our pretax earnings among locations with varying tax rates.
Net income of $119.9 million in 2005 represents an increase of $28.2 million from $91.7 million in 2004. Net income per diluted share of $1.03 in 2005 represents a 27.2% increase from net income per diluted share of $0.81 in 2004. Net income per diluted share for 2005 included $0.03 per share, net of tax, for the gain on exchange of assets associated with the acquisition of SurroMed’s biomarker business which was offset by $0.03 per share, net of tax, for impairment of equity investments.
Liquidity and Capital Resources
As of December 31, 2006, we had $179.8 million of cash and cash equivalents and $255.9 million of short-term investments. Our cash and cash equivalents 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, including our new corporate headquarters facility, repayment of the construction debt, expansion of services, possible acquisitions, investments and compound partnering collaborations, geographic expansion, dividends, working capital and other general corporate purposes. We have historically funded our operations, dividends and growth, including acquisitions, primarily with cash flow from operations. In the first quarter of 2006, we entered into a construction loan to finance the construction of our new corporate headquarters building and related parking facility in Wilmington, North Carolina.
In 2006, our operating activities provided $187.4 million in cash as compared to $182.1 million for the same period last year. The increase in cash flow from operations is due to a combination of increases and decreases in various line items of our cash flow statement. The primary increases in cash flow were due to a $36.8 million increase in net income, an increase in cash provided by unearned income of $16.0 million and an increase in the cash provided by the provision for deferred taxes of $13.3 million. These increases were partially offset by the decrease in cash flow as a result of an increase in the cash used for increased receivables of $54.2 million and the decrease in cash provided by accrued income taxes of $23.9 million. Fluctuations in receivables and unearned income occur on a regular basis as we perform services, achieve milestones or other billing criteria, send invoices to clients and collect outstanding accounts receivable. Such activity varies by individual client and contract.
In 2006, we used $265.7 million in cash related to investing activities. We used cash to purchase available-for-sale investments of $680.3 million, make capital expenditures of $148.0 million and purchase other investments of $1.8 million. These amounts were partially offset by maturities and sales of available-for-sale investments of $562.1 million, proceeds from the sale of an investment of $1.5 million and proceeds from the sale of property and equipment of $0.9 million. Our capital expenditures in 2006 primarily consisted of $73.5 million for
our new corporate headquarters building and related parking facility in Wilmington, North Carolina, $23.4 million for computer software and hardware, $16.1 million related to leasehold improvements at various sites, $8.9 million for additional scientific equipment for our Phase I and laboratory units and $8.7 million for our new building in Scotland. We expect our capital expenditures in 2007 will be approximately $105 million to $110 million, of which approximately $30 million will be related to the ongoing construction of our new headquarters building. The majority of the remaining forecasted capital expenditures are related to the up-fit costs for facilities of approximately $30 million, information technology expenditures and additional laboratory equipment.
In 2006, our financing activities provided $71.9 million in cash. We received $74.8 million in borrowings under our construction loan, $28.3 million in proceeds from stock option exercises and purchases under our employee stock purchase plan and $5.4 million in income tax benefits from the exercise of stock options and disqualifying dispositions of stock. These amounts were partially offset by repayment of borrowings under our revolving credit facility of $17.1 million, dividend payments of $12.3 million, repayments of $6.0 million on long-term debt and repayments of capital lease obligations of $1.3 million.
The following table sets forth amounts from our consolidated balance sheet affecting our working capital along with the dollar amount of the change from 2005 to 2006.
Working capital as of December 31, 2006 was $412.7 million, compared to $327.6 million at December 31, 2005. The increase in working capital was due primarily to the increase in short-term investments and accounts receivable and unbilled services. These increases were partially offset by increases in accounts payable, other accrued expenses, unearned income and current maturities of long-term debt and capital lease obligations.
The number of days’ revenue outstanding in accounts receivable and unbilled services, net of unearned income, also known as DSO, increased to 44.0 days for the year ended December 31, 2006 from 34.1 days for the year ended December 31, 2005. We calculate DSO by dividing accounts receivable and unbilled services less unearned income by average daily gross revenue for the applicable period. Accounts receivable, net of allowance for doubtful accounts, as of December 31, 2006 were $267.5 million. While DSO increased in part due to the increase
in accounts receivable, more than 90% of our accounts receivable balance as of December 31, 2006 was less than 60 days old. Unearned income as of December 31, 2006 was $195.7 million, which represented 47.9% of our accounts receivable and unbilled services balance. This percentage has decreased from December 31, 2005 when our unearned income of $162.7 million represented 53.6% of our accounts receivable and unbilled services balance. This decrease in unearned income as a percentage of receivables and unbilled services caused DSO to increase. DSO also rose in 2006 due to longer payment terms with some clients. We expect DSO will continue to fluctuate in the future depending on contract terms, the mix of contracts performed within a quarter, the levels of investigator advances and unearned income, and our success in collecting receivables.
We maintain a defined benefit pension plan for certain employees and former employees in the United Kingdom. This pension plan was closed to new participants as of December 31, 2002. The projected benefit obligation for the benefit plan at December 31, 2005 and December 31, 2006, as determined in accordance with SFAS No. 87, “Employers Accounting for Pensions”, was $41.8 million and $51.8 million, respectively, and the value of the plan assets was $29.3 million and $40.9 million, respectively. As a result, the plan was under-funded by $12.5 million in 2005 and by $10.8 million in 2006, respectively. The amount of contributions to the plan for the years ended December 31, 2005 and 2006 were $1.5 million and $3.2 million, respectively. It is likely that the amount of our contributions to the plan could increase in future years. We expect the pension cost to be recognized in our financial statements will decrease slightly from the $2.9 million in 2006 to approximately $2.1 million in 2007. The expense to be recognized in future periods could increase or decrease depending upon the change in the fair market value of the plan assets and changes in the projected benefit obligation.
A decrease in the market value of plan assets and/or declines in interest rates are likely to cause the amount of the under-funded status to increase. After completion of the actuarial valuations in 2007, we could be required to record an additional reduction to shareholders’ equity. In connection with the plan, we recorded a reduction to shareholders’ equity in 2005 of $1.6 million and an increase to shareholders’ equity in 2006 of $2.8 million, offset by a decrease of $3.3 million due to the adoption of SFAS No. 158. Given the impact that the discount rate and stock market performance have on the projected benefit obligation and market value of plan assets, future changes in either one of these factors could significantly reduce or increase the amount of our pension plan under-funding.
In July 2006, we renewed our $50.0 million revolving credit facility with Bank of America, N. A. Indebtedness under the facility is unsecured and subject to traditional covenants relating to financial ratios and restrictions on certain types of transactions. This revolving credit facility does not expressly restrict or limit the payment of dividends, and we do not expect any of the covenants to affect our ability to pay dividends under our cash dividend policy for the foreseeable future. We were in compliance with all loan covenants as of December 31, 2006. 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 2007, at which time any outstanding balance will be due. As of December 31, 2006, no amounts were outstanding under this credit facility, although the aggregate amount we are able to borrow had been reduced by $1.3 million due to outstanding letters of credit issued under this facility. As of February 15, 2007, we had borrowed approximately $25.0 million under this facility.
In February 2006, we entered into an $80.0 million construction loan facility with Bank of America, N.A. This construction loan facility is in addition to the $50.0 million revolving credit facility discussed above. Indebtedness under the construction loan facility is unsecured and is subject to the same covenants as the revolving credit facility and additional covenants commonly used in construction loan agreements. In addition, we must maintain at least $50.0 million in cash, cash equivalents and short-term investments while the loan is outstanding. We were in compliance with all loan covenants as of December 31, 2006. Borrowings under this credit facility are available to finance the construction of our new corporate headquarters building and related parking facility in Wilmington, North Carolina and bear interest at an annual fluctuating rate equal to the one-month LIBOR plus a margin of 0.6%. Interest on amounts borrowed under this construction loan facility is payable quarterly. This credit facility has a term of two years and will mature in February 2008, at which time the entire principal balance and all accrued and unpaid interest will be due. As of December 31, 2006, we had borrowed approximately $74.8 million under this facility. We expect to pay off this construction loan in full within the next 12 months and thus have shown this as a current liability on our consolidated balance sheet as of December 31, 2006.
On October 3, 2005, our Board of Directors adopted a cash dividend policy. We paid the first quarterly cash dividend under our dividend policy in the fourth quarter of 2005, and in each of the first three quarters of 2006, we paid a similar dividend of $0.025 per share. In October 2006, our Board of Directors amended the annual cash dividend policy to increase the annual dividend rate by 20 percent, from $0.10 to $0.12 per share, payable quarterly at a rate of $0.03 per share. The new dividend rate was effective beginning in the fourth quarter of 2006. The cash dividend policy and the payment of future quarterly cash dividends under that policy are not guaranteed and are subject to the discretion of and continuing determination by our Board of Directors that the policy remains in the best interests of our shareholders and in compliance with applicable laws and agreements.
In September 2005, we became a limited partner in Bay City Capital Fund IV, L.P., a venture capital fund formed to invest in life sciences companies. We have committed to invest up to a maximum of $10.0 million in this fund. Aggregate capital calls through December 31, 2006 totaled $3.2 million. Because no capital call can exceed 20% of our aggregate capital commitment, we anticipate that our remaining capital commitment of $6.8 million will be invested through a series of future capital calls over the next several years. Our capital commitment will expire in June 2009.
In November 2003, we became a limited partner in A. M. Pappas Life Science Ventures III, L.P., a venture capital fund formed to invest in life sciences, healthcare and technology industries. We have committed to invest up to a maximum of $4.8 million in this fund. Aggregate capital calls through December 31, 2006 totaled $1.2 million. Because no capital call can exceed 10% of our aggregate capital commitment, we anticipate that our remaining capital commitment of $3.6 million will be invested through a series of future capital calls over the next several years. Our capital commitment will expire in May 2009.
As of December 31, 2006, we had liabilities of $9.1 million for certain unsettled matters in connection with tax positions taken on our tax returns, including interpretations of applicable income tax laws and regulations. We establish a reserve when, despite management’s belief that our tax returns reflect the proper treatment of all matters, the treatment of certain tax matters is likely to be challenged. Significant judgment is required to evaluate and adjust the reserves in light of changing facts and circumstances. Further, a number of years may lapse before a particular matter for which we have established a reserve is audited and finally resolved. While it is difficult to predict the final outcome or the timing of resolution of any particular tax matter, management believes that the reserves of $9.1 million reflect the probable outcome of known tax contingencies. We believe it is unlikely that the resolution of these matters will have a material adverse effect on our financial position or results of operations.
