10-Q 1 d10q.htm FORM 10-Q Form 10-Q
Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2011.

OR

 

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

For the transition period from                            to                           .

Commission File Number 0-27570

PHARMACEUTICAL PRODUCT

DEVELOPMENT, INC.

(Exact name of registrant as specified in its charter)

 

North Carolina   56-1640186
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification Number)

929 North Front Street

Wilmington, North Carolina

(Address of principal executive offices)

28401

(Zip Code)

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  X   No       

Indicate by check mark whether the registrant has submitted electronically and posted on its Corporate website every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulations S-T (§232.405 of this chapter) during the preceding 12 months (or for shorter period that the registrant was required to submit and post such files). Yes  X   No       

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 113,895,407 shares of common stock, par value $0.05 per share, as of July 27, 2011.

 

 

 

 


Table of Contents

INDEX

 

     Page  

Part I. FINANCIAL INFORMATION

  

Item 1. Financial Statements

  

Consolidated Condensed Statements of Income for the Three and Six Months Ended June  30, 2010 and 2011 (unaudited)

     3   

Consolidated Condensed Balance Sheets as of December 31, 2010 and June 30, 2011 (unaudited)

     4   

Consolidated Condensed Statements of Cash Flows for the Six Months Ended June  30, 2010 and 2011 (unaudited)

     5   

Notes to Consolidated Condensed Financial Statements (unaudited)

     6   

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

     26   

Item 3. Quantitative and Qualitative Disclosures about Market Risk

     40   

Item 4. Controls and Procedures

     42   

Part II. OTHER INFORMATION

  

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

     43   

Item 6. Exhibits

     44   

Signatures

     45   

 

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Table of Contents

Part I. FINANCIAL INFORMATION

Item 1. Financial Statements

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTS OF INCOME

(in thousands, except per share data)

(unaudited)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
         2010             2011             2010             2011      

Net revenue:

        

Service revenue

   $   341,496      $   376,199      $   665,616      $   732,364   

Reimbursed revenue

     28,423        31,504        51,072        58,542   
                                

Total net revenue

     369,919        407,703        716,688        790,906   
                                

Direct costs

     192,170        221,390        374,972        428,213   

Research and development expenses

     8,445        1,792        14,783        4,012   

Selling, general and administrative expenses

     112,106        110,456        225,016        215,403   

Depreciation and amortization

     17,114        16,919        34,151        33,683   
                                

Total operating expenses

     329,835        350,557        648,922        681,311   
                                

Operating income

     40,084        57,146        67,766        109,595   

(Loss) income from equity method investment

     (1,747     10,639        (3,789     13,188   

Gain (loss) on investments

     2,590        (1,319     2,541        (1,105

Other income (expense), net

     157        321        1,479        60   
                                

Income from continuing operations before provision for income taxes

     41,084        66,787        67,997        121,738   

Provision for income taxes

     17,522        21,372        26,153        38,956   
                                

Income from continuing operations

     23,562        45,415        41,844        82,782   

Loss from discontinued operations, net of income taxes

     (2,585     -        (3,662     -   
                                

Net income

     20,977        45,415        38,182        82,782   

Net loss attributable to noncontrolling interests

     -        1,091        -        1,338   
                                

Net income attributable to shareholders

   $ 20,977      $ 46,506      $ 38,182      $ 84,120   
                                

Income per common share from continuing operations:

        

Basic

   $ 0.20      $ 0.41      $ 0.35      $ 0.73   
                                

Diluted

   $ 0.20      $ 0.41      $ 0.35      $ 0.72   
                                

Basic and diluted loss per common share from discontinued operations

   $ (0.02     -      $ (0.03   $ -   
                                

Net income per common share

        

Basic

   $ 0.18      $ 0.41      $ 0.32      $ 0.73   
                                

Diluted

   $ 0.18      $ 0.41      $ 0.32      $ 0.72   
                                

Dividends declared per common share

   $ 0.15      $ 0.15      $ 0.30      $ 0.30   
                                

Weighted-average number of common shares outstanding:

        

Basic

     118,542        113,393        118,501        115,122   

Dilutive effect of stock options and restricted stock

     373        1,327        277        1,317   
                                

Diluted

     118,915        114,720        118,778        116,439   
                                

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

 

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Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED BALANCE SHEETS

(in thousands)

(unaudited)

 

 

     December 31,
2010
        June 30,    
2011
 
Assets   

Current assets:

    

Cash and cash equivalents

   $ 479,574      $ 370,864   

Short-term investments

     79,976        -   

Accounts receivable and unbilled services, net

     435,876        502,885   

Income tax receivable

     12,327        19,824   

Investigator advances

     16,032        13,971   

Prepaid expenses

     24,535        30,409   

Deferred tax assets

     30,910        31,983   

Cash held in escrow

     10,304        2,288   

Other current assets

     44,172        24,205   
                

Total current assets

     1,133,706        996,429   

Property and equipment, net

     385,863        406,144   

Goodwill

     291,217        298,048   

Long-term investments

     78,747        69,259   

Other investments

     47,833        70,413   

Intangible assets

     31,444        29,130   

Other assets

     23,236        40,757   
                

Total assets

   $ 1,992,046      $ 1,910,180   
                
Liabilities and Equity   

Current liabilities:

    

Accounts payable

   $ 29,858      $ 32,722   

Payables to investigators

     56,612        60,879   

Accrued income taxes

     1,918        12,599   

Other accrued expenses

     208,128        191,161   

Unearned income

     317,191        335,454   
                

Total current liabilities

     613,707        632,815   

Accrued income taxes

     32,924        35,245   

Accrued pension liability

     10,989        11,930   

Deferred rent

     16,411        15,763   

Deferred tax liabilities

     16,552        18,570   

Other liabilities

     10,796        5,162   
                

Total liabilities

     701,379        719,485   
                

Redeemable noncontrolling interests

     1,657        675   

Total equity:

    

Shareholders’ equity:

    

Common stock

     5,952        5,677   

Paid-in capital

     609,281        606,219   

Retained earnings

     682,160        563,644   

Accumulated other comprehensive income (loss)

     (17,140     6,721   
                

Total shareholders’ equity

     1,280,253        1,182,261   

Noncontrolling interests

     8,757        7,759   
                

Total equity

     1,289,010        1,190,020   
                

Total liabilities and equity

   $ 1,992,046      $ 1,910,180   
                

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

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

     Six Months Ended
June 30,
 
         2010             2011      

Cash flows from operating activities:

    

Net income

   $ 38,182      $ 82,782   

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

    

Depreciation and amortization

     35,164        33,683   

Equity compensation expense

     9,649        10,675   

Loss (income) from equity investment, net of taxes

     2,469        (8,480

Benefit for deferred income taxes

     (3,231     (2,294

Other

     1,531        1,334   

Net change in operating assets and liabilities

     37,725        (58,092
                

Net cash provided by operating activities

     121,489        59,608   
                

Cash flows from investing activities:

    

Purchases of property and equipment

     (27,156     (48,145

Proceeds from sale of property and equipment

     57        55   

Purchases of investments

     (3,179     (1,527

Maturities and sales of investments

     98,039        91,676   

Purchases of other investments

     (7,030     (2,768

Proceeds from liquidation of other investments

     -        539   

Net cash paid for acquisitions

     (10,169     (7,936

Changes in restricted cash

     3,000        7,936   

Proceeds from sale of business

     3,464       
-
  

Advances to related party

     (4,000     (6,300
                

Net cash provided by investing activities

     53,026        33,530   
                

Cash flows from financing activities:

    

Proceeds from exercise of stock options and employee stock purchase plan

     6,143        19,955   

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

     138        720   

Cash and cash equivalents contributed to Furiex Pharmaceuticals, Inc.

     (100,000     -   
                

Repurchase of common stock

     -        (200,000

Cash dividends paid

     (35,581     (35,692
                

Net cash used in financing activities

     (129,300     (215,017
                

Effect of exchange rate changes on cash and cash equivalents

     (20,044     13,169   
                

Net increase (decrease) in cash and cash equivalents

     25,171        (108,710

Cash and cash equivalents, beginning of the period

     408,903        479,574   
                

Cash and cash equivalents, end of the period

   $ 434,074      $ 370,864   
                

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

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

1. Significant Accounting Policies

The significant accounting policies followed by Pharmaceutical Product Development, Inc. and its subsidiaries (collectively, the “Company”) for interim financial reporting are consistent with the accounting policies followed for annual financial reporting. The Company prepared these unaudited consolidated condensed financial statements in accordance with Rule 10-01 of Regulation S-X and, in management’s opinion, has included all adjustments of a normal recurring nature necessary for a fair presentation. The accompanying consolidated condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010. The results of operations for the three-month and six-month periods ended June 30, 2011 are not necessarily indicative of the results to be expected for the full year or any other period. The amounts in the December 31, 2010 consolidated condensed balance sheet are derived from the audited financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

On June 14, 2010, the Company spun off its compound partnering business into a new independent, publicly traded company, Furiex Pharmaceuticals, Inc. (Nasdaq: FURX). Substantially all of the operating business components of the Discovery Sciences segment were included in the spin-off. The Company contributed $100.0 million of cash and cash equivalents to Furiex and distributed all outstanding shares of Furiex to the Company’s shareholders as a pro-rata, tax-free dividend, issuing one share of Furiex common stock for every twelve shares of the Company’s common stock to shareholders of record on June 1, 2010. The results of operations for the former compound partnering business conducted by the Company until June 14, 2010 are included as part of this report as continuing operations because the Company believes this transaction does not qualify for discontinued operations treatment due to the ongoing master development services agreement between the Company and Furiex. The Company does not have any equity or other form of ownership interest in Furiex subsequent to the separation.

Prior to the Company’s June 2010 spin-off, the Discovery Sciences segment included the compound partnering business, a preclinical toxicology research business, and a biomarker discovery services business. In 2009, the Company sold both its preclinical toxicology research and biomarker discovery businesses, which were part of the Discovery Sciences segment. In 2010, the Company discontinued the operations of its wholly owned subsidiary PPD Dermatology, Inc. The Company’s Discovery Sciences revenues were all generated in the United States.

Principles of consolidation

The accompanying consolidated condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, or U.S. GAAP, and include the accounts of Pharmaceutical Product Development, Inc. and its majority-owned subsidiaries that it controls. Amounts pertaining to the noncontrolling ownership interests held by third parties in the operating results and financial position of the Company’s majority-owned subsidiaries are reported as noncontrolling interests. All intercompany balances and transactions have been eliminated in consolidation.

In connection with the formation of the Company’s subsidiary BioDuro Biologics Pte. Ltd., or BioDuro Biologics, the Company has contractual rights and restrictions related to certain activities of MAB Discovery GmbH, or MAB, a variable interest entity that provides services to BioDuro Biologics. The Company determined that it has a controlling financial interest in MAB because it directs the most significant activities that impact MAB’s economic performance and has an obligation to absorb certain losses that could potentially be significant to MAB. As a result, the Company consolidates the financial results of MAB into its financial statements. MAB creditors have no recourse against the Company in the event of a default by MAB. As of June 30, 2011, MAB had total assets of $4.5 million and total liabilities of $5.5 million, and the Company had a commitment to provide up to $9.4 million of credit to MAB for purposes of acquiring equipment, of which $3.9 million had been advanced.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

1. Significant Accounting Policies

 

Recently issued accounting standards

In May 2011, the Financial Account Standards Board, or FASB, issued updated fair value measurement and disclosure guidance that clarifies how to measure fair value and requires additional disclosures regarding Level 3 fair value measurements, as well as any transfers between Level 1 and Level 2 fair value measurements. The updated accounting guidance is effective for fiscal years and interim periods beginning on or after December 15, 2011 on a prospective basis. The Company is currently evaluating the impact of adopting the updated fair value guidance, and it does not expect the adoption to have a material impact on its consolidated condensed financial statements.