We have been involved in compound development and commercialization collaborations since 1997. We developed a risk-sharing research and development model to help pharmaceutical and biotechnology clients develop compounds. Through collaborative arrangements based on this model, we assist our clients by sharing the risks and potential rewards associated with the development and commercialization of drugs at various stages of development. We currently have four such arrangements that involve the potential future receipt of one or more of the following: 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 still in development and have not been approved for sale in any country.
Our collaboration with ALZA Corporation, a subsidiary of Johnson & Johnson, for dapoxetine requires us to pay a royalty to Eli Lilly & Company of 5% on annual net sales of the compound in excess of $800 million. ALZA received a “not approvable” letter from the FDA in October 2005, but has continued its global development program and has indicated that it may file for approval in Europe as early as late 2007. As a result of the risks associated with drug development, including obtaining regulatory approval to sell in any country, the receipt of any further milestone payments, royalties or other payments is uncertain. During the first quarter of 2006, we earned a $15.0 million milestone payment under our DPP4 collaboration with Takeda.
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 and the payment of future cash dividends from existing cash, cash flows from operations and, if necessary or appropriate, borrowings under our existing or future credit facilities. We believe that these sources of liquidity will be sufficient to fund our operations and dividends for the foreseeable future. From time to time, we evaluate potential acquisitions, investments and other growth opportunities that might require additional external financing, and we might seek funds from public or private issuances of equity or debt securities. While we believe we have sufficient liquidity to fund our operations for the foreseeable future, our sources of liquidity and ability to pay dividends could be affected by our dependence on a small number of industries and clients; compliance with regulations; international risks; breach of contract, personal injury or other tort claims; environmental or intellectual property claims; or other factors described under “Item 1A. Risk Factors”, in this Item 7 under the subheadings “Contractual Obligations”, “Critical Accounting Policies and Estimates”, “Potential Liability and Insurance”, “Potential Volatility of Quarterly Operating Results and Stock Price” and under “Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
We are exposed to foreign currency risk by virtue of our international operations. We derived approximately 27.6%, 29.2% and 32.3% of our net revenues for the years ended December 31, 2004, 2005 and 2006, respectively, from operations outside the United States. We generally reinvest funds generated by each subsidiary in the country where they are earned, although in 2005, we repatriated $48.0 million of undistributed earnings in the form of dividends from our foreign affiliates under the American Jobs Creation Act of 2004. Our operations in the United Kingdom generated more than 28.3% of our net revenue from international operations during 2006. Accordingly, we are exposed to adverse movements in foreign currencies, predominately in the pound sterling.
The vast majority of our contracts are entered into by our U.S. or U.K. subsidiaries. The contracts entered into by the U.S. subsidiaries are almost always denominated in U.S. dollars. Contracts entered into by our U.K. subsidiaries are generally denominated in U.S. dollars, pounds sterling or euros, with the majority in U.S. dollars. Although an increase in exchange rates for the pound sterling or euro relative to the U.S. dollar would increase net revenue from contracts denominated in these currencies, a negative impact on income from operations results from dollar-denominated contracts for services rendered in countries other than the United States. In these cases, revenue is not impacted by the weakening of the U.S. dollar, but the costs associated with performing these contracts, which are paid in local currency, are negatively impacted when translated into U.S. dollars. In January 2004, we began entering into foreign currency hedging activities in an effort to manage our potential foreign exchange exposure. At December 31, 2006, no such hedging contracts were outstanding.
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 had increased by 10%, our foreign currency transaction loss would have increased by $2.8 million in the year ended December 31, 2006.
Our strategy for managing foreign currency risk relies primarily on receiving payment in the same currency used to pay expenses and from time to time using foreign currency derivatives, such as forward exchange contracts. As of December 31, 2006, we did not have any outstanding foreign exchange derivative contracts. If the U.S. dollar had weakened an additional 10% relative to the pound sterling, euro and Brazilian real in 2006, net income would have been approximately $9.4 million lower for the year based on 2006 revenues and the costs related to our foreign operations. During 2006, the net impact to income from operations was $3.6 million attributable to foreign currency transactions.
Changes in exchange rates between the applicable foreign currency and the U.S. dollar will affect the translation of foreign subsidiaries’ financial results into U.S. dollars for purposes of reporting our consolidated financial results. The process by which we translate each foreign subsidiary’s financial results to U.S. dollars is as follows:
•
we translate income statement accounts at average exchange rates for the period;
•
we translate balance sheet assets and liability accounts at end of period exchange rates; and
•
we translate equity accounts at historical exchange rates.
Translation of the balance sheet in this manner affects shareholders’ equity through the cumulative translation adjustment account. This account exists only in the foreign subsidiary’s U.S. dollar balance sheet and is necessary to keep the foreign balance sheet, stated in U.S. dollars, in balance. We report translation adjustments with accumulated other comprehensive income (loss) as a separate component of shareholders’ equity. To date, cumulative translation adjustments have not been material to our consolidated financial position. However, future translation adjustments could materially and adversely affect us.
Currently, there are no material exchange controls on the payment of dividends or otherwise prohibiting the transfer of funds out of or from within any country in which we conduct operations. Although we perform services for clients located in a number of foreign jurisdictions, we have not experienced any difficulties in receiving funds remitted from foreign countries. However, new or modified exchange control restrictions could have an adverse effect on our financial condition.
We are exposed to changes in interest rates on our cash, cash equivalents and short-term investments and amounts outstanding under notes payable and lines of credit. We invest our cash and cash equivalents in financial instruments with interest rates based on financial market conditions. We do not expect that a 10% change in interest rates in the future would have a material effect on our financial statements.
Item 8.
Item 8. Financial Statements and Supplementary Data
The information called for by this Item is set forth herein commencing on page.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. 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 last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Management’s Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining effective internal control over financial reporting as defined in Rules 13a-15(f) under the Securities Exchange Act of 1934. Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of management and our Board of Directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.
A control system, no matter how well designed and operated, can only provide reasonable, not absolute, assurance that the objectives of the control system are met and must reflect the fact that there are resource constraints that require management to consider the benefits of internal controls relative to their costs. Because of these inherent limitations, management does not expect that our internal controls over financial reporting will prevent all errors and all fraud. Also, internal controls might become inadequate because of changes in business conditions or a decline in the degree of compliance with our policies or procedures.
Management, with the participation of our Chief Executive Officer and Chief Financial Officer, assessed the effectiveness of our internal control over financial reporting as of December 31, 2006. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrated Framework. Based on our assessment, we believe that, as of December 31, 2006, our internal control over financial reporting was effective based on those criteria. Our independent registered public accounting firm, Deloitte & Touche LLP, has issued an attestation report on our assessment of our internal control over financial reporting, which follows.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of
Pharmaceutical Product Development, Inc. and Subsidiaries
Wilmington, North Carolina
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that Pharmaceutical Product Development, Inc. and subsidiaries (the
“Company”) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s Board of Directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2006 of the Company and our report dated February 26, 2007 expressed an unqualified opinion on those financial statements and included explanatory paragraphs relating to the adoption of Financial Accounting Standards Board (“FASB”) Statement No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106, and 132 (R)” and FASB Statement No. 123 (revised), “Share-Based Payment”.
/s/ DELOITTE & TOUCHE LLP
Raleigh, North Carolina
February 26, 2007
Item 9B.
Item 9B. Other information
None.
PART III
Certain information required by Part III is omitted from this report because the Registrant intends to file a definitive proxy statement for its 2007 Annual Meeting of Shareholders to be held on May 16, 2007 (the “Proxy Statement”) within 120 days after the end of its fiscal year pursuant to Regulation 14A promulgated under the Securities Exchange Act of 1934, as amended, and the information included therein is incorporated herein by reference to the extent provided below.
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The information required by Item 10 of Form 10-K concerning the Registrant’s executive officers is set forth under the heading “Executive Officers” located at the end of Part I of this Form 10-K.
The Board of Directors has determined that Frederick Frank, Stuart Bondurant and John A. McNeill, Jr., the members of the Finance and Audit Committee, are independent as defined in Rule 4200(a) (15) of the Nasdaq listing standards and Rule 10A-3 under the Securities Exchange Act of 1934. The Board of Directors has also determined that at least one committee member, namely Mr. Frank, is an “audit committee financial expert” as defined in Item 407(d)(5) of Regulation S-K.
Our Board of Directors has adopted a code of conduct that applies to all of our directors and employees. Our board has also adopted a separate code of ethics for our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer and Controller, or persons performing similar functions. We will provide copies of our code of conduct and code of ethics without charge upon request. To obtain a copy of the code of ethics or code of conduct, please send your written request to Pharmaceutical Product Development, Inc., 3151 South 17th Street, Wilmington, NC 28412, Attn: General Counsel.
The other information required by Item 10 of Form 10-K is incorporated by reference to the information under the headings “Proposal No. 1 - Election of Directors” and “Other Information-Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement.
Item 11.
Item 11. Executive Compensation
The information required by Item 11 of Form 10-K is incorporated by reference to the information under the heading “Other Information - Compensation of Non-Employee Directors”, “ - Director Compensation in Fiscal 2006,” “ - Executive Compensation”,” and “ - Compensation Committee Interlocks and Insider Participation” in the Proxy Statement.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Equity Compensation Plans
The following table sets forth the indicated information with respect to our equity compensation plans as of December 31, 2006:
(1) This includes 6,228,701 shares of stock available for issuance under our amended and restated Equity Compensation Plan and 2,255,473 shares available for issuance under our Employee Stock Purchase Plan.
The other information required by Item 12 of Form 10-K is incorporated by reference to the information under the heading “Other Information - Principal Shareholders” in the Proxy Statement.
Item 13.
Item 13. Certain Relationships and Related Transactions
The information required by Item 13 of Form 10-K is incorporated by reference to the information under the headings “Proposal No. 1 - Election of Directors - Nominees” and “Information About the Board of Directors and its Committees”, and “Other Information - Related Party Transactions” in the Proxy Statement.
Item 14.
Item 14. Principal Accountant Fees and Services
The information required by Item 14 of Form 10-K is incorporated by reference to the information under the heading “Other Information - Report of the Finance & Audit Committee” and “- Fees Paid to the Independent Registered Public Accounting Firm” in the Proxy Statement.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) Financial Statements
Our consolidated financial statements filed as part of this report are listed in the attached Index to Consolidated Financial Statements. There are no schedules to our consolidated financial statements.
(b) Exhibits
^ Confidential treatment requested for portions of this exhibit.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
Pharmaceutical Product Development, Inc. and Subsidiaries
Wilmington, North Carolina
We have audited the accompanying consolidated balance sheets of Pharmaceutical Product Development, Inc. and subsidiaries (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Pharmaceutical Product Development, Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Notes 1 and 10 to the consolidated financial statements, in 2006 the Company changed its method of accounting for stock-based compensation to conform to FASB Statement No. 123 (revised), “Share-Based Payment” and, retrospectively, adjusted the 2005 and 2004 financial statements for the change.
As discussed in Notes 1 and 12 to the consolidated financial statements, in 2006 the Company changed its method of accounting for its defined benefit pension plan to conform to FASB Statement No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106, and 132 (R)”.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 26, 2007 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
/s/ DELOITTE & TOUCHE LLP
Raleigh, North Carolina
February 26, 2007
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
(in thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31, 2005 AND 2006
(in thousands, except share data)
The accompanying notes are an integral part of these consolidated financial statements.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
(in thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
1. Summary of Operations and Significant Accounting Policies:
Nature of Business
Pharmaceutical Product Development, Inc. and its subsidiaries (collectively the “Company”) provide a broad range of research and development and consulting services through its Development and Discovery Sciences segments. In the Development segment, the Company provides a broad range of development services, which include preclinical programs and Phase I to IV clinical development services as well as bioanalytical product testing and clinical laboratory services. In addition, for marketed drugs, biologics and devices, the Company offers 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. The Discovery Sciences services include preclinical evaluations of anticancer and diabetes therapies, biomarker discovery and patient sample analyses and compound development and commercialization collaborations. The Company provides services to clients and partners in the pharmaceutical, biotechnology and medical device industries and to academic and government organizations. The Company markets its Development services primarily in the United States and Europe. The Company’s Discovery Sciences revenues have all been generated in the United States.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts and results of operations of the Company. All intercompany balances and transactions have been eliminated in consolidation.
Stock Split
On December 30, 2005, the Company’s Board of Directors approved a two-for-one stock split. The record date for the stock split was February 17, 2006. The distribution of shares was completed on February 28, 2006. All share and per share amounts for all periods presented in the accompanying consolidated financial statements have been adjusted to reflect the effect of this stock split.
Recent Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards, or SFAS, No. 123 (revised), “Share-Based Payment”, that requires compensation costs related to share-based payment transactions to be recognized in the financial statements. With limited exceptions, the amount of compensation cost is measured based on the fair value on the date of grant of the equity or liability instruments issued. In addition, the fair value of liability instruments is remeasured each reporting period. Compensation cost is recognized over the period that an employee provides service in exchange for the award. In March 2005, the SEC issued Staff Accounting Bulletin 107, which describes the SEC staff’s expectations in determining the assumptions that underlie the fair value estimates and discusses the interaction of SFAS No. 123 (revised) with existing SEC guidance. SFAS No. 123 (revised) became effective for fiscal years that began after June 15, 2005, so on January 1, 2006, the Company adopted the modified retrospective transition method permitted by the statement using the Black-Scholes option-pricing method it previously used in footnote disclosure. In accordance with the modified retrospective application method, the Company has adjusted its financial statements for all periods prior to January 1, 2006 to give effect to the fair-value based method of accounting for all awards granted in fiscal years beginning after December 15, 1994. Amounts previously disclosed as pro forma adjustments have been reflected in earnings for all prior periods. See Note 10 for further details.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
1. Summary of Operations and Significant Accounting Policies (continued):
Recent Accounting Pronouncements (continued)
In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligation”, or FIN 47, to clarify that the term “conditional asset retirement obligation” as used in SFAS No. 143 refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. An entity must recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. FIN 47 also defines when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN 47 is effective as of the end of fiscal years ending after December 15, 2005. The adoption of this statement did not have a material impact on the Company’s financial statements.
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections”, which changes the requirements for the accounting and reporting of a change in accounting principle. SFAS No. 154 applies to all voluntary changes in accounting principle as well as to changes required by an accounting pronouncement that does not include specific transition provisions. SFAS No. 154 requires that changes in accounting principle be retrospectively applied. SFAS No. 154 became effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company will apply SFAS No. 154 for changes occurring after January 1, 2006, as appropriate.
In June 2005, the Emerging Issues Task Force, or EITF, reached a consensus on EITF Issue 05-6, “Determining the Amortization Period for Leasehold Improvements Purchased after Lease Inception or Acquired in a Business Combination”. EITF 05-6 requires leasehold improvements purchased after the beginning of the initial lease term or that are acquired in a business combination to be amortized over the lesser of the useful life of the assets or a term that includes the original lease term plus any renewals that are reasonably assured at the date the leasehold improvements were purchased or acquired. In September 2005, the EITF clarified that this issue does not apply to preexisting leasehold improvements. This guidance was effective for leasehold improvements purchased or acquired in reporting periods beginning after June 29, 2005. The adoption of this statement did not have a material impact on the Company’s financial statements.
In October 2005, the FASB issued Staff Position FAS 13-1, “Accounting for Rental Costs Incurred During a Construction Period”, or FSP 13-1. FSP 13-1 states that rental costs associated with ground or building operating leases incurred during a construction period shall be recognized as rental expense and not capitalized. FSP 13-1 became effective for the first reporting period beginning after December 15, 2005. The adoption of this statement did not have a material impact on the Company’s financial statements.
In November 2005, the FASB issued Staff Position FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments”. This statement addresses the determination as to when an investment is considered impaired, whether the impairment is other-than-temporary and the measurement of an impairment loss. The statement became effective for reporting periods beginning after December 15, 2005. The adoption of this statement did not have a material impact on the Company’s financial statements.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
1. Summary of Operations and Significant Accounting Policies (continued):
Recent Accounting Pronouncements (continued)
In June 2006, the EITF reached a consensus on EITF Issue 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)”, which addresses the income statement disclosure of taxes assessed by a governmental authority that are directly imposed on a revenue-producing transaction between a seller and a customer. Taxes within the scope of EITF 06-3 include sales taxes, use taxes, value-added taxes, and some types of excise taxes. For any such taxes that are reported on a gross basis, a company should disclose the amounts of those taxes in interim and annual financial statements for each period for which an income statement is presented if those amounts are significant. EITF 06-3 will be effective for interim and annual reporting periods beginning after December 15, 2006. The Company already accounts for taxes on a net basis. Therefore, EITF 06-3 will not have a material impact on the Company’s financial statements.
In June 2006, the FASB issued Staff Position FIN 46(R)-6, “Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)”, or FSP FIN 46(R)-6, which introduces a “by-design” approach in determining variability. FSP FIN 46(R)-6 provides a two-step approach: 1) analyze the nature of the risk in the entity; and 2) determine the purpose(s) for which the entity was created and determine the variability. This standard is applicable for all entities (including newly created entities) with which an enterprise first becomes involved, and for all entities previously required to be analyzed under FIN 46(R) when a reconsideration event has occurred beginning the first day of the reporting period beginning after June 15, 2006. The Company adopted the provisions of FSP FIN 46(R)-6 on July 1, 2006 and the statement did not have a material impact on the Company’s financial statements.
In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109”, or FIN 48, which clarifies the accounting for uncertainty in tax positions. FIN 48 requires that the Company recognize in its financial statements the impact of a tax position, if that position will more likely than not be sustained on audit, based on the technical merits of the position. The provisions of FIN 48 also provide a measurement attribute for the financial statement recognition of the tax position. FIN 48 will be effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating and has not determined the impact of the adoption of FIN 48 on its financial statements.
In September 2006, the FASB issued SFAS 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 beginning after November 15, 2007 and interim periods within those years. The Company is currently evaluating and has not determined the impact of the adoption of SFAS No. 157 on its financial statements.
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. This standard requires employers to recognize the underfunded or overfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in the funded status in the year in which the changes occur through accumulated other comprehensive income. Additionally, 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 recognition of an asset and liability related to the funded status of a plan and the new disclosure provisions of SFAS No. 158 are effective for fiscal years ending after December 15, 2006. 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 Company adopted the provisions of SFAS No. 158 and the impact on its financial statements are disclosed in Note 12.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
1. Summary of Operations and Significant Accounting Policies (continued):
Recent Accounting Pronouncements (continued)
In September 2006, the SEC staff issued Staff Accounting Bulletin 108 “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements”, or SAB 108, which requires that companies utilize a “dual-approach” when quantifying and evaluating the materiality of financial misstatements. This dual approach includes both an income statement focused assessment and a balance sheet focused assessment. The guidance in SAB 108 must be applied to annual financial statements for fiscal years ending after November 15, 2006. The adoption of this statement did not have a material impact on the Company’s financial statements.
Revenue Recognition
The Company records revenue from contracts, other than time-and-material contracts, on a proportional performance basis in its Development and Discovery Sciences segments. To measure performance on a given date, the Company compares effort expended through that date to estimated total effort to complete the contract. The Company believes this is the best indicator of the performance of the contractual obligations because the costs relate primarily to the amount of labor incurred to perform the service. Changes to the estimated total contract direct costs result in a cumulative adjustment to the amount of revenue recognized. For time-and-material contracts in both its Development and Discovery Sciences segments, the Company recognizes revenue as hours are worked, multiplied by the applicable hourly rate. For the Company’s Phase I, laboratory and biomarker businesses, the Company recognizes revenue from unitized contracts as subjects or samples are tested, multiplied by the applicable unit price. The Company offers volume discounts to its large customers based on annual volume thresholds. Revenue is reported net of volume discounts provided to clients.
In connection with the management of clinical trials, the Company pays, on behalf of its clients, fees to investigators and test subjects as well as other out-of-pocket costs for items such as travel, printing, meetings and couriers and its clients reimburse the Company for these costs. As required by EITF 01-14, amounts paid by the Company as a principal for out-of-pocket costs are included in direct costs as reimbursable out-of-pocket expenses and the reimbursements the Company receives as a principal are reported as reimbursed out-of-pocket revenue. In the statements of operations, the Company combines amounts paid by the Company as an agent for out-of-pocket costs with the corresponding reimbursements, or revenue, the Company receives as an agent. During the years ended December 31, 2004, 2005 and 2006, fees paid to investigators and other fees the Company paid as an agent and the associated reimbursements were approximately $226.9 million, $279.8 million and $292.6 million, respectively.