In June 2011, the FASB amended the manner in which an entity presents the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single, continuous statement of comprehensive income or in two separate but consecutive statements. The amendment eliminates the option to present the components of other comprehensive income as part of the statement of equity. The amendment is effective for fiscal years and interim periods beginning on or after December 15, 2011 on a retrospective basis. The adoption of this guidance will not change the previously reported amounts of comprehensive income but will change the Company’s presentation of comprehensive income in the consolidated condensed financial statements for the period ending March 31, 2012.

Recently adopted accounting standards

In October 2009, the FASB issued a new accounting standard related to accounting for revenue arrangements with multiple deliverables. This standard applies to all deliverables in contractual arrangements in all industries in which the vendor will perform multiple revenue-generating activities. This standard also addresses the unit of accounting for an arrangement involving multiple deliverables and how arrangement consideration should be allocated. This standard was effective on January 1, 2011 on a prospective basis. The adoption of this standard did not have a material impact on the Company’s consolidated condensed financial statements, other than requiring additional disclosures included below under “Revenue recognition.”

In March 2010, the FASB issued a new accounting standard, the objective of which is to establish a revenue recognition model for contingent consideration that is payable upon the achievement of an uncertain future event, referred to as a milestone. This standard applies to milestones in single or multiple-deliverable arrangements involving research and development transactions and was effective on January 1, 2011 on a prospective basis. The adoption of this standard did not have a material impact on the Company’s consolidated condensed financial statements, other than requiring additional disclosures included below under “Revenue recognition.”

In April 2011, the FASB issued an accounting standard update clarifying the guidance as to whether a restructuring of accounts receivable constitutes a troubled debt restructuring. The guidance applies to modifications of receivables when a debtor is experiencing financial difficulties. The updated guidance was effective on July 1, 2011 on a retrospective basis to January 1, 2011. The adoption of this standard did not have a material impact on the Company’s consolidated condensed financial statements as the Company did not modify any of its receivables.

Revenue recognition

The Company generally enters into contracts with clients to provide services with payments based on fixed and variable fee arrangements. The Company recognizes revenue for services, as rendered, only after persuasive evidence of an arrangement exists, the sales price is determinable and collectability is reasonably assured. Once the above criteria have been met, the Company recognizes revenue for the services provided based on the proportional performance methodology, which determines the proportion of outputs or performance obligations that have been completed or delivered compared to the total contractual outputs or performance obligations.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

1. Significant Accounting Policies

 

Revenue recognition

Some of the Company’s contractual arrangements with clients involve multiple service deliverables, such as developing testing methodologies, database management, investigator recruitment and clinical trial monitoring, among others. Upon entering into the contractual arrangement, the Company determines whether each deliverable has standalone value to the client. If the multiple deliverables within the arrangement each have standalone value to the client, then a separate unit of accounting is assigned to each separate deliverable. If the multiple deliverables are not considered to each have standalone value to the client because the separate deliverables can only be used together, then the deliverables are considered bundled and only one unit of accounting is assigned to the entire arrangement.

A newly adopted accounting standard related to the accounting for revenue arrangements with multiple deliverables requires the allocation of the contractual arrangement’s value based on the relative selling price of the separately identified units of accounting within the arrangement. The standard requires a hierarchy of evidence to be followed when determining the best evidence of the selling price of an item. The best evidence of selling price for a unit of accounting is vendor-specific objective evidence, or VSOE, or the price charged when a deliverable is sold routinely on a standalone basis. When VSOE is not available to determine selling price, relevant third-party evidence, or TPE, of selling price should be used, such as prices competitors charge for interchangeable services to similar clients. When neither VSOE nor TPE of selling price for similar deliverables exists, the Company must use its best estimate of selling price, or BESP, considering all relevant information that is available.

The Company generally is not able to establish TPE for its services, as its deliverables are highly customized and competitor pricing is not available. VSOE can often be established for certain deliverables based on the Company’s standard price lists used for unitized services or the unit price or hourly rates set forth in the customer arrangement. BESP for deliverables is generally established based on labor costs, risks, and expected profit margins developed from the competitive bidding process for client contracts. The Company allocates the contractual arrangement’s value at the inception of the arrangement using the relative selling prices of the deliverable services within the contract based upon VSOE when available but primarily upon BESP. Consistent with the Company’s accounting policies prior to the adoption of this standard, the Company recognizes revenue for the separate elements of its contracts in accordance with the revenue recognition criteria above. The adoption of this standard did not have a material impact on the Company’s consolidated condensed financial statements.

Under a small number of client contracts, a portion of the payments owed to the Company are contingent upon successful achievement of performance standards or research and development success milestones. These payments are not included in the total contract value used for the proportional performance calculations until the achievement of the performance standard or milestone is reasonably assured. Milestone payments on contracts entered into subsequent to January 1, 2011 were immaterial.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

1. Significant Accounting Policies

 

Fair value

The accounting standards establish a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. The fair value measurement of a financial instrument and its classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement in its entirety. Observable inputs are inputs that market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the assumptions market participants would use in pricing the asset or liability based on the best information available in the circumstances. The hierarchy is broken down into three levels based on the inputs as follows:

 

   

Level 1 – Valuations based on quoted prices for identical assets or liabilities in active markets that the Company has the ability to access. Items valued using Level 1 inputs include money market funds, U.S. treasury securities and exchange-traded equity securities.

 

   

Level 2 – Valuations based on quoted prices in markets that are not active, or for which all significant inputs are observable, either directly or indirectly. Level 2 valuations include the use of matrix pricing models, quotes for comparable securities and valuation models using observable market inputs. Items valued using Level 2 inputs include derivative instruments, corporate and municipal debt securities and asset-backed securities.

 

   

Level 3 – Valuations based on inputs that are unobservable and significant to the overall fair value measurement. Items valued using Level 3 inputs include auction rate securities valued using unobservable inputs such as time to market liquidity and appropriate rates of return for comparable securities, and equity method investments valued at net asset value as determined by the fund manager based on the most recent financial information available.

Earnings per share

The Company computes basic income per common share based on the weighted-average number of common shares outstanding during the period. The Company computes diluted income per common share information based on the weighted-average number of common shares outstanding during the period plus the effects of any dilutive common stock equivalents. The Company excluded 5,288,542 shares and 6,551,764 shares from the calculation of diluted earnings per common share during the three months ended June 30, 2010 and 2011, respectively, and 6,697,784 shares and 6,667,938 shares from the calculation of diluted earnings per share during the six months ended June 30, 2010 and 2011, respectively, because they were antidilutive. The antidilutive shares consist of shares underlying stock options, employee stock purchase plan subscriptions and restricted stock units that were antidilutive for the period.

Use of estimates in preparation of the financial statements

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

2. Acquisitions and Dispositions

Acquisitions

In October 2010, the Company acquired 64 percent of the outstanding securities of X-Chem, Inc., which is developing proprietary small molecule drug discovery services capabilities, for total consideration of $15.5 million. The Company paid $7.0 million to acquire existing outstanding equity interests and $8.5 million to acquire newly issued shares. The Company recorded the transaction as an acquisition of a controlling interest and consolidates X-Chem’s operating results in the financial statements of the Company. As of the acquisition date, the Company recorded the assets, liabilities and noncontrolling interests at fair value, including accounts receivable, net of $0.6 million. The Company estimated the fair value of the noncontrolling interests in X-Chem by applying the income approach using discounted cash flows. The fair value measurement is based on significant inputs not observable in the market and thus represents a Level 3 measurement. At any time prior to October 31, 2014, the Company has the option to purchase the remaining 36 percent of X-Chem at an entity valuation of $70.0 million. If the Company does not exercise its option, the noncontrolling interest holders will have the right to purchase the Company’s ownership interests at an entity valuation of $20.0 million between November 1, 2015 and November 30, 2015. X-Chem is required to declare and pay dividends in the future based on a formula agreed to by the Company and the noncontrolling interest holders. As of June 30, 2011, the Company had paid $4.5 million of the total $7.0 million purchase price to acquire outstanding equity interests. The Company deposited the remaining $2.5 million of the purchase price into an escrow account to secure indemnification claims and the payment of other obligations. As of June 30, 2011, the Company recorded a liability to pay the escrowed funds, which are scheduled to be released in April 2013, as a component of other liabilities. Through the acquisition, the Company expanded its drug discovery services capabilities. This acquisition is included in the Company’s Laboratory Services segment.

Acquisition costs related to X-Chem were not significant and were included in selling, general and administrative costs in the consolidated condensed statements of income. The factors that contributed to the recognition of goodwill included securing new technologies and synergies that are specific to the Company’s business, access to new market segments which are expected to increase revenues and profits, and acquisition of a talented workforce. The Company will not be able to deduct this goodwill for tax purposes.

The Company accounted for this acquisition under the acquisition method of accounting. The total purchase price for this acquisition was allocated based on the estimated fair value of assets acquired and liabilities assumed, which are set forth in the following table:

 

         X-Chem  
 

Current assets

   $ 9,309   
 

Property and equipment, net

     22   
 

Current liabilities

     (1,011
 

Other liabilities

     (3,592
 

Noncontrolling interests

     (8,297
 

Identifiable intangible assets

     9,030   
 

Goodwill

     10,039   
    

 

 

 
 

Total

   $ 15,500   
    

 

 

 

Pro forma results of operations prior to the date of acquisition have not been presented because those results are not materially different from the actual results presented.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

2. Acquisitions and Dispositions

 

As of June 30, 2011, the Company held $6.5 million in escrow relating to payments to be made for previous acquisitions, of which $2.3 million is reflected as cash held in escrow and $4.2 million is reflected as a component of other assets in the accompanying consolidated condensed balance sheet. These escrows secure the indemnification obligations contained in the definitive agreements governing these transactions. The Company recorded $6.5 million in liabilities related to these acquisitions of which $2.3 million is recorded as a component of other accrued expenses and $4.2 million is recorded as a component of other liabilities. The Company classified these balances as current or long-term based on the expected date of the release of the funds.

In December 2010, the Company formed BioDuro Biologics Pte. Ltd. to develop proprietary biological drug discovery services capabilities. The Company invested $5.0 million and sold a 25 percent interest in the entity in exchange for $1.7 million in intangible assets. The Company recorded the exchange of the 25 percent noncontrolling interests in the entity at the fair value of the intangible assets acquired. At any time between December 2014 and December 2016, the Company has the right to acquire the noncontrolling interests at fair value. If the Company fails to exercise its purchase option, then during the 183-day period following the expiration of this option the minority owners have the right to require the Company to purchase their noncontrolling interests at fair value. BioDuro Biologics is included in the Company’s Laboratory Services segment.

Dispositions

In May 2010, the Company discontinued the operations of its wholly owned subsidiary PPD Dermatology, Inc., which was part of the Company’s Discovery Sciences segment.

The results of PPD Dermatology are reported as discontinued operations within the consolidated condensed statements of income as set forth in the following table:

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
     2010           2011            2010           2011        

Loss from discontinued operations

   $ (2,833   $ -       $ (4,444   $ -   

Benefit for income taxes

     248        -         782        -   

Loss from discontinued operations, net of income taxes

     (2,585     -         (3,662     -   

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

3. Cash and Cash Equivalents, Short-term Investments, Long-term Investments and Other Investments

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

 

     Cash and
Cash
Equivalents
     Short-term
Investments
     Long-term
Investments
     Other
Investments
     Unrealized
Gains
     Unrealized
Losses
 

As of December 31, 2010

                 

Cash

   $ 246,843                  

Money market funds

     232,731                  

Auction rate securities

         $ 78,747             $ 14,203   

Municipal debt securities

      $ 32,707             $ 122         24   

Corporate debt securities – FDIC insured

        9,160               105         1   

Treasury securities

        38,109               118         2   

Equity method investment:

                 

Celtic Therapeutics Holdings, L.P.

            $ 30,724         

Cost method investments:

                 

Bay City Capital Funds

              7,069         

A.M. Pappas Funds

              3,486         

Liquidia Technologies, Inc.

              5,000         

Other investments

              1,554         
                 

Total

   $ 479,574       $ 79,976       $ 78,747       $ 47,833       $ 345       $ 14,230   
                 

As of June 30, 2011

                 

Cash

   $ 273,205                  

Money market funds

     86,829                  

Certificates of deposit

     10,830                  

Auction rate securities

         $ 55,858             $ 12,193   

Asset-backed securities

           13,401          $ 44      

Equity method investments:

                 

Celtic Therapeutics Holdings, L.P.

            $ 51,925         

VenBio Global Strategic Fund, L.P.

              200         

Cost method investments:

                 

Bay City Capital Funds

              8,010         

A.M. Pappas Funds

              3,546         

Liquidia Technologies, Inc.

              5,000         

Other investments

              1,732         
                 

Total

   $ 370,864       $ -       $ 69,259       $ 70,413       $ 44       $ 12,193   
                 

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

3. Cash and Cash Equivalents, Short-term Investments, Long-term Investments and Other Investments

 

For the three and six months ended June 30, 2010 and 2011, the Company had the following gross realized gains and losses on investments:

 

    Three Months Ended
June 30,
    Six Months Ended
June 30,
 
    2010         2011         2010         2011      

Gross realized gains on short-term investments

  $ -      $ 203      $ 4      $ 422   

Gross realized gains on cost method investments

    3,340        244        3,340        244   

Gross realized losses on short-term investments

    -        -        53        5   

Gross realized losses on long-term investments

    -        842        -        842   

Gross realized losses on cost method investments

    750        924        750        924   

Short-term and long-term investments

The Company classifies its short-term and long-term investments as available-for-sale securities. The Company determines realized and unrealized gains and losses on short-term and long-term investments on a specific identification basis.

The Company held $78.7 million and $55.9 million, net of unrealized losses, in auction rate securities at December 31, 2010 and June 30, 2011, respectively. The Company’s portfolio of investments in auction rate securities consists principally of interests in government-guaranteed student loans, insured municipal debt obligations and municipal preferred auction rate securities. The Company classified its entire balance of auction rate securities as long-term investments as of June 30, 2011 due to continuing uncertainties about the liquidity of the auction rate securities market. The Company also recorded unrealized losses on these investments of $14.2 million and $12.2 million as of December 31, 2010 and June 30, 2011, respectively. The Company recorded these unrealized losses based on a Level 3 valuation, including assumptions about appropriate maturity periods of the instruments by utilizing a 2 to 5 year workout period based on industry expectations, market interest rates for comparable securities and the underlying credit-worthiness of the issuers. The Company concluded that this impairment was temporary because of its ability to hold the auction rate securities until the fair value recovers and has no current plans to sell the securities. The Company will continue to review the classification and valuation of these securities on a quarterly basis.

In May 2011, the Company converted $14.2 million of its government-guaranteed student loan auction rate securities to $14.2 million of government-guaranteed student loan asset-backed securities from the same issuer. For the three and six months ended June 30, 2011, the Company recognized a loss of $0.8 million on this conversion. The Company classified $13.4 million of government-guaranteed student loan asset-backed securities as long-term investments as of June 30, 2011 due to continued uncertainties about the liquidity of these securities. The Company has no current plans to sell the securities. The Company will continue to review the classification and valuation of these securities on a quarterly basis.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

3. Cash and Cash Equivalents, Short-term Investments, Long-term Investments and Other Investments

 

Equity method investment

In 2009, the Company committed to invest up to $102.7 million in Celtic Therapeutics Holdings, L.P., or Celtic, as a limited partner. Celtic is an investment partnership organized for the purpose of identifying, acquiring and investing in a diversified portfolio of novel therapeutic product candidates, with a focus on mid-stage compounds that have progressed through human proof of concept studies and that are targeted to address unmet medical needs. As of June 30, 2011, the Company owned 50.8% of the outstanding partnership interests of Celtic. The Company accounts for this investment under the equity method of accounting because the Company is a limited partner and the general partner has all decision-making authority relating to investment decisions and fund operations. As such, the Company is deemed to lack the control of the entity required for consolidation. As of June 30, 2011, the Company had a remaining commitment of $60.0 million, which it expects to fund over a period of up to four years. During 2010, the Company loaned Celtic $10.0 million, of which $2.0 million was repaid in 2010 and the remaining $8.0 million was converted to additional equity in connection with the settlement of a $10.0 million capital call during the first quarter of 2011. For the three months ended June 30, 2010 and 2011, the Company recognized a loss of $1.7 million and income of $10.6 million, respectively, based on the allocation of profits and losses to the partners’ capital accounts. For the six months ended June 30, 2010 and 2011, the Company recognized a loss of $3.8 million and income of $13.2 million, respectively, based on the allocation of profits or losses to the partners’ capital accounts. As of June 30, 2011, the Company had an investment balance of $51.9 million.

In April 2011, the Company committed to invest up to $50.0 million in venBio Global Strategic Fund, L.P., or venBio, as a limited partner over the next five years. venBio invests in early stage life sciences companies. The Company accounts for this investment under the equity method of accounting because the Company is a limited partner and the general partner has all decision-making authority relating to investment decisions and fund operations. As such, the Company is deemed to lack the control of the entity required for consolidation. As of June 30, 2011, the Company had a remaining commitment of $49.8 million. As of June 30, 2011, the Company had an investment balance of $0.2 million and had an ownership interest in venBio of approximately 40%.

Cost method investments

The Company is a limited partner in several venture capital funds established for the purpose of investing in life science and healthcare companies. These funds require the Company to commit to make investments in the funds over a period of time. The Company accounts for these funds as cost method investments, determining realized and unrealized losses on a specific identification method.

The Company is a stockholder in Accelerator III Corporation and certain of its incubator companies. Accelerator III requires the Company to make investments upon request up to its committed capital amount. The Company accounts for this investment as a cost method investment, determining realized and unrealized losses on a specific identification method.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

3. Cash and Cash Equivalents, Short-term Investments, Long-term Investments and Other Investments

 

The Company’s capital commitments in these funds as of June 30, 2011 were as follows:

 

Fund

   Ownership   Total
Capital
Commitment
   Remaining
Commitment
   Commitment
    Expiration    

Bay City Capital Fund IV, L.P.

   2.9%   $10,000    $1,039    September 2010  (2)

Bay City Capital Fund V, L.P.

   2.0%   10,000      5,959    October 2012

A.M. Pappas Life Science Ventures III, L.P.

   4.7%   4,750         594    December 2009  (2)

A.M. Pappas Life Science Ventures IV, L.P.

   3.0%   2,935      1,702    February 2014

Accelerator III and incubator companies (1)

   19.9%   4,802         819    None

 

(1) 

The Company’s percentage ownership of Accelerator III and incubator companies might vary but will not exceed 19.9%.

(2) 

The funding commitments to Bay City Capital Fund IV, L.P. and A.M. Pappas Life Science Ventures III, L.P. have expired for new investments. The Company may still be required to fund additional investments in existing fund portfolio companies and the ongoing operations of these funds up to the amount of the remaining capital commitment.

In May 2010, the Company invested $5.0 million for an ownership interest in Liquidia Technologies, Inc. As of June 30, 2011, the Company’s ownership interest in Liquidia was 8.6%.

 

4. Accounts Receivable and Unbilled Services

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

 

     December 31,
2010
    June 30,
2011
 

Billed

   $ 276,240      $ 326,959   

Unbilled

     168,037        182,348   

Allowance for doubtful accounts

     (8,401     (6,422
                

Total accounts receivable and unbilled services, net

   $ 435,876      $ 502,885   
                

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

5. Property and Equipment

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

 

     December 31,
2010
    June 30,
2011
 

Land

   $ 8,201      $ 8,307   

Buildings and leasehold improvements

     274,716        279,279   

Fixed assets not placed in service

     13,843        34,338   

Information technology systems under development

     28,808        26,014   

Furniture and equipment

     234,132        246,884   

Computer equipment and software

     203,867        222,699   
                

Total property and equipment

     763,567        817,521   

Less accumulated depreciation

     (377,704     (411,377
                

Property and equipment, net

   $ 385,863      $ 406,144   
                

As of June 30, 2011, fixed assets not placed in service included software licenses purchased from a third-party vendor with annual payment terms as follows:

 

June 1, 2012

   $ 4,212   

Present value discount

     (122
        

Present value of remaining payments

   $ 4,090   
        

The Company classified its liability related to these licenses as other accrued expenses on its consolidated condensed balance sheet as of June 30, 2011. Depreciation expense was $16.2 million and $15.9 million for the three months ended June 30, 2010 and 2011, respectively, and $32.3 million and $31.7 million for the six months ended June 30, 2010 and 2011, respectively.

 

6. Goodwill and Intangible Assets

Changes in the carrying amount of goodwill for the six months ended June 30, 2011, by operating segment, were as follows:

 

     Clinical
Development
Services
     Laboratory
Services
    Total  

Balance as of December 31, 2010

   $ 106,671       $ 184,546      $ 291,217   

Adjustments to goodwill for prior year acquisitions

     -         (825     (825

Translation adjustments

     4,305         3,351        7,656   
                         

Balance as of June 30, 2011

   $ 110,976       $ 187,072      $ 298,048   
                         

As of June 30, 2011, the Company recorded a $0.8 million adjustment to goodwill related to X-Chem resulting from information regarding the valuation estimates that became available after the preliminary purchase price allocation was established.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

6. Goodwill and Intangible Assets

 

The Company reviews goodwill for impairment annually on October 1st, and more frequently if impairment indicators arise. An impairment indicator represents an event or change in circumstances that would more likely than not reduce the fair value of a goodwill reporting unit below its carrying amount. A significant amount of judgment is involved in determining if an indicator of goodwill impairment has occurred. The Company monitors events and changes in circumstances in between annual testing dates to determine if any events or changes in circumstances indicate impairment. In connection with the most recent annual impairment test on October 1, 2010, the Company reviewed goodwill for impairment and the analysis indicated a significant amount of fair value in excess of carrying value for each goodwill reporting unit. However, the fair value of goodwill could be impacted by future adverse changes such as a significant decline in operating results, a sustained decline in the valuation of pharmaceutical and biotechnology company stocks, including the valuation of the Company’s own common stock, a significant adverse change in legal factors or in the business climate, a further significant slowdown in the worldwide economy or the pharmaceutical and biotechnology industry, or the sustained failure to meet the performance projections included in the forecasts of future operating results for any of the Company’s goodwill reporting units. Any adverse change in these factors could have a significant impact on the recoverability of goodwill, and could have a material impact on the Company’s consolidated financial statements. There were no such indicators of impairment during the second quarter of 2011.