Most of the Company’s contracts can be terminated by the client either immediately or after a specified period following notice. These contracts typically require payment to the Company of expenses to wind down a study, fees earned to date and, in some cases, a termination fee or some portion of the fees or profit that the Company could have earned under the contract if it had not been terminated early. Therefore, revenue recognized prior to cancellation does not generally require a significant adjustment upon cancellation. If the Company determines that a loss will result from the performance of a fixed-price contract, the entire amount of the estimated loss is charged against income in the period in which 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. The Company only recognizes 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 are not required.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
1. Summary of Operations and Significant Accounting Policies (continued):
Cash and Cash Equivalents
Cash and cash equivalents consist of unrestricted cash accounts that are not subject to withdrawal restrictions or penalties and all highly liquid investments rated A or better by Standard & Poor’s or Moody’s and that have a maturity of three months or less at the date of purchase.
Supplemental cash flow information consisted of the following:
See Note 2 for non-cash investing and financing activities related to the 2005 acquisition of biomarker services from SurroMed, Inc.
Payables to Investigators and Investigator Advances
Billings and payments to investigators are based on contractual agreements that can differ from the accrual of the related costs. The Company generally recognizes investigator costs based upon the status of the work completed as a percentage of the total procedures required under the contract or based on patient enrollment over the term of the contract. The Company classifies payments made in excess of the accrued costs as investigator advances and accrued costs in excess of amounts paid as payables to investigators in its consolidated balance sheets.
Inventory
The Company values inventories, which consist principally of laboratory supplies, at the lower of cost (first-in, first-out method) or market. As of December 31, 2005 and 2006, prepaid expenses and other current assets included inventories totaling $2.3 million and $2.7 million, respectively.
Property and Equipment
Property and equipment are stated at cost less accumulated depreciation. Depreciation is recorded using the straight-line method, based on estimated useful lives of 40 to 50 years for buildings, five years for laboratory equipment, two to five years for software, computers and related equipment and five to ten years for furniture and equipment, except for aircrafts which are depreciated over 30 years. Leasehold improvements are depreciated over the shorter of the respective lives of the leases or the useful lives of the improvements. Property under capital leases is depreciated over the life of the lease or the service life, whichever is shorter.
Internal Use Software
The Company accounts for internal use software in accordance with the provisions of AICPA Statement of Position No. 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use”, which requires certain direct costs and interest costs incurred during the application stage of development to be capitalized and amortized over the useful life of the software.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
1. Summary of Operations and Significant Accounting Policies (continued):
Operating Leases
The Company records rent expense for operating leases, some of which have escalating rentals over the term of the lease, on a straight-line basis over the initial effective lease term. The Company begins amortization on the date of initial possession, which is generally when the Company enters the space and begins to make improvements in preparation of intended use. The Company accounts for the difference between rent expense and rent paid as deferred rent. For tenant improvement allowances, rent holidays and other lease incentives, the Company records a deferred rent liability at the inception of the lease term and amortizes the deferred rent over the term of the lease as a reduction to rent expense.
Goodwill
The excess of the purchase price of a business acquired over the fair value of net tangible assets, identifiable intangible assets and acquired in-process research and development costs at the date of the acquisition has been assigned to goodwill. In accordance with SFAS 142, “Goodwill and Other Intangible Assets”, the Company evaluates goodwill for impairment on an annual basis or more frequently if events or changes in circumstances indicate that goodwill might be impaired.
Realizability of Carrying Value of Long-Lived Assets
The Company reviews the recoverability of long-lived and finite-lived intangible assets when circumstances indicate that the carrying amount of assets may not be recoverable. This evaluation is based on various analyses, including undiscounted cash flow projections. In the event undiscounted cash flow projections indicate impairment, the Company would record an impairment based on the fair value of the assets at the date of the impairment. In 2004, 2005 and 2006, the Company recorded no material impairments of long-lived assets.
Short-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 investments are classified as available-for-sale securities due to management’s intent regarding these securities. The Company determines realized and unrealized gains and losses on short-term investments on a specific identification basis.
Investments
The Company has equity investments in publicly traded entities. The Company classifies investments in publicly traded entities 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 an other-than-temporary decline has occurred. The market value of the Company’s equity investments in publicly traded entities is based on the closing price as quoted by the applicable stock exchange or market on the last day of the reporting period. The Company’s equity investments in publicly traded companies are classified as long-term assets due to the Company’s ability to hold its investments long-term, the strategic nature of the investment and the lack of liquidity in the public markets for these securities.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
1. Summary of Operations and Significant Accounting Policies (continued):
Investments (continued)
The Company also has investments in privately held entities in the form of equity and convertible debt instruments that are not publicly traded and for which fair values are not readily determinable. The Company records all of its investments in private entities under the cost method of accounting. The Company 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, among other things, the market condition of the overall industry, historical and projected financial performance, expected cash needs and recent funding events. This impairment analysis requires significant judgment.
Unbilled Services and Unearned Income
In general, prerequisites for billings are established by contractual provisions, including predetermined payment schedules, the achievement of contract milestones or submission of appropriate billing detail. Unbilled services represent revenue recognized to date for which amounts are currently unbillable to the customer pursuant to contractual terms. Conversely, unearned income is recorded for cash received from customers for which revenue has not been recognized at the balance sheet date.
Income Taxes
Income taxes are computed using the asset and liability approach, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company’s financial statements or tax returns. In estimating future tax consequences, the Company generally considers all expected future events other than enactment of changes in tax law or rates. If it is more likely than not that some or all of a deferred tax asset will not be realized, the Company records a valuation allowance.
Concentration of Credit Risk
SFAS No. 105, “Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk”, requires disclosure of information about financial instruments with off-balance-sheet risk and financial instruments with concentrations of credit risk. Financial instruments that subject the Company to concentrations of credit risk consist principally of accounts receivable, cash equivalents and short-term investments.
The Company’s clients are primarily pharmaceutical and biotechnology companies and academic and government organizations. No single client accounted for more than 10% of the Company’s net revenue in 2004, 2005 or 2006. Concentrations of credit risk with respect to accounts receivable are limited to a degree due to the large number of clients comprising the Company’s client base. No single client accounted for more than 10% of the Company’s accounts receivable balance as of December 31, 2005 or 2006. The Company performs ongoing credit evaluations of clients’ financial condition and, generally, does not require collateral. The Company maintains allowances for potential credit losses and these losses, in the aggregate, have historically not exceeded estimates.
The Company’s cash equivalents consist principally of commercial paper. Bank deposits exceed the FDIC insurance limit. Based on the nature of the financial instruments and/or historical realization of these financial instruments, the Company believes they bear minimal credit risk. At December 31, 2006, short-term investments were generally triple-A rated municipal and government securities.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
1. Summary of Operations and Significant Accounting Policies (continued):
Comprehensive Income
The Company has elected to present comprehensive income and its components in the statements of shareholders’ equity. The components of comprehensive income are net income and all other non-owner changes in equity.
The balances in accumulated other comprehensive income were as follows:
Foreign Currency Translations and Transactions
The Company translates assets and liabilities of foreign operations, where the functional currency is the local currency, into U.S. dollars at the rate of exchange at each reporting date. The Company translates income and expenses at the average rates of exchange prevailing during the month in which a transaction occurs. Gains or losses from translating foreign currency financial statements are recorded in other comprehensive income. The changes in cumulative translation adjustment included in other comprehensive income for the years ended December 31, 2004, 2005 and 2006 totaled $6.2 million, $(10.1) million and $9.7 million, respectively. Foreign currency transaction gains and losses are included in other income, net. Foreign currency transaction gains during 2004, 2005 and 2006 were $2.6 million, $2.1 million and $2.8 million, respectively. Foreign currency transaction losses during 2004, 2005 and 2006 were $3.3 million, $2.4 million and $4.9 million, respectively.
Earnings Per Share
The Company computes basic income per share information based on the weighted average number of common shares outstanding during the year. The Company computes diluted income per share information based on the weighted average number of common shares outstanding during the year plus the effects of any dilutive common stock equivalents. Excluded from the calculation of earnings per diluted share were 3,778,600 shares, 215,800 shares and 130,100 shares during 2004, 2005 and 2006, respectively, because they were antidilutive.
Stock-Based Compensation
Prior to January 1, 2006, the Company accounted for its stock-based compensation plan in accordance with the intrinsic value provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”, or APB No. 25, and provided the required pro forma disclosures of SFAS No. 123, “Accounting for Stock-Based Compensation”. Accordingly, because all stock options granted had an exercise price equal to the market value of the underlying common stock on the date of the grant, the Company recognized no expense related to employee stock options. Because the Company considered the employee stock purchase plan noncompensatory, the Company recognized no expense related to this plan. The Company recognized expense related to the grant of restricted stock in the consolidated statements of operations as required under APB No. 25.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
1. Summary of Operations and Significant Accounting Policies (continued):
Stock-Based Compensation (continued)
Effective January 1, 2006, the Company adopted SFAS No. 123 (revised) using the modified retrospective application method. Accordingly, the Company measures stock-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. In accordance with the modified retrospective application method, the Company has adjusted its financial statements for all periods prior to January 1, 2006 to give effect to the fair-value based method of accounting for all awards granted in fiscal years beginning after December 15, 1994. Amounts previously disclosed as pro forma adjustments have been reflected in earnings for all prior periods. The details of the impact of the retrospective application of SFAS No. 123 (revised) on previously reported amounts in the consolidated statements of operations and the consolidated balance sheet are shown in Note 10.
Advertising Costs
The Company charges advertising costs to operations as incurred. Advertising costs were approximately $0.8 million, $0.8 million and $0.9 million for the years ended December 31, 2004, 2005 and 2006, respectively.
Research and Development Costs
The Company charges research and development costs to operations as incurred. Research and development costs are disclosed on the consolidated statements of operations.
Restructuring Charges
In 2004, the Company recorded a $2.6 million restructuring charge associated with exiting the Company’s chemistry facility in Research Triangle Park, North Carolina. These charges include lease payments and termination costs, net of sublease rentals, of approximately $2.1 million and a loss on sale of assets used in the chemistry services of approximately $0.5 million. The Company will pay the lease termination liability over the remaining life of the lease which will end in 2015. During 2004, 2005 and 2006, the Company paid lease payments, termination costs and related expenses of $0.9 million, $0.9 million and $0.1 million, respectively. The restructuring liability of $0.3 million as of December 31, 2005 and 2006 is reported in the consolidated balance sheets as a component of other accrued expenses and deferred rent and other.