The Company’s amortized intangible assets were composed of the following as of the dates set forth below:

 

     December 31, 2010      June 30, 2011  
     Carrying
Amount
     Accumulated
Amortization
    Net      Carrying
Amount
     Accumulated
Amortization
    Net  

Customer relationships

   $ 17,658       $ (2,844   $ 14,814       $ 17,894       $ (3,887   $ 14,007   

Non-compete agreements

     2,047         (84     1,963         1,350         (206     1,144   

Trade name

     150         (150     -         150         (150     -   

Backlog

     7,217         (2,770     4,447         7,369         (3,610     3,759   
                                                   

Total

   $ 27,072       $ (5,848   $ 21,224       $ 26,763       $ (7,853   $ 18,910   
                                                   

The Company had total non-amortizing intangible assets of $10.2 million as of December 31, 2010 and June 30, 2011. Unamortized intangible assets consist of $8.2 million of in-process research and development and $2.0 million of other intangible asset.

Amortization expense for the three months ended June 30, 2010 and 2011 was $0.9 million and $1.0 million, respectively. Amortization expense for the six months ended June 30, 2010 and 2011 was $1.9 million and $2.0 million, respectively. As of June 30, 2011, expected amortization expense for each of the next five years is as follows:

 

2011 (remaining six months)

   $ 1,953   

2012

     3,274   

2013

     3,097   

2014

     2,344   

2015

     1,769   

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

7. Debt Instruments

In April 2011, the Company entered into a $50.0 million revolving line of credit facility with Barclays Bank PLC. The facility has a term of one-year and the Company can use borrowings for general corporate purposes. The credit facility contains customary affirmative, negative and financial covenants for financings of this size and kind. Outstanding borrowings under the credit facility bear interest at an annual fluctuating rate tied to certain financial indices plus an agreed upon margin. The credit facility is currently scheduled to expire in April 2012, at which time any outstanding balance will be due. As of June 30, 2011, no borrowings were outstanding under this credit facility.

 

8. Shareholders’ Equity

Stock options

The Company estimates the fair value of each award on the grant date using the Black-Scholes option-pricing model and recognizes it as expense over the employee’s requisite service period.

During the six months ended June 30, 2011, the Company granted options to purchase approximately 1,708,000 shares with a weighted-average exercise price of $27.35. This amount includes options to purchase approximately 1,554,500 shares granted in the Company’s annual grant during the first quarter of 2011. All options have 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. The weighted-average grant date fair value per share and the aggregate fair value of options granted during the six months ended June 30, 2010 and 2011 was $5.91 and $6.79 per share, and $16.0 million and $11.6 million, respectively. As of June 30, 2011, the Company had options outstanding to purchase 12.1 million shares of its common stock.

Restricted stock units

The Company has issued restricted stock units that 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 award date. The Company determines expense based on the market value of the restricted stock units on the award date, and recognizes expense on a straight-line basis over the vesting period.

During the six months ended June 30, 2011, the Company awarded approximately 359,000 restricted stock units to employees, all of which were granted in the Company’s annual grant during the first quarter of 2011. The weighted-average award date fair value per unit and the aggregate fair value of units during the six months ended June 30, 2011 was $27.27 per share and $9.8 million, respectively. As of June 30, 2011, approximately 355,000 restricted stock units were outstanding.

 

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

8. Shareholders’ Equity

 

Stock repurchase program

In February 2008, the Company’s Board of Directors approved a stock repurchase program authorizing the Company to repurchase up to $350.0 million of its common stock from time to time. In February 2011, the Company entered into an accelerated share repurchase, or ASR, arrangement with Barclays Capital Inc., or Barclays, under which the Company used $200.0 million of the remaining amount to repurchase additional shares of its common stock. During the first quarter of 2011, the Company repurchased approximately 6.5 million shares of its common stock under this arrangement for an aggregate purchase price of $200.0 million.

The agreement with Barclays for the ASR includes a forward sale contract settlement date in December 2011 but it could be settled prior to that date. Under the terms of the forward sale contract, Barclays is required to purchase, in the open market, $200.0 million of shares of the Company’s common stock during the term of the contract to fulfill its obligation related to the shares it borrowed from third parties and sold to the Company. At settlement, the Company, at its option, is required to either pay cash or issue registered or unregistered shares of its common stock to Barclays if Barclays’ volume weighted-average purchase price of open market purchases is higher than the average price of the 6.5 million shares purchased by the Company from Barclays, such average price is referred to as the hedge price. If Barclays’ volume weighted-average price is lower than the hedge price, Barclays is required to pay the Company either cash or additional shares of the Company’s common stock, at the Company’s option. The Company accounted for this forward sale contract as an equity instrument under accounting guidelines. As the fair value of the forward sale contract at inception was zero, no accounting for the forward sale contract is required until settlement, as long as the forward sale continues to meet the requirements for classification as an equity instrument.

As of June 30, 2011, $60.7 million remained available for stock repurchases authorized by the Board of Directors. The manner of the purchases, the amount the Company spends and the number of shares repurchased will vary based on a variety of factors, including the status of the Barclays ASR program, the stock price and blackout periods in which the Company is restricted from repurchasing shares.

 

9. Comprehensive Income (Loss)

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

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2010     2011     2010     2011  

Net income, as reported

   $ 20,977      $ 45,415      $ 38,182      $ 82,782   

Other comprehensive income (loss):

        

Cumulative translation adjustment

     (20,542     7,093        (32,452     23,515   

Change in fair value of hedging transactions, net of tax benefit (expense) of $244, ($530), $1,456 and ($1,034), respectively

     (1,130     939        (3,984     1,994   

Reclassification adjustment for hedging results included in direct costs, net of tax benefit of $253, $753, $936 and $1,295, respectively

     (312     (1,589     (1,561     (2,765

Net unrealized gain on investments, net of tax expense of ($217),($1,076), ($1,162) and ($619), respectively

     391        1,939        2,233        1,117   
                                

Total other comprehensive income (loss)

     (21,593     8,382        (35,764     23,861   
                                

Comprehensive income (loss)

   $ (616   $ 53,797      $ 2,418      $ 106,643   
                                

 

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

9. Comprehensive Income (Loss)

 

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

 

     December 31,
2010
    June 30,
2011
 

Translation adjustment

   $ 28      $ 23,543   

Pension liability, net of tax benefit of $4,865

     (11,705     (11,705

Fair value on hedging transactions, net of tax expense of ($1,714) and ($1,489), respectively

     3,523        2,752   

Net unrealized losses on investments, net of tax benefit of $4,899 and $4,280, respectively

     (8,986     (7,869
                

Total

   $ (17,140   $ 6,721   
                

 

10. Accounting for Derivative Instruments and Hedging Activities

The Company has significant international revenues and expenses, and related receivables and payables, denominated in currencies other than the functional currency of the related subsidiary. As a result, the Company’s operating results can be affected by changes in foreign currency exchange rates. In an effort to minimize this risk, from time to time, the Company purchases foreign currency option and forward contracts as hedges against anticipated and recorded transactions, and the related receivables and payables denominated in foreign currencies. The Company only uses foreign currency option and forward contracts as hedges to minimize the variability in the Company’s operating results arising from foreign currency exchange rate movements and not for speculative or trading purposes.

The Company recognizes changes in the fair value of the effective portion of foreign exchange derivatives that are designated and qualify as cash flow hedges of forecasted revenue and expense transactions 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 reclassifies OCI associated with hedges of foreign currency revenue into direct costs upon recognition of the forecasted transaction in the statements of income. The Company recognizes the ineffective portion of a derivative instrument in earnings in the current period as a component of other income, and measures it by comparing the fair value of the forward contract to the change in the forward value of the anticipated transaction. Hedging portfolio ineffectiveness during the three months ended June 30, 2010 and 2011 was a loss of $0.4 million and a gain of $0.1 million, respectively. Hedging portfolio ineffectiveness during the six months ended June 30, 2010 and 2011 was a loss of $0.2 million and a gain of $0.1 million, respectively.

The Company also manages its exposure on receivables and payables denominated in currencies other than the entity’s functional currency through the use of natural hedges and foreign currency options and forwards, if necessary. The Company records foreign currency derivatives at fair value, with fluctuations in the fair value being included in the statements of income as a component of other income. There were two outstanding foreign currency options and forwards related to receivables and payables hedging outstanding as of June 30, 2011. The fair value of the derivative liability and the gains and losses reported in the statements of income were not significant.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

10. Accounting for Derivative Instruments and Hedging Activities

 

As of June 30, 2011, the Company’s outstanding hedging contracts were scheduled to expire over the next 18 months. The Company expects to reclassify the current gain positions of $2.8 million, net of tax, within the next 12 months from OCI into the statement of income. As of December 31, 2010 and June 30, 2011, the Company’s foreign currency derivative portfolio resulted in the Company recognizing an asset of $6.7 million and $5.9 million, respectively, as a component of other current assets and a liability of $1.4 million and $1.5 million, respectively, as a component of other accrued expenses.

 

11. Pension Plan

Net periodic pension costs for the U.K. pension plan included the following components:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2010     2011     2010     2011  

Interest cost

   $ 764      $ 827      $ 1,563      $ 1,640   

Expected return on plan assets

     (595     (755     (1,218     (1,497

Amortization of losses

     255        215        522        427   
                                

Net periodic pension cost

   $ 424      $ 287      $ 867      $ 570   
                                

During the six months ended June 30, 2011, the Company did not make any contributions to the plan but still expects to contribute approximately $3.0 million during the remainder of 2011.

 

12. Commitments and Contingencies

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 payable to the issuers of the letters of credit competitively determined in the marketplace. As of June 30, 2011, the Company had four letters of credit outstanding for a total of $1.8 million.

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 in amounts up to $5.0 million.

The Company is self-insured for health insurance for the majority of its employees located within the United States, but maintains stop-loss insurance on a “claims made” basis for expenses in excess of $0.4 million per member per year.

As of June 30, 2011, the Company had commitments to invest up to an aggregate additional $9.3 million in several venture capital funds, $0.8 million in other cost method investments and $109.8 million in equity method investments. For further details, see Note 3.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

12. Commitments and Contingencies

 

In 2010, the Company entered into a non-revolving line of credit agreement to loan Celtic Pharma Development Services Bermuda Ltd., a subsidiary of Celtic Pharmaceutical Holdings L.P., up to $18.0 million to finance trade payables in connection with a specified drug candidate. Celtic Pharma Development Services Bermuda Ltd. has appointed the Company to conduct certain clinical studies on the drug candidate. Principal and interest are due and payable no later than June 30, 2013 and are secured by a guarantee of an affiliate of the borrower. As of June 30, 2011, the Company had advanced $15.5 million to the borrower which is recorded as a component of other assets.

In 2010, the Company sold a noncontrolling interest in its BioDuro Biologics Pte. Ltd. subsidiary. During the 183-day period commencing in December 2016, the minority equity holders have the right to require the Company to purchase their noncontrolling interests at fair value.

As of June 30, 2011, the Company’s total gross unrecognized tax benefits were $28.2 million, of which $16.1 million, if recognized, would reduce its effective tax rate. The Company believes that it is reasonably possible that the total amount of unrecognized tax benefits could decrease up to $4.8 million within the next twelve months due to the settlement of audits and the expiration of statutes of limitations.

The Company’s policy for recording interest and penalties associated with tax audits is to record them as a component of provision for income taxes. As of June 30, 2011, the Company accrued $5.0 million of interest and $0.9 million of penalties with respect to uncertain tax positions. To the extent interest and penalties are not assessed with respect to uncertain tax positions, the Company will reduce amounts accrued and reflect them as a reduction of the overall income tax provision.

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

In the normal course of business, the Company is a party to various claims and legal proceedings. The Company records a reserve for pending and threatened litigation matters when an adverse outcome is probable and the amount of the potential liability is reasonably estimable. Although the ultimate outcome of pending and threatened litigation is currently not determinable and litigation costs can be material, management of the Company, after consultation with legal counsel, does not believe that the resolution of these matters will have a material effect upon the Company’s financial condition, results of operations or cash flows.

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

13. Fair Value of Financial Instruments

The Company has categorized its assets and liabilities recorded at fair value based upon a fair value hierarchy in accordance with the applicable accounting standards.

The following table presents information about the Company’s assets and liabilities required to be measured at fair value on a recurring basis:

 

     Level 1      Level 2      Level 3      Total  

As of December 31, 2010

           

Assets

           

Cash equivalents

   $   232,731       $ -       $ -       $   232,731   

Short-term investments:

           

Treasury securities

     38,109         -         -         38,109   

Municipal debt securities

     -         32,707         -         32,707   

Corporate debt securities

     -         9,160         -         9,160   

Long-term investments

     -         -         78,747         78,747   

Equity method investment

     -         -         30,724         30,724   

Derivative contracts

     -         6,668         -         6,668   
                                   

Total assets

   $   270,840       $   48,535       $   109,471       $   428,846   
                                   

Liabilities

           

Derivative contracts

   $ -       $     1,373       $ -       $ 1,373   
                                   

Total liabilities

   $ -       $     1,373       $ -       $ 1,373   
                                   
     Level 1      Level 2      Level 3      Total  

As of June 30, 2011

           

Assets

           

Cash equivalents

   $     97,659       $ -       $ -       $     97,659   

Long-term investments

     -         13,401         55,858         69,259   

Equity method investments

     -         -         52,125         52,125   

Derivative contracts

     -         5,931         -         5,931   
                                   

Total assets

   $     97,659       $   19,332       $   107,983       $   224,974   
                                   

Liabilities

           

Derivative contracts

   $ -       $     1,546       $ -       $       1,546   
                                   

Total liabilities

   $ -       $     1,546       $ -       $       1,546   
                                   

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

13. Fair Value of Financial Instruments

The following table provides a reconciliation of the beginning and ending balances for assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs, or Level 3, for the six months ended June 30, 2011:

 

        Long-term
Investments
 
 

Balance as of December 31, 2010

  $ 109,471   
 

Adjustment to previously recognized unrealized loss on investments included in other comprehensive income

    (1,119
 

Income from equity method investment

    2,549   
 

Additional investment in equity method investment

    8,012   
 

Liquidation of investments

    (75
         
 

Balance as of March 31, 2011

    118,838   
 

Adjustment to previously recognized unrealized loss on investments included in other comprehensive income

    3,129   
 

Realized loss on investments

    (842
 

Income from equity method investment

    10,639   
 

Additional investment in equity method investments

    200   
 

Liquidation of investments

    (10,625
 

Transfers out of Level 3

    (13,357
         
 

Balance as of June 30, 2011

  $     107,982   
         

 

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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(numbers in tables in thousands)

(unaudited)

 

14. Business Segment Data

The Company evaluates segment performance and allocates resources based on net revenue and operating income (loss). Depreciation and amortization expense is allocated to the business unit based on various operational metrics, such as headcount and space. In addition, net revenue and operating income (loss) by segment exclude reimbursed revenue. The Company has a global infrastructure supporting its business segments, and therefore, assets are not identified by reportable segment.

Net revenue and operating income (loss) by business segment were as follows as of the dates set forth below:

 

     Three Months Ended
June 30,
          Six Months Ended
June 30,
 
     2010     2011           2010     2011  

Net revenue:

            

Clinical Development Services

   $     255,436      $     291,547          $     504,730      $     571,205   

Laboratory Services

     78,343        84,652            152,876        161,159   

Discovery Sciences

     7,717        -            8,010        -   

Reimbursed revenue

     28,423        31,504            51,072        58,542   
                                    

Total

   $ 369,919      $ 407,703          $ 716,688      $ 790,906   
                                    

Operating income (loss):

            

Clinical Development Services

   $ 31,142 $        48,484          $ 58,148      $ 94,978   

Laboratory Services

     11,944        8,662            21,478        14,617   

Discovery Sciences

     (3,002     -            (11,860     -   
                                    

Total

   $ 40,084      $ 57,146          $ 67,766      $ 109,595   
                                    

 

15. Related Party Transactions

As of June 30, 2011, the Company provided services to and owned 50.8% of Celtic Therapeutics Holdings, L.P., or Celtic, which is accounted for under the equity method. During 2010, the Company loaned Celtic $10.0 million, of which $2.0 million was repaid in 2010. During the first quarter of 2011, the outstanding loan was converted to additional equity in connection with the settlement of a $10.0 million capital call. The Company recognized $0.5 million and $0.6 million of net revenue from Celtic for the three months ended June 30, 2010 and 2011, respectively, and $0.5 million and $2.2 million in net revenue from Celtic for the six months ending June 30, 2010 and 2011, respectively.

 

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

The following discussion and analysis is provided to increase the understanding of, and should be read in conjunction with, our consolidated condensed financial statements and accompanying notes. In this discussion, the words “PPD”, “we”, “our” and “us” refer to Pharmaceutical Product Development, Inc., together with its subsidiaries where appropriate.

Forward-looking Statements

This Form 10-Q contains forward-looking statements within the meaning of the federal securities laws. These statements relate to future events or our future financial performance. Forward-looking statements include statements concerning plans, objectives, goals, strategies, future events or performance, expectations, predictions, assumptions and other statements that are not statements of historical facts. In some cases, you can identify forward-looking statements by terminology such as “might”, “will”, “should”, “expect”, “plan”, “anticipate”, “believe”, “estimate”, “predict”, “intend”, “potential” or “continue”, or the negative of these terms, or other comparable terminology. These statements are only predictions. These statements rely on a number of assumptions and estimates that could be inaccurate and that are subject to risks and uncertainties. Actual events or results might differ materially due to a number of factors, including those listed in “Potential Volatility of Quarterly Operating Results and Stock Price” below and in “Item 1A. Risk Factors” included in our Annual Report on Form 10-K for the year ended December 31, 2010. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements.

Company Overview

We are a leading global contract research organization providing drug discovery, development and lifecycle management services. Our clients include pharmaceutical, biotechnology, medical device, academic, non-profit and government organizations. We apply innovative technologies, therapeutic expertise and a commitment to quality to help our clients accelerate the development of safe and effective therapeutics and maximize the returns on their research and development investments.

We have been in the drug development business for more than 25 years. Our development services include preclinical drug discovery services, Phase I through Phase IV clinical development services and post-approval services, as well as bioanalytical, cGMP, global central laboratory and vaccines and biologics laboratory services. We have extensive clinical trial experience, including regional, national and global studies across a wide spectrum of therapeutic areas in over 100 countries, spanning six continents. In addition, for marketed drugs, biologics and devices, we offer support such as medical information, patient compliance programs, patient and disease registry programs, product safety and pharmacovigilance, standard response document development, observational studies, Phase IV monitored studies and prescription-to-over-the-counter, or Rx to OTC, programs. Our services offer our clients a way to identify and develop drug candidates more quickly and cost-effectively.

With 87 offices in 44 countries and more than 11,000 employees worldwide, our global infrastructure enables us to accommodate the multinational drug development needs of our clients. We have provided services to 49 of the top 50 pharmaceutical companies in the world as ranked by 2009 healthcare research and development spending. We also work with leading biotechnology companies and government organizations that sponsor clinical research. We are one of the world’s largest providers of drug development services based on 2010 annual net revenue generated from contract research organizations. For more detailed information on PPD, see our Annual Report on Form 10-K for the year ended December 31, 2010.

 

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Executive Overview

Our revenues depend on a relatively small number of industries and clients. As a result, we closely monitor the market for our services. For a discussion of the trends affecting the market for our services, see “Item 1. Business – Trends Affecting the Drug Discovery and Development Industry” in our Annual Report on Form 10-K for the year ended December 31, 2010. We continue to believe in the fundamentals of the CRO services market. We expect many clinical trial sponsors to continue to narrow their drug discovery and development services vendor lists and outsource a greater percentage of their research and development budgets in the years ahead. For the remainder of 2011, we plan to continue to pursue and establish innovative and strategic client relationships, while enhancing our focus on execution and quality to differentiate our company and create value for our clients and our shareholders. We also expect to expand the scope of our discovery services offerings through new technologies that should differentiate us from our competitors. We continue to focus on all selling, general and administrative, or SG&A, expenses and on driving efficiencies, while selectively investing for future growth and productivity gains. Finally, we will continue the initiatives started in 2010 to improve productivity and control costs to achieve our 2011 financial objectives.

We review various metrics to evaluate our financial performance, including period-to-period changes in backlog, new authorizations, cancellation rates, revenue, revenue conversion, margins and earnings. In the second quarter of 2011, we had net authorizations, defined as new authorizations less cancellations and adjustments, of $484.0 million, a 4.0% increase over the same period in 2010. The cancellation rate for the second quarter of 2011 was 7.5% of beginning backlog compared to 4.6% for the same period in 2010. Cancellations were high in the second quarter of 2011 due in part to a $43.2 million cancellation for a global clinical trial. The average length of our contracts in backlog decreased to 33 months as of June 30, 2011 from 34 months as of December 31, 2010. In the second quarter of 2011, revenue conversion, defined as revenue divided by prior periods’ ending backlog, excluding backlog from the discovery segment, averaged 10.5% compared to 10.7% for the same period in 2010.

Backlog by client type as of June 30, 2011 was 77.6% pharmaceutical, 16.6% biotech and 5.8% government/other, as compared to 78.1% pharmaceutical, 15.2% biotech and 6.7% government/other as of June 30, 2010. Net revenue by client type for the quarter ended June 30, 2011 was 79.3% pharmaceutical, 17.0% biotech and 3.7% government/other, compared to 77.3% pharmaceutical, 17.7% biotech and 5.0% government/other for the same period in 2010. The change in the composition of our net revenue was primarily a result of an increase in percentage of authorizations from pharmaceutical companies during the trailing twelve-month period ended June 30, 2011 and mergers of biotechnology clients into pharmaceutical companies.

For the second quarter of 2011, net revenue contribution by business segment was 77.5% from Clinical Development Services and 22.5% from Laboratory Services, compared to net revenue contribution for the second quarter of 2010 of 74.8% from Clinical Development Services, 22.9% from Laboratory Services and 2.3% from Discovery Sciences. Our top therapeutic areas by net revenue for the quarter ended June 30, 2011 were oncology, circulatory/cardiovascular, endocrine/metabolic, infectious disease and central nervous system. For a detailed discussion of our revenue, margins, earnings and other financial results for the second quarter of 2011, see “Results of Operations – Three Months Ended June 30, 2010 versus Three Months Ended June 30, 2011” below.

Our operating margin increased to 14.0% in the second quarter of 2011 from 10.8% in the second quarter of 2010. Our Clinical Development Services segment operating margin of 16.6% remained consistent sequentially, and our Laboratory Services segment operating margin increased sequentially to 10.2% from 7.8% in the first quarter of 2011. Increased investment to support anticipated future growth of our drug discovery services business, BioDuro, and lower than expected net revenue in our Vaccines and Biologics Center of Excellence continued to pressure the Laboratory Services segment gross and operating margins in the second quarter of 2011. We expect our Laboratory Services segment operating margin to continue to increase throughout the year, driven by sequential net revenue growth and operating efficiency.