Reclassifications
The Company has reclassified certain 2004 and 2005 financial statement amounts to conform to the 2006 financial statement presentation.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
2. Acquisitions:
In February 2005, the Company completed its acquisition of substantially all of the assets of SurroMed, Inc.’s biomarker business. This biomarker business is part of the Discovery Sciences segment of the Company. In exchange for the assets, the Company surrendered to SurroMed all shares of preferred stock of SurroMed it held. As additional consideration for the acquisition, the Company assumed approximately $3.4 million of SurroMed liabilities under capital leases and additional operating liabilities, and agreed to guarantee repayment of up to $1.5 million under a SurroMed bank loan. In accordance with the requirements of FASB Statement No. 5, “Accounting for Contingencies”, as clarified by FASB Interpretation No. 45, the Company recorded a liability for the estimated fair value of the net obligation it assumed under this guarantee. The Company’s guarantee expired on December 31, 2006. In connection with the acquisition, the Company recognized a pre-tax gain on exchange of assets of $5.1 million, primarily related to the $4.9 million gain on the termination of a preexisting facility lease arrangement with SurroMed in accordance with EITF 04-01, “Accounting for Preexisting Relationships between the Parties to a Business Combination”. The fair value of the leasing arrangement was determined based on the discounted cash flows of the difference between the future required rental payments under the lease agreement and the current market rate for similar facilities.
This acquisition was accounted for using the purchase method of accounting, utilizing appropriate fair value techniques to allocate the purchase price based on the estimated fair values of the assets and liabilities. Accordingly, the estimated fair value of assets acquired and liabilities assumed were included in the Company’s consolidated balance sheet as of the effective date of the acquisition.
The total purchase price for the SurroMed acquisition in 2005 was allocated to the estimated fair value of assets acquired and liabilities assumed as set forth in the following table:
Goodwill related to SurroMed is deductible for tax purposes.
The results of operations from the biomarker assets acquired are included in the Company’s consolidated statements of operations as of and since February 1, 2005, the effective date of the acquisition. Pro forma results of operations for the full year ended December 31, 2005 have not been presented because the financial results related to the biomarker assets for the one-month period ended January 31, 2005 are not material to the consolidated statements of operations.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
3. Accounts Receivable and Unbilled Services:
Accounts receivable and unbilled services consisted of the following amounts on the dates set forth below:
The Company derived 20.1% and 22.6% of its accounts receivable and unbilled services from operations outside the United States as of December 31, 2005 and 2006, respectively. Of these amounts, the Company derived 70.4% and 65.3% from operations in the United Kingdom as of December 31, 2005 and 2006, respectively.
Change in provision for doubtful accounts consisted of the following:
4. Property and Equipment:
Property and equipment, stated at cost, consisted of the following amounts on the dates set forth below:
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
4. Property and Equipment (continued):
Capitalized costs for the new corporate headquarters facility in Wilmington, North Carolina, included in construction in progress as of December 31, 2005 and 2006 were $19.7 million and $104.5 million, respectively. In February 2006, the Company entered into an $80.0 million construction loan facility with Bank of America, N.A. Borrowings under this credit facility are available to finance the construction of the Company’s new corporate headquarters building and related parking facility. As of December 31, 2006, the Company had borrowed $74.8 million under this credit facility. During 2005 and 2006, the Company capitalized interest of approximately $0.1 million and $2.5 million, respectively, relating to the construction of the new corporate headquarters facility.
In connection with the purchase of the 7.5-acre tract of land for the Company’s new headquarters building, the Company guaranteed an $8.0 million bank loan to the seller, Almont Shipping Company, in order to refinance existing liens on the property. This loan was secured by a lien on substantially all of Almont’s assets, including a 28-acre tract of land adjacent to the tract the Company acquired. During 2006, Almont filed for bankruptcy and the Company was required to perform under its guarantee by purchasing the note and related loan documents for approximately $7.4 million. The Company subsequently refinanced the note with a new buyer. In December 2006, the Company received all remaining principal and interest due on the note.
The Company owned a building in Kersewell, Scotland, with a net book value of $1.3 million as of December 31, 2006. This building was classified as available for sale and was included in prepaid expenses and other current assets on its consolidated balance sheet as of December 31, 2006. This building was used to house employees performing work in the Development segment of the Company. In January 2007, the Company sold this building for approximately $1.4 million resulting in a gain of $0.1 million.
In 2006, the Company disposed of property and equipment in its Discovery segment which resulted in a loss on disposal of assets of $0.8 million. The Company also recorded an impairment of $0.4 million related to the value of its building in Leicester, United Kingdom, which was the site of the Company’s former U.K. Phase I operations. The Company’s Phase I operations are included in its Development segment. The Company determined fair value of these assets based on comparable market prices for similar assets. These amounts are included in loss on impairment and disposal of assets in the Company’s consolidated statements of operations.
Property and equipment under capital leases, stated at cost, consisted of the following amounts on the dates set forth below:
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
5. Goodwill and Intangible Assets:
Changes in the carrying amount of goodwill for the twelve months ended December 31, 2005 and 2006, by operating segment, were as follows:
Information regarding the Company’s other intangible assets follows:
The Company amortizes all intangible assets on a straight-line basis, based on estimated useful lives of three to five years for backlog and customer relationships and three to ten years for license and royalty agreements. The weighted average amortization period is 4.1 years for backlog and customer relationships, 6.2 years for license and royalty agreements and 5.9 years for all intangibles collectively.
Amortization expense for the twelve months ended December 31, 2004, 2005 and 2006 was $1.2 million, $1.1 million and $0.6 million, respectively. As of December 31, 2006, estimated amortization expense for each of the next five years was as follows:
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
6. Short-term Investments and Investments:
Short-term investments, which are composed of available-for-sale securities, and investments consisted of the following amounts on the dates set forth below:
Short-term Investments
As of December 31, 2005, the Company’s short-term investments consisted of Auction Rate Securities, or ARS. Since the fair market value equaled the adjusted cost, there were no unrealized gains or losses associated with these investments as of December 31, 2005.
At December 31, 2006, the Company had short-term investments in ARS, various other debt securities and preferred stock. As of December 31, 2006, unrealized gains associated with these investments were $0.2 million and unrealized losses were $0.3 million. The gross realized gains on these securities in 2004, 2005 and 2006 were $0.6 million, $0 and $0, respectively, and there were no gross realized losses.
The estimated fair value of short-term investment securities at December 31, 2006, by contractual maturity, were as follows:
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
6. Short-term Investments and Investments (continued):
Investments
The Company had long-term investments in marketable securities as of December 31, 2005 and 2006. As of December 31, 2005 and 2006, gross unrealized gains were $8.5 million and $0.7 million, respectively. There were no gross unrealized losses as of December 31, 2005 or 2006.
During 2005, the Company recorded charges to earnings for other-than-temporary declines in the fair market value of its cost basis investments of $5.6 million, which included $1.6 million related to the outstanding balance of a revolving line of credit that was guaranteed by the Company, and its marketable equity securities of $0.3 million. The write-downs were due to a business failure, current fair market values, historical and projected performance and liquidity needs of the investees.
During 2004, the Company recorded a charge to earnings of $2.0 million for an other-than-temporary decline in the fair market value of its investment in Chemokine Therapeutics Corp. The write-down of Chemokine was recorded based primarily on its historical and projected financial performance and issuances of shares to new investors at lower valuations than the Company’s recorded value.
In September 2005, the Company became a limited partner in Bay City Capital Fund IV, L.P., a venture capital fund established in July 2004 for the purpose of investing in life sciences companies. The Company has committed to invest up to a maximum of $10.0 million in this fund. Aggregate capital calls through December 31, 2006 were $3.2 million. Because no capital call can exceed 20% of the Company’s aggregate capital commitment, the Company anticipates its remaining capital commitment of $6.8 million will be made through a series of future capital calls over the next several years. The Company owned approximately 2.9% of the Bay City Fund IV as of December 31, 2006. The Company’s capital commitment will expire in June 2009.
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. The Company has committed to invest up to a maximum of $4.8 million in this fund. Aggregate capital calls through December 31, 2006 were $1.2 million. Because no capital call can exceed 10% of the Company’s aggregate capital commitment, the Company anticipates that its remaining capital commitment of $3.6 million will be made through a series of future capital calls over the next several years. The Company owned approximately 4.7% of the Pappas Fund as of December 31, 2006. The Company’s capital commitment will expire in May 2009.
In June 2002, the Company purchased approximately 0.7 million units of BioDelivery Sciences International, Inc. Each unit consisted of one share of common stock and one warrant for common stock. The Company’s ownership of common stock of BioDelivery Sciences International represented an ownership interest of approximately 4.9% in BioDelivery Sciences International’s outstanding common stock as of December 31, 2006. BioDelivery Sciences International is a publicly traded company that is developing and seeking to commercialize a drug delivery technology designed for a potentially broad base of pharmaceuticals, vaccines and over-the-counter drugs.
In April 2003, the Company purchased 2.0 million shares of Chemokine Therapeutics Corp. Series A convertible preferred stock. In December 2004, Chemokine completed an initial public offering of its common stock in Canada. In May 2006, the Company sold its 2.0 million shares of Chemokine Therapeutics Corp. preferred stock for total consideration of $1.5 million and recorded a gain on sale of its investment of $0.8 million in other income, net, in the Company’s consolidated statements of operations. In addition, the Company surrendered its license rights to Chemokine’s compound CTCE-0214 in exchange for $0.1 million and potential milestone payments up to $2.5 million.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
6. Short-term Investments and Investments (continued):
Investments (continued)
In 2004 and 2005, the Company purchased 15.0 million shares of Accentia Biopharmaceuticals, Inc. Series E convertible preferred stock. Accentia’s Series E convertible preferred stock paid a dividend based on a percentage of net sales of certain Accentia products. The Company received dividends in excess of Accentia’s earnings in 2004 and 2005 and thus recorded these as a reduction of cost of the investment in Accentia. On October 28, 2005, Accentia completed its initial public offering of 2.4 million shares of common stock for $8.00 per share. Upon completion of the initial public offering, the Company’s 15.0 million shares of Series E convertible preferred stock were converted to 4.3 million shares of common stock. The Company owned approximately 13.5% of the outstanding capital stock of Accentia as of December 31, 2006. Accentia is a specialty biopharmaceutical company focused on the development and commercialization of late-stage clinical products in the areas of respiratory disease and oncology.
7. Other Accrued Expenses:
Other accrued expenses consisted of the following amounts on the dates set forth below:
8. Long-Term Debt, Line of Credit and Lease Obligations:
Long-Term Debt
Long-term debt consisted of the following amounts on the dates set forth below:
The Company previously had a note payable related to a laboratory building in Brussels, Belgium. This note was assumed in the acquisition of Medical Research Laboratories International, Inc. in February 2002. In May 2006, the Company paid the $5.9 million unpaid balance and retired the note.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
8. Long-Term Debt, Line of Credit and Lease Obligations (continued):
Revolving Credit Facility
In July 2006, the Company renewed its $50.0 million revolving line of credit facility with Bank of America, N.A. Indebtedness under the facility is unsecured and subject to traditional covenants relating to financial ratios and restrictions on certain types of transactions. This revolving credit facility does not expressly restrict or limit the payment of dividends. The Company was in compliance with all loan covenants as of December 31, 2006. 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 2007, at which time any outstanding balance will be due. As of December 31, 2006, no amounts were outstanding under this credit facility, although the aggregate amount available for borrowing had been reduced by $1.3 million due to outstanding letters of credit issued under this facility. As of February 15, 2007, the Company had borrowed approximately $25.0 million under this facility.
Construction Loan Facility
In February 2006, the Company entered into an $80.0 million construction loan facility with Bank of America, N.A. This construction loan facility is in addition to the $50.0 million revolving credit facility discussed above. Indebtedness under the construction loan facility is unsecured and is subject to the same covenants as the revolving credit facility and additional covenants commonly used in construction loan agreements. In addition, the Company must maintain at least $50.0 million in cash, cash equivalents and short-term investments while the loan is outstanding. The Company was in compliance with all loan covenants as of December 31, 2006. Borrowings under this credit facility are available to finance the construction of the Company’s new corporate headquarters building and related parking facility in Wilmington, North Carolina, and bear interest at an annual fluctuating rate equal to the one-month LIBOR plus a margin of 0.6%. Interest on amounts borrowed under this construction loan facility is payable quarterly. This credit facility has a term of two years and will mature in February 2008, at which time the entire principal balance and all accrued and unpaid interest will be due. However, the Company has classified these borrowings as short-term due to management’s intent to pay off the loan in full in 2007. As of December 31, 2006, the Company had borrowed approximately $74.8 million under this credit facility.
Lease Obligations
The Company is obligated under noncancellable operating leases expiring at various dates through 2021 relating to its buildings and certain equipment. Rental expense for all operating leases, net of sublease income of $2.1 million, $1.1 million and $1.5 million, was $30.3 million, $37.5 million and $44.3 million for the years ended December 31, 2004, 2005 and 2006, respectively.
Certain facility leases provide for concessions by the landlords, including payments for leasehold improvements and free rent periods. These concessions have been reflected as deferred rent and other in the accompanying consolidated financial statements. The Company is recording rent expense on a straight-line basis for these leases.
The Company has also assumed capital lease obligations in connection with its acquisition of SurroMed, Inc. in February 2005.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
8. Long-Term Debt, Line of Credit and Lease Obligations (continued):
Lease Obligations (continued)
As of December 31, 2006, future minimum payments for all lease obligations for years subsequent were as follows:
In March 2005, the Company entered into a lease for additional space in Austin, Texas for its Phase II through IV operations. The additional space is adjacent to the Company’s Phase I clinic. To induce the Company to enter into the lease for additional space, the landlord deposited $5.5 million into an escrow account to be used to reimburse the Company for the rent and other expenses paid by the Company under the lease for the existing facilities after July 1, 2005 and the costs and expenses to sublease those facilities. The Company accounted for the amount to be received from the escrow account as a lease incentive that would be recognized in income over the life of the ten-year term of the lease. In April 2006, the Company and the landlord agreed to settle a dispute relating to this escrow account. Under the terms of the settlement, the Company received $4.3 million in full and final settlement of all claims.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
9. 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 “Accounting for Derivative Instruments and Hedging Activities”. 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. The fair market value of the hedged exposure is presumed to be the market value of the hedge instrument when critical terms match. The Company’s hedging portfolio had no ineffectiveness during 2004, 2005 or 2006.
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, from time to time the Company purchases currency option and forward contracts as cash flow hedges to help manage certain foreign currency exposures that can be identified and quantified. Pursuant to its foreign exchange risk hedging policy, the Company may hedge anticipated and recorded transactions, and the related receivables and payables denominated in non-functional currencies, using forward foreign exchange rate contracts and foreign currency options. The Company’s policy is to only use foreign currency derivatives 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 twelve months from their inception.
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 December 31, 2006, no such hedging contracts were outstanding.
The Company also enters into foreign currency forward contracts to hedge against changes in the fair value of monetary assets and liabilities denominated in a non-functional currency. These derivative instruments are not designated as hedging instruments; therefore, the Company recognizes changes in the fair value of these contracts immediately in other income, net, as an offset to the changes in the fair value of the monetary assets or liabilities being hedged. At December 31, 2006, no such contracts were outstanding.
At December 31, 2005 and 2006, the Company’s foreign currency derivative portfolio resulted in the Company recording a loss of $0.8 million and $0, respectively, recorded as a component of other accrued expenses.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
10. Stock Plans:
Adoption of Statement of Financial Accounting Standard No. 123 (R)
Prior to January 1, 2006, the Company accounted for its stock-based compensation plan in accordance with the intrinsic value provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”, or APB No. 25, and provided the required pro forma disclosures of SFAS No. 123, “Accounting for Stock-Based Compensation”. Accordingly, because all stock options granted had an exercise price equal to the market value of the underlying common stock on the date of the grant, the Company recognized no expense related to employee stock options. Because the Company considered the employee stock purchase plan noncompensatory, the Company recognized no expense related to this plan. The Company recognized expense related to the grant of restricted stock in the consolidated statements of operations as required under APB No. 25.
Effective January 1, 2006, the Company adopted SFAS No. 123 (revised) using the modified retrospective application method. Accordingly, the Company measures stock-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. In accordance with the modified retrospective application method, the Company has adjusted its financial statements for all periods prior to January 1, 2006 to give effect to the fair-value based method of accounting for all awards granted in fiscal years beginning after December 15, 1994. Amounts previously disclosed as pro forma adjustments have been reflected in earnings for all prior periods.
The following table details the impact of retrospective application of SFAS No. 123 (revised) on previously reported amounts:
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
10. Stock Plans (continued):
Adoption of Statement of Financial Accounting Standard No. 123 (R) (continued)
Equity Compensation Plan
The Company has an equity compensation plan (the “Plan”) under which the Company may grant stock options, restricted stock and other types of stock-based awards to its employees and directors. Total shares authorized for grant under this plan are 21.3 million. The exercise price of each option granted is equal to the market price of the Company’s common stock on the date of grant and the maximum exercise term of each option granted does not exceed ten years. Options are granted upon approval of the Compensation Committee of the Board of Directors and vest over various periods, as determined by the Compensation Committee at the date of the grant. The majority of the Company’s options vest ratably over a period of three or four years. The options expire on the earlier of ten years from the date of grant or within specified time limits following termination of employment, retirement or death. Shares are issued from the Company’s authorized but unissued stock. The Company does not pay dividends on unexercised options. As of December 31, 2006, there were 6.2 million shares of common stock remaining available for grant under the Plan.
For the years ended December 31, 2004, 2005 and 2006, stock-based compensation cost totaled $9.4 million, $14.7 million and $17.3 million, respectively. The associated future income tax benefit recognized was $3.4 million, $5.2 million and $6.5 million for the years ended December 31, 2004, 2005 and 2006, respectively.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
10. Stock Plans (continued):
Equity Compensation Plan (continued)
For the years ended December 31, 2004, 2005 and 2006, the amount of cash received from the exercise of stock options was $6.9 million, $23.0 million and $21.1 million, respectively. In connection with these exercises, the actual excess tax benefit realized for the tax deductions by the Company for the years ended December 31, 2004, 2005 and 2006 were $1.3 million, $8.6 million and $5.3 million, respectively.
A summary of the option activity under the Plan at December 31, 2004, 2005 and 2006, and changes during the years, is presented below:
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
10. Stock Plans (continued):
Equity Compensation Plan (continued)
The following table summarizes information about the Plan’s stock options at December 31, 2006:
All options granted during the years ended December 31, 2004, 2005 and 2006 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, except for shares granted under the U.K. Subplan where the fair value of the Company’s common stock on the grant date is 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 of options granted during the years ended December 31, 2004, 2005 and 2006 was $10.06, $12.11 and $15.36, respectively. The aggregate fair value of options granted during the years ended December 31, 2004, 2005 and 2006 was $46.8 million, $5.4 million and $27.3 million, respectively. The total intrinsic value (which is the amount by which the market value of the Company’s common stock exceeded the exercise price of the options on the date of exercise) of options exercised during the years ended December 31, 2004, 2005 and 2006 was $6.5 million, $35.1 million and $24.4 million, respectively.
A summary of the status of unvested options as of December 31, 2006, and changes during the year then ended, is presented below:
As of December 31, 2006, the total unrecognized compensation cost related to unvested stock options was approximately $28.8 million. The Company expects to recognize this cost over a weighted-average period of 1.9 years in accordance with the vesting periods of the options. The total fair value of shares vested during the years ended December 31, 2004, 2005 and 2006 was $7.4 million, $16.4 million and $14.5 million, respectively.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
10. Stock Plans (continued):
Equity Compensation Plan (continued)
The Company estimates fair value of each option award on the grant date using the Black-Scholes option-pricing model. The following table indicates the assumptions used in estimating fair value for the years ended December 31, 2004, 2005 and 2006.
The expected term represents an estimate of the period of time options are expected to remain outstanding and is based on historical exercise and termination data. The dividend yield is based on the most recent dividend payment over the market price of the stock at the beginning of the period. The risk-free interest rate is based on the rate at the date of grant for a zero-coupon U.S. Treasury bond with a term that approximates the expected term of the option. Expected volatilities are based on the historical volatility of the Company’s stock price over the expected term of the options.
Restricted Stock
The Company awards shares of restricted stock to members of the senior management team and the Company’s non-employee directors. The shares awarded to members of the senior management team are subject to a three-year linear vesting schedule with one-third of the grant vesting on each of the first, second and third anniversaries of the grant date. The Company determines compensation cost based on the market value of shares on the date of grant, and records compensation expense on these shares on a straight-line basis over the three-year vesting period. The restricted stock shares granted to the Company’s non-employee directors vest over a three-year period, with ninety percent of the shares vesting on the first anniversary of the grant and five percent vesting on each of the second and third anniversary dates. The Company records compensation expense on these shares according to this vesting schedule.