Capital expenditures for the three months ended June 30, 2011 totaled $26.0 million. These capital expenditures were primarily for our new bioanalytical laboratory in Richmond, Virginia for a dedicated client, the expansion of our vaccine laboratory in Wayne, Pennsylvania, scientific equipment for our laboratory units and computer software. We made these investments to support growth in our businesses and to improve the efficiencies of our operations.

 

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As of June 30, 2011, we had $440.1 million of cash, cash equivalents and long-term investments. In the second quarter of 2011, we generated $17.7 million in cash from operations which was impacted by significant income tax payments and an increase in accounts receivable and unbilled services, net. The number of days’ revenue outstanding in accounts receivable and unbilled services, net of unearned income, also known as DSO, was 26 days for the six months ended June 30, 2011, compared to 22 days for the year ended December 31, 2010. Collection efficiency remains solid, demonstrated by our aged accounts receivables less than 90 days which remains over 90% of total accounts receivable for the six months ended June 30, 2011. We plan to continue to monitor DSO and the various factors that affect it. However, we expect DSO will continue to fluctuate in the future depending on contract terms, the mix of contracts performed and our success in collecting receivables.

New Business Authorizations and Backlog

We add new business authorizations, which are sales of our services, to backlog when we enter into a contract or letter of intent or receive a verbal commitment. Authorizations have and will continue to vary significantly from quarter to quarter and contracts generally have terms ranging from several months to several years. We recognize revenue on these authorizations as services are performed. Our new authorizations for the three months ended June 30, 2010 and 2011 were $610.5 million and $752.6 million, respectively.

The dollar amount of our backlog consists of anticipated future net revenue from contracts, letters of intent and verbal commitments we consider highly reliable, that either have not started but are anticipated to begin in the future, or are in process and have not been completed. As of June 30, 2011, the remaining duration of the contracts in our backlog ranged from one to 170 months, with a weighted-average duration of 33 months. The weighted-average duration of the contracts in our backlog will fluctuate from period to period in the future based on the contracts constituting our backlog at any given time. The dollar amount of our backlog excludes net revenue that has been recognized previously in our statements of income and is adjusted each quarter for foreign currency fluctuations. Our backlog as of June 30, 2010 and 2011 was $3.2 billion and $3.7 billion, respectively. For various reasons discussed in “Item 1. Business – Backlog” of our Form 10-K, our backlog might never be fully recognized as net revenue and is not necessarily a meaningful predictor of future performance.

Results of Operations

Revenue Recognition

We generally enter into contracts with clients to provide services with payments based on fixed and variable fee arrangements. We recognize revenue for services, as rendered, only after persuasive evidence of an arrangement exists, the sales price is determinable and collectability is reasonably assured. Once the above criteria have been met, we recognize revenue for the services provided based on the proportional performance methodology, which determines the proportion of outputs or performance obligations that have been completed or delivered compared to the total contractual outputs or performance obligations.

Some of our contractual arrangements with clients involve multiple service deliverables, such as developing testing methodologies, database management, investigator recruitment and clinical trial monitoring, among other services. Upon entering into the contractual arrangement, we determine whether each deliverable has standalone value to the client. If the multiple deliverables within the arrangement each have standalone value to the client, then a separate unit of accounting is assigned to each separate deliverable. If the multiple deliverables are not considered to each have standalone value to the client because the separate deliverables can only be used together, then the deliverables are considered bundled and only one unit of accounting is assigned to the entire arrangement.

A newly adopted accounting standard related to the accounting for revenue arrangement with multiple deliverables requires the allocation of the contractual arrangement’s value based on the relative selling price of the separately identified units of accounting within the arrangement. The standard requires a hierarchy of evidence to be followed when determining the best evidence of the selling price of an item. The best evidence of selling price for a unit of accounting is vendor-specific objective evidence, or VSOE, or the price charged when a deliverable is sold routinely on a standalone basis. When VSOE is not available to determine selling price, relevant third-party evidence, or TPE, of selling price should be used, such as prices competitors charge for interchangeable services to similar clients. When neither VSOE nor TPE of selling price for similar deliverables exists, we must use our best estimate of selling price, or BESP, considering all relevant information that is available.

 

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We generally are not able to establish TPE for our services, as our deliverables are highly customized and competitor pricing is not available. VSOE can often be established for certain deliverables based on our standard price lists used for unitized services or the unit price or hourly rates set forth in the customer arrangement. BESP for deliverables is generally established based on labor costs, risks, and expected profit margins developed from the competitive bidding process for client contracts. We allocate the contractual arrangement’s value at the inception of the arrangement using the relative selling prices of the deliverable services within the contract based upon VSOE when available but primarily upon BESP. Consistent with our accounting policies prior to the adoption of this standard, we recognize revenue for the separate elements of our contracts in accordance with the revenue recognition criteria above. The adoption of this standard did not have a material impact on our consolidated condensed financial statements.

Under a small number of client contracts, a portion of the payments owed to us are contingent upon successful achievement of performance standards or research and development success milestones. These payments are not included in the total contract value used for the proportional performance calculations until the achievement of the performance standard or milestone is reasonably assured. Milestone payments on contracts entered into subsequent to January 1, 2011 were immaterial.

For most clinical trial related service contracts in our Clinical Development Services segment and our Laboratory Services segment, we base measurement of performance on a comparison of direct costs through that date to estimated total direct costs to complete the contract. Direct costs relate primarily to the amount of labor and related overhead costs for the delivery of services. We believe this is the best indicator of the performance of the contractual obligations. Changes in the estimated total direct costs to complete a contract without a corresponding proportional change to the contract value result in a cumulative adjustment to the amount of revenue recognized in the period in which the change in estimate is determined. For time-and-material contracts, we recognize revenue as hours are worked, multiplied by the applicable hourly rate.

Additionally, the Laboratory Services segment enters into arrangements in which the performance obligation is a specified laboratory test. We recognize revenue under these arrangements based upon the number of samples tested times the contracted unit price.

In the event of changes in the scope, nature, duration, or volume of services of the contract with a client, we negotiate to modify our existing contract or establish a new contract to reflect the changes. We recognize renegotiated amounts as revenue by revision to the total contract value resulting from the renegotiated contract.

We often offer volume rebates to our large clients based on annual volume thresholds. We record an estimate of the annual volume rebate as a reduction of revenue throughout the period based on the estimated total rebate to be earned for the period.

In connection with the management of clinical trials, we pay, on behalf of our clients, fees to investigators and test subjects as well as other out-of-pocket costs for items such as travel, printing, meetings and couriers. Our clients reimburse us for these costs. Amounts paid by us as a principal for out-of-pocket costs are included in direct costs and the reimbursements we receive as a principal are reported as reimbursed revenue. In our statements of income, we combine amounts paid by us as an agent for out-of-pocket costs with the corresponding reimbursements, or revenue, we receive as an agent. During the three months ended June 30, 2010 and 2011, fees paid to investigators and other fees we paid as an agent and the associated reimbursements were approximately $91.3 million and $113.0 million, respectively.

Most of our contracts can be terminated by our clients either immediately or after a specified period following notice. Upon early termination, these contracts typically require the client to pay us the fees earned through the termination date, the fees and expenses to wind down the study and, in some cases, a termination fee or some portion of the fees or profit that we could have earned under the contract if it had not been terminated early. Therefore, revenue recognized prior to cancellation generally does not require a significant adjustment upon cancellation.

Prior to our June 2010 spin-off of the Discovery Sciences segment, we generated Discovery Sciences segment revenue from our compound partnering business in the form of upfront payments, development and regulatory milestone payments, and royalties. Upfront payments were generally paid within a short period of time following the execution of an out-license and collaboration agreement. Milestone payments were typically one-time payments to us triggered by the collaborator’s achievement of specified development and regulatory events such as the commencement of Phase III trials or regulatory submission or approval. Royalties were payments received by us based on net product

 

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sales of a collaboration. We recognized these various forms of payment from our collaborators when the event which triggered the obligation of payment had occurred, there were no further obligations on our part in connection with the payment and collection was reasonably assured.

Recording of Expenses

We record our operating expenses among the following categories:

 

   

direct costs;

 

   

research and development;

 

   

selling, general and administrative; and

 

   

depreciation and amortization.

Direct costs consist of amounts necessary to carry out the revenue and earnings process, and include direct labor and related benefit charges, other costs directly related to contracts, an allocation of facility and information technology costs, and reimbursable out-of-pocket expenses. Direct costs, as a percentage of net revenue, will 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 for the Clinical Development Services and Laboratory Services segments consist of labor and related benefits charges, materials, supplies and technology costs related to the development of new services offerings for clients. R&D costs for the Discovery Sciences segment consisted primarily of costs associated with preclinical studies and the clinical trials of our product candidates, development materials, patent costs, labor and related benefit charges associated with personnel performing research and development work, supplies associated with this work, consulting services and an allocation of facility and information technology costs.

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 and amortization expenses consist of facility and equipment depreciation and amortization of intangible assets. We record property and equipment at cost less accumulated depreciation. We record depreciation expense on a straight-line method. We depreciate leasehold improvements over the shorter of the respective lives of the leases or the useful lives of the improvements.

 

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Three Months Ended June 30, 2010 versus Three Months Ended June 30, 2011

The following table sets forth amounts from our consolidated condensed financial statements along with the dollar and percentage change for the three months ended June 30, 2010 compared to the three months ended June 30, 2011.

 

     Three Months Ended              
     June 30,              
(in thousands, except per share data)    2010     2011     $ Inc (Dec)     % Inc (Dec)  

Net revenue:

        

Service revenue

   $ 341,496      $ 376,199      $ 34,703        10.2

Reimbursed revenue

     28,423        31,504        3,081        10.8   
                          

Total net revenue

     369,919        407,703        37,784        10.2   

Direct costs

     192,170        221,390        29,220        15.2   

Research and development expenses

     8,445        1,792        (6,653     (78.8

Selling, general and administrative expenses

     112,106        110,456        (1,650     (1.5

Depreciation and amortization

     17,114        16,919        (195     (1.1
                          

Operating income

     40,084        57,146        17,062        42.6   

(Loss) income from equity method investment

     (1,747     10,639        12,386        709.0   

Gain (loss) on investments

     2,590        (1,319     (3,909     (150.9

Other income (expense), net

     157        321        164        104.5   
                          

Income from continuing operations before provision for income taxes

     41,084        66,787        25,703        62.6   

Provision for income taxes

     17,522        21,372        3,850        22.0   
                          

Income from continuing operations

     23,562        45,415        21,853        92.7   

Loss from discontinued operations, net of income taxes

     (2,585     -        2,585        100.0   
                          

Net income

     20,977        45,415        24,438        116.5   

Net loss attributable to noncontrolling interests

     -        1,091        1,091        100.0   
                          

Net income attributable to shareholders

   $ 20,977      $ 46,506      $ 25,529        121.7   
                          

Income per diluted share from continuing operations

   $ 0.20      $ 0.41      $ 0.21        105.0   
                          

Loss per diluted share from discontinued operations

   $ (0.02   $ -      $ 0.02        100.0   
                          

Net income per diluted share

   $ 0.18      $ 0.41      $ 0.23        127.8   
                          

Total net revenue increased $37.8 million to $407.7 million in the second quarter of 2011. Service revenue was $376.2 million, which accounted for 92.3% of total net revenue for the second quarter of 2011. The $34.7 million increase in service revenue was attributable to a $36.1 million increase in net revenue from our Clinical Development Services segment and a $6.3 million increase in net revenue from our Laboratory Services segment. The second quarter of 2010 included $7.7 million in net revenue from our Discovery Sciences segment. The increase in net revenue from our Clinical Development Services segment was primarily related to an increase in authorizations over the last several quarters. The increase in net revenue from our Laboratory Services segment was primarily the result of the strong authorizations in our bioanalytical and cGMP laboratories.