During the years ended December 31, 2005 and 2006, the Company awarded 162,280 and 16,512 shares of restricted stock, respectively, with a fair value of $4.1 million and $0.5 million, respectively. The Company did not grant any shares of restricted stock in 2004. The weighted average grant date fair value of each share was $25.16 and $31.47 for the years ended December 31, 2005 and 2006, respectively. Total compensation expense recorded during the years ended December 31, 2005 and 2006 for restricted stock shares granted was $1.0 million and $1.6 million, respectively. The associated future income tax benefit recognized was $0.4 million and $0.6 million for the years ended December 31, 2005 and 2006, respectively. As of December 31, 2006, the total unrecognized compensation cost related to 80,374 shares of unvested restricted stock was approximately $1.1 million. The Company expects to recognize this cost over a weighted-average period of 1.4 years in accordance with the vesting periods of the restricted stock. The total fair value of restricted stock shares vested during the year ended December 31, 2006 was $1.7 million.
In May 2006, shares of restricted stock held by two members of the senior management team vested. These employees elected to surrender to the Company a portion of their vested shares to pay the income taxes due as a result of the vesting. As a result, 10,855 shares were forfeited to satisfy tax obligations. In connection with this vesting, the tax benefit realized by the Company for the year ended December 31, 2006 was $0.4 million. In addition, the Company’s president resigned effective December 31, 2006 and the Company canceled 30,000 shares of unvested deferred restricted stock units that had previously been granted to him.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
10. Stock Plans (continued):
Employee Stock Purchase Plan
The Board of Directors and shareholders have reserved 4.5 million shares of the Company’s common stock for issuance under the Employee Stock Purchase Plan (the “ESPP”). The ESPP has two six-month offering periods (each an “Offering Period”) each year, beginning January 1 and July 1, respectively. Eligible employees can elect to make payroll deductions from 1% to 15% of their base pay during each payroll period of an Offering Period. Special limitations apply to eligible employees who own 5% or more of the outstanding common stock of the Company. In addition, in accordance with the ESPP and beginning with the first six-month Offering Period in 2006, the Board of Directors set a limit on the total payroll deductions for each year of $8.0 million. None of the contributions made by eligible employees to purchase the Company’s common stock under the ESPP are tax-deductible to the employees. During 2005, the purchase price was 85%, and beginning January 1, 2006 it became 90%, of the lesser of (a) the reported closing price of the Company’s common stock for the first day of the Offering Period or (b) the reported closing price of the common stock for the last day of the Offering Period. As of December 31, 2006, there were 2.3 million shares of common stock available for purchase by ESPP participants, after giving effect to shares purchased for the second Offering Period of 2006 that were issued in January 2007.
Employees eligible to participate in the ESPP include employees of the Company and most of its operating subsidiaries, except those employees who customarily work less than 20 hours per week or five months in a year. Because the eligible employee determines both participation in and contributions to the ESPP, it is not possible to determine the benefits and amounts that would be received by an eligible participant or group of participants in the future.
The fair value of each ESPP share is estimated using the Black-Scholes option-pricing model. The following table indicates the assumptions used in estimating fair value for the years ended December 31, 2004, 2005 and 2006.
The compensation costs for the ESPP, as determined based on the fair value of the discount and option feature of the underlying ESPP grant, consistent with the method of SFAS No. 123, were $1.9 million, $3.3 million and $1.7 million for years ended December 31, 2004, 2005 and 2006, respectively. The income tax benefit recognized was $0.7 million, $1.2 million and $0.2 million for the years ended December 31, 2004, 2005 and 2006, respectively. The weighted average grant date fair value per share during the years ended December 31, 2004, 2005 and 2006 was $4.15, $8.37 and $6.12, respectively. As of December 31, 2006, there was no unrecognized compensation cost related to ESPP shares.
For the years ended December 31, 2004, 2005 and 2006, the value of stock issued for ESPP purchases was $5.2 million, $6.6 million and $7.2 million, respectively. In connection with disqualifying dispositions, the tax benefits realized by the Company for the years ended December 31, 2004, 2005 and 2006 were $0.1 million, $0.2 million and $0.1 million, respectively.
During the years ended December 31, 2004, 2005 and 2006, employees contributed $5.7 million, $7.3 million and $7.8 million, respectively, to the ESPP for the purchase of 458,000, 391,000 and 274,000 shares, respectively. The aggregate fair value of shares purchased during the years ended December 31, 2004, 2005 and 2006 was $6.7 million, $8.6 million and $9.1 million, respectively. Contributions for the second Offering Period of 2006 were not converted to issued shares until January 2007.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
11. Income Taxes:
The components of income before provision for income taxes were as follows:
The components of the provision for income taxes were as follows:
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
11. Income Taxes (continued):
Taxes computed at the statutory U.S. federal income tax rate of 35% are reconciled to the provision for income taxes as follows:
Components of the current deferred tax assets were as follows:
The current deferred tax liabilities of $0.1 million at both December 31, 2005 and 2006 relates to various expenses deducted for tax purposes, not book purposes.
Components of the long-term deferred tax assets were as follows:
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
11. Income Taxes (continued):
Components of the long-term deferred tax liabilities were as follows:
The Company has recorded a deferred tax asset for foreign and state net operating losses and credits that are subject to either five-year, 15-year, 20-year or indefinite carryforward periods. Management has recorded a valuation allowance of $3.9 million against the net operating loss assets and $1.0 million against the tax credit assets for amounts that it does not believe are more likely than not to be utilized.
The Company also recorded a deferred tax asset related to U.S. net operating losses received in an acquisition in 2003. Although the net operating losses are subject to annual limitation under IRC Section 382, management expects all losses to be utilized during the 20-year carryforward period that is available.
The Company has also established a deferred tax asset for federal and state tax related to unrealized investment losses and state tax on realized capital losses. Management has recorded a valuation allowance of $0.7 million for the state tax benefit that it does not believe is more likely than not to be realized. The federal valuation allowance for unrealized and realized investment losses has been fully released.
In 2006, the total valuation allowance decreased by $1.0 million primarily due to the closing of a state audit. The total valuation allowance decreased by $1.7 million in 2005. This decrease was primarily attributable to a $6.9 million decrease in the valuation allowance for investment losses resulting from increases in the market value of these investments and management’s determination that the benefits of past investment losses were more likely than not to be realized. This decrease was offset by an increase in the valuation allowances related to foreign and state loss carryforwards.
As of December 31, 2006, the Company had liabilities of $9.1 million for certain unsettled matters in connection with tax positions taken on the Company’s tax returns, including interpretations of applicable income tax laws and regulations. The Company establishes a reserve when, despite management’s belief that the Company’s tax returns reflect the proper treatment of all matters, the treatment of certain tax matters is likely to be challenged. Significant judgment is required to evaluate and adjust the reserves in light of changing facts and circumstances. Further, a number of years may lapse before a particular matter for which the Company has established a reserve is audited and finally resolved. While it is difficult to predict the final outcome or the timing of resolution of any particular tax matter, management believes that the reserves of $9.1 million reflect the probable outcome of known tax contingencies. The Company believes it is unlikely that the resolution of these matters will have a material adverse effect on the Company’s financial position or results of operations.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
11. Income Taxes (continued):
The Company records current and deferred income tax expense related to its foreign operations to the extent those earnings are taxable. Historically, the Company has made no provision for the additional taxes that would result from the distribution of earnings of foreign subsidiaries because the Company expected to invest them permanently. The American Jobs Creation Act of 2004 provided for a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer completed by the end of 2005. As a result of this one-time provision, the Company repatriated $48.0 million of earnings in the form of dividends from its foreign affiliates in 2005 and recorded tax expense, net of foreign tax credits, of $1.7 million.
The Company considers that the remainder of its foreign earnings will remain permanently invested overseas. The cumulative amount of undistributed earnings for which no U.S. tax liability has been recorded was $37.0 million and $73.3 million for December 31, 2005 and 2006, respectively.
12. Employee Savings and Pension Plans:
Savings Plan
The Company provides a 401(k) Retirement Savings Plan to its U.S. employees. The Company matches 50% of an employee’s savings up to 6% of pay and these contributions vest ratably over a four-year period. Company matching contributions, net of forfeitures, for all employees for the years ended December 31, 2004, 2005 and 2006 were $4.8 million, $5.4 million and $6.6 million, respectively.
Non-Qualified Deferred Compensation Plans
The Company maintains non-qualified, unfunded deferred compensation plans that permit certain highly paid executive employees who are employed in the United States and members of the Board of Directors to defer current income for future financial and retirement needs. An eligible employee participant may defer up to 25% of their base salary and/or a portion of their annual bonus on a pre-tax basis. Board of Directors participants may defer up to 100% of their annual retainer and meeting fees on a pre-tax basis. Participants also have the opportunity to defer receipt of restricted stock. There are no Company contributions to these plans, and other than accruals for interest or dividend equivalents, all amounts credited to these plans are derived from elective deferrals of compensation otherwise payable to participants.
Cash amounts deferred each quarter will accrue interest based upon the three-month London Interbank Offered Rate, or LIBOR, plus 1.5%. Shares of restricted stock that are deferred are held as restricted stock units, payable as shares of common stock if and when the units become distributable. The restricted stock units remain subject to the same vesting conditions as applicable to the shares of restricted stock. In addition, restricted stock units provide for cash dividend equivalents that are payable as cash at the time the units become vested or when the units become distributable, depending on the participant’s election.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
12. Employee Savings and Pension Plans (continued):
Non-Qualified Deferred Compensation Plans (continued)
The plans offer a number of account distribution options providing flexibility for financial and retirement planning. Employee participants elect with each set of annual deferrals to have the deferrals payable either (i) on a specified date that is at least two years after the deferral election is made but not more than 10 years after termination of employment or (ii) upon termination of employment. The amount deferred will be payable either in a lump sum or installments over a period of five, 10 or 15 years as elected by the participant at the time of deferral. However, these payment elections only become effective if the employee participant retires after age 55 with 10 years of service. Otherwise, the deferrals are payable in a lump sum following termination of employment. Board of Director participants may elect with each set of annual deferrals to have the deferrals payable either (x) on a specified date that is at least two years after the deferral election is made but not more than 10 years after termination of services as a director or (y) the earlier of any such date and the date of termination of services as a director. Board of Director participants may choose to have deferrals payable either in a lump sum or installments over a period of five years.
These payment elections can be made separately with respect to cash and restricted stock deferrals. There is a limited ability to subsequently change the payment elections, provided the election is made at least 12 months before the scheduled payment date and defers commencement of the payment by at least five years. Other special payment rules apply in case of death or disability and with respect to certain “key employees” (whose payments must be delayed by at least six months following termination of employment). Additionally, the Board of Directors may elect to pay out participants in the event of a “Change of Control”. As of December 31, 2005 and 2006, 141,388 and 127,900 shares of restricted stock granted to members of management and the Board of Directors were deferred under this plan and had not been issued.
At December 31, 2005 and 2006, the Company recorded a deferred compensation liability under this plan of $1.5 million and $1.9 million, respectively, in the consolidated balance sheets as a component of other accrued expenses.
Pension Plans
During 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 recognize the underfunded or overfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in the funded status in the year in which the changes occur through accumulated other comprehensive income effective for fiscal years ending after December 15, 2006. SFAS No. 158 did not change net income or comprehensive income for the fiscal year ending December 31, 2006. Rather, it requires a one-time adjustment to accumulated other comprehensive income. The Company recorded a one-time adjustment of $3.3 million, net of tax of $1.4 million, during 2006. Additionally, 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 Company determined pension costs under the provisions of SFAS No. 87, “Employers’ Accounting for Pensions” and related disclosures are determined under the provisions of SFAS No. 132 (Revised 2003), “Employers’ Disclosures about Pensions and other Postretirement Benefits” as modified by SFAS No. 158.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
12. Employee Savings and Pension Plans (continued):
Pension Plans (continued)
The Company has a separate contributory defined benefit plan for its qualifying U.K. employees employed by the Company’s U.K. subsidiaries. This pension plan was closed to new participants as of December 31, 2002. The benefits for the U.K. Plan are based primarily on years of service and average pay at retirement. Plan assets consist principally of investments managed in a mixed fund.
Following closure of the above plan to new participants, the Company set up a new defined contribution plan for qualifying U.K. employees employed by the Company’s U.K. subsidiaries. The employees can contribute between 3% and 6% of their annual compensation and the Company matches those contributions with 5% to 8% of the employees’ annual compensation. Company contributions for the years ended December 31, 2005 and 2006 were $0.3 million and $0.6 million, respectively.
Pension costs and other amounts recognized in other comprehensive income for the U.K. Plan included the following components:
The estimated net loss that will be amortized from accumulated other comprehensive income into net periodic pension cost over the next fiscal year is $0.5 million.
Weighted average assumptions used to determine net periodic pension cost for years ending December 31 were as follows:
To develop the expected long-term rate of return on assets assumption, the Company considered future expectations for yields on investments weighted in accordance with the asset allocation of the pension plan’s invested funds.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
12. Employee Savings and Pension Plans (continued):
Pension Plans (continued)
The change in benefit obligation, change in plan assets, funded status and amounts recognized for the defined benefit plan were as follows:
Amounts recognized in statement of financial position were as follows:
All amounts recognized in accumulated other comprehensive income are related to accumulated gains.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
12. Employee Savings and Pension Plans (continued):
Pension Plans (continued)
The projected benefit obligation, accumulated benefit obligation and fair value of plan assets were as follows:
Weighted average assumptions used to determine benefit obligations at end of plan year were as follows:
Plan Assets
The Company’s pension plan weighted-average allocations by asset category are as follows:
An independent third party manages the plan assets and tracks the return on a benchmark portfolio matching the above strategic asset allocation. Based on advice from the Company’s financial advisors, the trustees have determined the above mix of asset types in order to meet the investment objectives of the pension plan.
The Company expects to contribute $2.5 million to fund its pension plan during 2007. The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid:
(in thousands)
Expected benefit payments for fiscal year ending:
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
13. 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 $2.5 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 $0.25 million per member per year. As of December 31, 2005 and 2006, the Company maintained a reserve of approximately $5.0 million and $7.4 million, respectively, included in other accrued expenses on the consolidated balance sheets, to cover open claims and estimated claims incurred but not reported.
In September 2005, the Company became a limited partner in Bay City Capital Fund IV, L. P., a venture capital fund. The Company has committed to invest up to a maximum of $10.0 million in this fund. Aggregate capital calls through December 31, 2006 totaled $3.2 million. Because no capital call can exceed 20% of the Company’s aggregate capital commitment, the Company anticipates its remaining capital commitment of $6.8 million will be made through a series of future capital calls over the next several years. The Company’s capital commitment will expire in June 2009. For further details, see Note 6.
In November 2003, the Company became a limited partner in A. M. Pappas Life Science Ventures III, L.P., a venture capital fund. The Company has committed to invest up to a maximum of $4.8 million in this fund. Aggregate capital calls through December 31, 2006 totaled $1.2 million. Because no capital call can exceed 10% of the Company’s aggregate capital commitment, the Company anticipates its remaining capital commitment of $3.6 million will be made through a series of future capital calls over the next several years. The Company’s capital commitment will expire in May 2009. For further details, see Note 6.
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. The Company currently has four such arrangements that involve the potential future receipt of one or more of the following: 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 still in development and have not been approved for sale in any country.
The Company’s collaboration with ALZA Corporation, a subsidiary of Johnson & Johnson, for dapoxetine requires the Company to pay a royalty to Eli Lilly & Company of 5% on annual net sales of the compound in excess of $800 million. ALZA received a “not approvable” letter from the FDA in October 2005, but has continued the global development program and has indicated that it may file for approval in Europe as early as late 2007. As a result of the risks associated with drug development, including obtaining regulatory approval to sell in any country, the receipt of any further milestone payments, royalties or other payments is uncertain.
Under most of the agreements for Development services, the Company agrees to indemnify and defend the sponsor against third-party claims based on the Company’s negligence or willful misconduct. Any successful claims could have a material adverse effect on the Company’s financial condition, results of operations and future prospects.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
13. Commitments and Contingencies (continued):
In the normal course of business, the Company is a party to various claims and legal proceedings, including claims for alleged breaches of contract. In one proceeding currently pending against the Company, a former client is claiming the Company breached its contract and committed tortious acts in conducting a clinical trial. That former client is claiming that it does not owe the Company the remaining amounts due under the contract and is seeking other damages from the Company’s alleged breach of contract and tortious acts. The Company records a reserve for 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 these matters is currently not determinable, management of the Company, after consultation with legal counsel, does not believe that the resolution of these matters will have a material effect upon the Company’s financial condition, results of operations or cash flows.
14. Related Party Transactions:
The Company leases its Highland Heights, Kentucky, building under an operating lease with a former employee and less than one percent shareholder of the Company. Rent paid to this shareholder for the years ended December 31, 2004, 2005 and 2006 totaled $0.7 million, $0.8 million and $0.8 million, respectively. This lease was renewed on January 1, 2005 and will expire on December 31, 2014. Future rent under this lease is included in the future minimum payments for all lease obligations included in Note 8.
The Company provided services to three companies in which three members of the Company’s Board of Directors hold board positions. The Company provided services to these three companies in 2004, 2005 and 2006. Revenue received from these three companies for the years ended December 31, 2004, 2005 and 2006 were $6.9 million, $4.4 million and $5.9 million, respectively. As of December 31, 2005 and 2006, these three companies owed the Company $0.7 million and $1.1 million, respectively, for services rendered by the Company.
15. Fair Value of Financial Instruments:
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
Accounts Receivable, Accounts Payable and Accrued Liabilities
The carrying amount approximates fair value because of the short maturity of these items.
Long-Term Debt
The Company believes the carrying value approximates the fair value on December 31, 2005 and 2006.
Investments
The Company’s investments in BioDelivery Sciences International and Accentia Biopharmaceuticals are recorded at $2.4 million and $14.9 million at December 31, 2006, respectively. BioDelivery Sciences International and Accentia Biopharmaceuticals are publicly traded companies. The Company records a gain or loss related to these investments at the end of each quarter based on the closing price of these investments at the end of each period. The Company records unrealized gains or losses in accumulated other comprehensive income until they are realized or an other-than temporary decline has occurred. For further information on investments, see Note 6.
The Company’s remaining investments, for which no public market exists, are accounted for using the cost method of accounting as the Company does not exert significant influence on the operations of these companies. The Company monitors these investments for other-than-temporary declines in value. The Company believes the carrying value approximates fair value as of December 31, 2005 and 2006. Of these investments, the Company recorded an impairment to one of its cost basis investments as of December 31, 2005. For further details, see Note 6.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
15. Fair Value of Financial Instruments (continued):
Derivative Instruments
The Company’s derivative financial instruments are recorded at a fair value. As of December 31, 2005 and 2006, the Company’s derivative portfolio had an unfavorable position of $0.8 million and $0, respectively, recorded as a component of other accrued expenses.
Letters of Credit
From time to time, the Company causes letters of credit to be issued to provide credit support for guarantees, contractual commitments and insurance policies. The fair values of the letters of credit reflect the amount of the underlying obligation and are subject to fees competitively determined in the marketplace. As of December 31, 2006, the Company had four letters of credit outstanding for a total of $1.3 million.
16. Business Segment Data:
The Company has two reportable segments: Development and Discovery Sciences. In the Development segment, the Company provides a broad range of development services, which include preclinical programs and Phase I to IV clinical development services as well as bioanalytical product testing and clinical laboratory services. In addition, for marketed drugs, biologics and devices, the Company offers 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. The Discovery Sciences segment provides services that include preclinical evaluations of anticancer and diabetes therapies, biomarker discovery and patient sample analyses, and compound development and commercialization collaborations.
The accounting policies of the segments are the same as those described in Note 1. The Company evaluates its segment performance and allocates resources based on service revenue, gross profit and income (loss) from operations.
Revenues by principal business segment are separately stated in the consolidated financial statements. Income (loss) from operations, depreciation and amortization, identifiable assets and capital expenditures by principal business segment were as follows:
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
17. Operations by Geographic Area:
Geographic information for net revenue and income from operations by country is determined by the location where the services are provided for the client. Geographic information for identifiable assets by country is determined by the physical location of the assets.
The following table presents information about the Company’s operations by geographic area:
(a)
Principally consists of operations in 40 countries, 16 of which are located in Europe, none of which comprises more than 10% of net revenue, income from operations or identifiable assets.
PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
18. Quarterly Financial Data (unaudited):
(in thousands, except per share data)
19. Subsequent Event:
On February 23, 2007, the Company exercised an option to license a statin compound from Ranbaxy Laboratories Ltd. (“Ranbaxy”) which the Company intends to develop as a treatment for dyslipidemia. The option was exercised pursuant to an agreement entered into effective as of December 15, 2006. Upon exercise to the option the Company paid a one-time license fee of $250,000. 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. Ranbaxy retained a non-exclusive right to co-market licensed products in India and generic equivalents in any country in the world in which a third party has sold the generic equivalent of a licensed product. 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 such product and commercial milestone payments based on the achievement of specified worldwide sales targets. If all criteria are met, the total amount of potential clinical and sales-based milestones over the development and commercialization period would be $44 million.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
Date: February 26, 2007
By:
/s/ Fredric N. Eshelman, Pharm.D.
Name:
Fredric N. Eshelman, Pharm.D.
Title:
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
S-1