 

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Total direct costs increased $29.2 million to $221.4 million in the second quarter of 2011. The increase was mainly attributable to a $23.2 million increase in direct personnel costs, a $3.1 million increase in reimbursable out-of-pocket expenses, a $2.4 million increase in supply costs related to our laboratories and a $1.0 million increase in facilities costs. These costs were partially offset by a hedging gain of $2.3 million in the second quarter of 2011 compared to a hedging gain of $0.5 million in the second quarter of 2010. Direct personnel costs increased due to an increase in utilization of resources for projects and additional employees to support revenue growth.

R&D expenses decreased $6.7 million to $1.8 million in the second quarter of 2011. The decrease in R&D expense was primarily due to the spin-off of the compound partnering business in June 2010, partially offset by increased spending in drug discovery services.

SG&A expenses decreased $1.7 million to $110.5 million in the second quarter of 2011. The decrease in SG&A expenses was primarily related to a $2.6 million decrease in SG&A expenses related to the spin-off of the compound partnering business and a $1.6 million decrease in facilities and information systems costs as a result of management’s efforts to control SG&A costs. This was partially offset by a $2.7 million net increase in personnel costs as a result of normal salary increases reduced by the increase in utilization of resources for projects noted above.

Depreciation and amortization expense decreased $0.2 million to $16.9 million in the second quarter of 2011.

(Loss) income from equity investment increased $12.4 million to income of $10.6 million in the second quarter of 2011. During the second quarter of 2011, our equity investee, Celtic Therapeutics Holdings, L.P., recorded a $10.6 million increase in the fair value of our share of the underlying investments in the fund. This increase was the result of the progress Celtic made on the development of the programs in its portfolio. As a result of the fact that the investments held by Celtic are recorded at fair value, we anticipate the potential for significant volatility in the amount of income or loss from equity method investments in the future.

Gain (loss) on investments decreased $3.9 million due primarily to a $0.9 million investment impairment and $0.5 million net loss on the sale of investments in the second quarter of 2011 compared to a $3.3 million gain on the sale of investments in the second quarter of 2010.

Other income (expense), net increased $0.2 million to net income of $0.3 million in the second quarter of 2011.

Our provision for income taxes from continuing operations increased $3.9 million to $21.4 million in the second quarter of 2011. Our effective income tax rate for the second quarter of 2010 and 2011 was 42.6% and 32.0%. Our effective rate was higher in the second quarter of 2010 primarily due to $3.8 million of tax expense related to a valuation allowance for deferred tax assets for the compound partnering spin-off.

In the second quarter of 2010, we incurred a loss from discontinued operations, net of income taxes of $2.6 million. This loss was attributable to discontinuing the operations of our wholly owned subsidiary PPD Dermatology, Inc.

Net income attributable to shareholders of $46.5 million in the second quarter of 2011 represents an increase of 121.7% from $21.0 million in the second quarter of 2010. Net income per diluted share of $0.41 in the second quarter of 2011 represents a 127.8% increase from $0.18 net income per diluted share in the second quarter of 2010. Net income changed for various reasons as explained above.

 

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Six Months Ended June 30, 2010 versus Six Months Ended June 30, 2011

The following table sets forth amounts from our consolidated condensed financial statements along with the dollar and percentage change for the six months ended June 30, 2010 compared to the six months ended June 30, 2011.

 

     Six Months Ended              
     June 30,              
(in thousands, except per share data)    2010     2011     $ Inc (Dec)     % Inc (Dec)  

Net revenue:

        

Service revenue

   $ 665,616      $ 732,364      $ 66,748        10.0

Reimbursed revenue

     51,072        58,542        7,470        14.6   
                          

Total net revenue

     716,688        790,906        74,218        10.4   

Direct costs

     374,972        428,213        53,241        14.2   

Research and development expenses

     14,783        4,012        (10,771     (72.9

Selling, general and administrative expenses

     225,016        215,403        (9,613     (4.3

Depreciation and amortization

     34,151        33,683        (468     (1.4
                          

Operating income

     67,766        109,595        41,829        61.7   

(Loss) income from equity method investment

     (3,789     13,188        16,977        448.1   

Gain (loss) on investments

     2,541        (1,105     (3,646     (143.5

Other income (expense), net

     1,479        60        (1,419     (95.9
                          

Income from continuing operations before provision for income taxes

     67,997        121,738        53,741        79.0   

Provision for income taxes

     26,153        38,956        12,803        49.0   
                          

Income from continuing operations

     41,844        82,782        40,938        97.8   

Loss from discontinued operations, net of income taxes

     (3,662     -        3,662        100.0   
                          

Net income

     38,182        82,782        44,600        116.8   

Net loss attributable to noncontrolling interests

     -        1,338        1,338        100.0   
                          

Net income attributable to shareholders

   $ 38,182      $ 84,120      $ 45,938        120.3   
                          

Income per diluted share from continuing operations

   $ 0.35      $ 0.72      $ 0.37        105.7   
                          

Loss per diluted share from discontinued operations

   $ (0.03   $ -      $ 0.03        100.0   
                          

Net income per diluted share

   $ 0.32      $ 0.72      $ 0.40        125.0   
                          

Total net revenue increased $74.2 million to $790.9 million in the first six months of 2011. Service revenue was $732.4 million, which accounted for 92.6% of total net revenue for the first six months of 2011. The $66.7 million increase in service revenue was attributable to a $66.5 million increase in net revenue from our Clinical Development Services segment and an $8.3 million increase in net revenue from our Laboratory Services segment. The first six months of 2010 included $8.0 million in net revenue from our Discovery Sciences segment. The increase in net revenue from our Clinical Development Services segment was primarily related to an increase in authorizations over the last several quarters. The increase in net revenue from our Laboratory Services segment was primarily the result of the strong authorizations in our bioanalytical and cGMP laboratories.

 

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Total direct costs increased $53.2 million to $428.2 million in the first six months of 2011. The increase was mainly attributable to a $40.4 million increase in direct personnel costs, a $7.5 million increase in reimbursable out-of-pocket expenses, a $2.4 million increase in supply costs related to our laboratories, a $1.9 million increase in contract labor and subcontractor costs, and a $1.6 million increase in facilities costs. These costs were partially offset by a $4.1 million hedging gain in the first six months of 2011 compared to a $2.4 million hedging gain in the first six months of 2010. Direct personnel costs increased due to an increase in utilization of resources for projects and additional employees to support revenue growth.

R&D expenses decreased $10.8 million to $4.0 million in the first six months of 2011. The decrease in R&D expense was primarily due to the spin-off of the compound partnering business in June 2010, partially offset by increased spending in drug discovery services.

SG&A expenses decreased $9.6 million to $215.4 million in the first six months of 2011. The decrease in SG&A expenses was primarily related to a $5.9 million decrease in SG&A expenses related to the spin-off of the compound partnering business, a $2.9 million decrease in non-billable travel and training costs, and a $1.5 million decrease in facilities and information system costs. This was partially offset by a $1.9 million increase in personnel costs as a result of normal salary increases reduced by the increase in utilization of resources for projects noted above.

Depreciation and amortization expense decreased $0.5 million to $33.7 million in the first six months of 2011.

(Loss) income from equity investment increased by $17.0 million to income of $13.2 million in the first six months of 2011. During the first six month of 2011, our equity investee, Celtic Therapeutics Holdings, L.P., recorded a $13.2 million increase in the fair value of our share of the underlying investments in the fund. This increase was the result of the progress Celtic made on the development of the programs in its portfolio. As a result of the fact that the investments held by Celtic are recorded at fair value, we anticipate the potential for significant volatility in the amount of income or loss from equity method investments in the future.

Gain (loss) on investments decreased $3.6 million due primarily to a $0.9 million investment impairment and a $0.3 million net loss on the sale of investments in the first six months of 2011, compared to a gain of $3.3 million on the sale of investments in the first six months of 2010.

Other income (expense), net decreased $1.4 million to net income of $0.1 million in the first six months of 2011. Changes in exchange rates from the time we recognize revenue until the client pays resulted in a net loss of $3.6 million in the first six months of 2011, up from a net loss of $0.2 million in the first six months of 2010. This loss was partially offset by a $1.4 million increase in interest income due to higher interest rates earned on cash balances.

Our provision for income taxes from continuing operations increased $12.8 million to $39.0 million in the first six months of 2011. Our effective income tax rate for the first six months of 2010 and 2011 was 38.5% and 32.0%. Our effective rate was higher in the first six months of 2010 primarily due to $3.8 million of tax expense related to a valuation allowance for deferred tax assets for the compound partnering spin-off.

In the first six months of 2010, we incurred a loss from discontinued operations, net of income taxes of $3.7 million. This loss was attributable to discontinuing the operations of our wholly owned subsidiary PPD Dermatology, Inc.

Net income attributable to shareholders of $84.1 million in the first six months of 2011 represents an increase of 120.3% from $38.2 million in the first six months of 2010. Net income per diluted share of $0.72 in the first six months of 2011 represents a 125.0% increase from $0.32 net income per diluted share in the first six months of 2010. Net income changed for various reasons as explained above.

 

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Liquidity and Capital Resources

As of June 30, 2011, we had $370.9 million in total cash and cash equivalents. We invest our cash and cash equivalents in bank deposits and financial instruments that are issued or guaranteed by the U.S. government. Our expected primary cash needs are for capital expenditures, expansion of services, possible acquisitions, investments, 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.

Our cash balances are held in numerous locations throughout the world, most of which are outside of the United States. While historically our U.S. cash balances have been a much higher proportion of our total cash balances, the $200.0 million stock repurchase plan executed during the first quarter of 2011 decreased our U.S. cash balances to $61.5 million as of June 30, 2011. We intend to fund our U.S. operations from existing cash, cash flows from operations and if necessary or appropriate, borrowings under our $50.0 million credit facility with Barclays. We have adopted the permanent reinvestment exception under income tax accounting standards with respect to future earnings of most of our foreign subsidiaries. As a result, while a portion of the foreign cash is available to repay intercompany financing arrangements owed to the United States’ subsidiaries, the majority of this cash is not presently available to fund domestic operations and obligations without paying a significant amount of taxes upon its repatriation. Where this is the case, we plan to continue to hold these funds outside the United States to fund local liquidity needs. We utilize a variety of tax planning and financing strategies with the objective of having our worldwide cash available in the locations where it is needed.

We held $78.7 million and $55.9 million, net of unrealized losses, in auction rate securities at December 31, 2010 and June 30, 2011, respectively. Our portfolio of investments in auction rate securities consists principally of interests in government-guaranteed student loans, insured municipal debt obligations and municipal preferred auction rate securities. We classified our entire balance of auction rate securities as long-term investments as of June 30, 2011 due to continuing uncertainties about the liquidity of the auction rate securities market. We also recorded unrealized losses on these investments of $14.2 million and $12.2 million as of December 31, 2010 and June 30, 2011, respectively. We concluded that this impairment was temporary because of our ability to hold the auction rate securities until the fair value recovers. In May 2011, we converted $14.2 million of government-guaranteed student loan auction rate securities to $14.2 million of government-guaranteed student loan asset-backed securities from the same issuer. For the three and six months ended June 30, 2011, we recognized a loss of $0.8 million on this conversion. We classified our entire balance of government-guaranteed student loan asset-backed securities as long-term investments due to continued uncertainties about the liquidity of these securities. We have no current plans to sell the securities. We will continue to review the classification and valuation of these securities on a quarterly basis.

In the first six months of 2011, our operating activities provided $59.6 million in cash as compared to $121.5 million for the same period last year. The change in operating cash flow was due primarily to a net change in operating cash receipts and payments totaling $95.8 million, a net-of-tax gain from equity investment of $8.5 million in the current period as compared to a net-of-tax loss from equity investment of $2.5 million in the six months ended June 30, 2010, a decrease in depreciation and amortization expense of $1.5 million, partially offset by a $44.6 million increase in net income in the first six months of 2011 compared to the same period of 2010 and a $1.5 million increase in equity compensation expense. The change in adjustments for accruals of expected future operating cash receipts and payments includes payables to investigators of $3.9 million and unearned income of $3.4 million. The change in adjustments to deferrals of past operating cash receipts and payments includes accounts receivable and unbilled services, net of ($75.6) million, accounts payable, other accrued expenses and deferred rent of ($17.7) million, accrued income taxes of ($4.0) million, other assets of ($3.5) million and prepaid expenses, other current assets and advance payments of ($2.3) million. Fluctuations in receivables and unearned income occur on a regular basis as we perform services, achieve billing criteria, send invoices to clients and collect outstanding accounts receivable. This activity varies by individual client and contract. We attempt to negotiate payment terms that provide for payment of services prior to or soon after the provision of services, but the levels of unbilled services and unearned revenue can vary significantly from period to period.

In the first six months of 2011, our investing activities provided $33.5 million in cash. We used cash of $48.1 million for capital expenditures, $6.3 million for advances to a related party and $4.3 million to purchase investments. These amounts were offset by maturity and sale of investments of $91.7 million. Our capital expenditures in the first six months of 2011 primarily consisted of $19.0 million for additional scientific equipment for our laboratory units, $17.3 million for various facility improvements and furnishings and $11.9 million for computer software and hardware.

 

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In the first six months of 2011, our financing activities used $215.0 million of cash. In the first six months of 2011, we paid $200.0 million to repurchase common stock and $35.7 million of dividends to shareholders, which were partially offset by proceeds of $20.0 million from stock option exercises and purchases under our employee stock purchase plan.

The following table sets forth amounts from our consolidated condensed balance sheet affecting our working capital, along with the dollar amount of the change from December 31, 2010 to June 30, 2011.

 

     December 31,      June 30,         
(in thousands)    2010      2011      $ Inc (Dec)  

Current assets:

        

Cash and cash equivalents

   $ 479,574       $ 370,864       $ (108,710

Short-term investments

     79,976         -         (79,976

Accounts receivable and unbilled services, net

     435,876         502,885         67,009   

Income tax receivable

     12,327         19,824         7,497   

Investigator advances

     16,032         13,971         (2,061

Prepaid expenses

     24,535         30,409         5,874   

Deferred tax assets

     30,910         31,983         1,073   

Cash held in escrow

     10,304         2,288         (8,016

Other current assets

     44,172         24,205         (19,967
                          

Total current assets

   $ 1,133,706       $ 996,429       $ (137,277
                          

Current liabilities:

        

Accounts payable

   $ 29,858       $ 32,722       $ 2,864   

Payables to investigators

     56,612         60,879         4,267   

Accrued income taxes

     1,918         12,599         10,681   

Other accrued expenses

     208,128         191,161         (16,967

Unearned income

     317,191         335,454         18,263   
                          

Total current liabilities

   $ 613,707       $ 632,815       $ 19,108   
                          

Working capital

   $ 519,999       $ 363,614       $ (156,385

Working capital as of June 30, 2011 was $363.6 million, compared to $520.0 million at December 31, 2010. The decrease in working capital was due primarily to a decrease in cash and cash equivalents and short-term investments of $108.7 million and $80.0 million, respectively, related to the repurchase of additional shares of our common stock, a decrease in other assets of $20.0 million, an increase in unearned income of $18.3 million and an increase in accrued income taxes of $10.7 million, partially offset by an increase in accounts receivable and unbilled services, net of $67.0 million and a decrease in other accrued expenses of $17.0 million.

For the six months ended June 30, 2011, DSO was 26 days, compared to 22 days for the year ended December 31, 2010. We calculate DSO by dividing accounts receivable and unbilled services less unearned income by average daily gross revenue for the applicable period. DSO will continue to fluctuate in the future depending on contract terms, the mix of contracts performed within a period, the levels of investigator advances and unearned income, and our success in collecting receivables.

In April 2011, we entered into a $50.0 million revolving line of credit facility with Barclays Bank PLC. The facility has a term of one-year and we can use borrowings for general corporate purposes. The credit facility contains customary affirmative, negative and financial covenants for financings of this size and kind. Outstanding borrowings under the credit facility bear interest at an annual fluctuating rate tied to certain financial indices plus an agreed upon margin. The credit facility is currently scheduled to expire in April 2012, at which time any outstanding balance will be due. As of June 30, 2011, no borrowings were outstanding under this credit facility.

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.

 

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In February 2008, our Board of Directors approved a stock repurchase program authorizing us to repurchase up to $350.0 million of its common stock from time to time. In February 2011, we entered into an accelerated share repurchase, or ASR, arrangement with Barclays Capital Inc. under which we used $200.0 million of the remaining amount to repurchase additional shares of our common stock. During the first quarter of 2011, we repurchased approximately 6.5 million shares of our common stock under this arrangement for an aggregate purchase price of approximately $200.0 million.

The agreement with Barclays for the ASR includes a forward sale contract settlement date in December 2011 but it could be settled prior to that date. Under the terms of the forward sale contract, Barclays is required to purchase, in the open market, $200.0 million of shares of our common stock during the term of the contract to fulfill its obligation related to the shares it borrowed from third parties and sold to us. At settlement, we, at our option, are required to either pay cash or issue registered or unregistered shares of our common stock to Barclays if Barclays’s volume weighted-average purchase price of open market purchases is higher than the average price of the 6.5 million shares purchased by us from Barclays, such average price is referred to as the hedge price. If Barclays’ volume weighted-average price is lower than the hedge price, Barclays is required to pay us either cash or additional shares of our common stock, at our option.

As of June 30, 2011, $60.7 million remained available for stock repurchases authorized by the Board of Directors. The manner of purchases, the amount we spend and the number of shares repurchased will vary based on a variety of factors, including the status of the Barclays ASR program, the stock price and blackout periods in which we are restricted from repurchasing shares.

In 2009, we committed to invest up to $102.7 million in Celtic Therapeutics Holdings L.P., or Celtic, as a limited partner. Celtic is an investment partnership organized for the purpose of identifying, acquiring and investing in a diversified portfolio of novel therapeutic product candidates, with a focus on mid-stage compounds that have progressed through human proof of concept studies that are targeted to address unmet medical needs. As of June 30, 2011, we had a remaining commitment of $60.0 million which we expect to fund over a period of up to four years and had an investment balance of $51.9 million.

In April 2011, we committed to invest up to $50.0 million in venBio Global Strategic Fund, L.P., or venBio, as a limited partner over the next five years. venBio invests in early stage life sciences companies. We account for this investment under the equity method of accounting because we are a limited partner and the general partner has all decision-making authority relating to investment decisions and fund operations. As such, we are deemed to lack the control of the entity required for consolidation. As of June 30, 2011, we had a remaining commitment of $49.8 million.

As of June 30, 2011, the Company had additional commitments to invest up to an aggregate additional $9.3 million in several venture capital funds and $0.8 million in other cost method investments. For further details, see Note 3.

In 2010, we entered into a non-revolving line of credit agreement to loan Celtic Pharma Development Services Bermuda Ltd., a subsidiary of Celtic Pharmaceutical Holdings L.P., up to $18.0 million to finance trade payables in connection with a specified drug candidate. Celtic Pharma Development Services Bermuda Ltd. has appointed us to conduct certain clinical studies on the drug candidate. Principal and interest are due and payable no later than June 30, 2013 and are secured by a guarantee of an affiliate of the borrower. As of June 30, 2011, we had advanced $15.5 million to the borrower.

As of June 30, 2011, our total gross unrecognized tax benefits were $28.2 million, of which $16.1 million, if recognized, would reduce our effective tax rate. We believe that it is reasonably possible that the total amount of unrecognized tax benefits could decrease by up to $4.8 million within the next twelve months due to the settlement of audits and the expiration of the statutes of limitations.

Our policy for recording interest and penalties associated with tax audits is to record them as a component of provision for income taxes. As of June 30, 2011, we accrued $5.0 million of interest and $0.9 million of penalties with respect to uncertain tax positions. To the extent interest and penalties are not assessed with respect to uncertain tax positions, we will reduce amounts accrued and reflect them as a reduction of the overall income tax provision.

We are subject to examination for the tax years between 2007 and 2011 in our primary tax jurisdictions and several of our foreign and state income tax returns are under examination by taxing authorities. We do not believe that the outcome of any examination will have a material impact on our financial condition or results of operations.

 

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Under most of our agreements for 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 and results of operations.

We expect to continue expanding our operations through internal growth, strategic acquisitions and investments. We expect to fund these activities, the payment of future cash dividends and repurchases of stock from existing cash, cash flows from operations and, if necessary or appropriate, borrowings under credit facilities. We believe that these sources of liquidity will be sufficient to fund our operations, dividends and stock repurchases for the foreseeable future. From time to time, we evaluate potential acquisitions, investments and other growth and strategic opportunities that might require additional external financing, and we might seek funds from public or private issuances of equity or debt securities. While we believe we have sufficient liquidity to fund our operations for the foreseeable future, our sources of liquidity and ability to pay dividends or repurchase our stock could be affected by current and anticipated difficult economic conditions; our dependence on a small number of industries and clients; compliance with regulations; reliance on key personnel; breach of contract, personal injury or other tort claims; international risks; environmental or intellectual property claims; or other factors described below under “Potential Liability and Insurance”, “Potential Volatility of Quarterly Operating Results and Stock Price” and “Quantitative and Qualitative Disclosures about Market Risk”. In addition, see “Risk Factors,” “Contractual Obligations” and “Critical Accounting Policies and Estimates” in our Annual Report on Form 10-K for the year ended December 31, 2010.

Off-Balance Sheet Arrangements

From time to time, we cause letters of credit to be issued to provide credit support for guarantees, contractual commitments and insurance policies. The fair values of the letters of credit reflect the amount of the underlying obligation and are subject to fees competitively determined in the marketplace. As of June 30, 2011, we had four letters of credit outstanding for a total of $1.8 million. We have no other off-balance sheet arrangements except for operating leases entered into in the normal course of business.

Contractual Obligations

There have been no significant changes to the Contractual Obligation table included in our Annual Report on Form 10-K for the year ended December 31, 2010.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America, or U.S. GAAP, requires management to make estimates and assumptions that affect 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 revenue and expenses during the reporting period. We discussed those estimates that we believe are critical and require the use of complex judgment in their application in our Annual Report on Form 10-K for the year ended December 31, 2010. Other than the adoption of the new accounting standard related to accounting for revenue arrangements with multiple deliverables and milestone payments, which requires additional disclosures, there were no material changes to our critical accounting policies and estimates in the first six months of 2011. For detailed information on our critical accounting policies and estimates, see our Annual Report on Form 10-K for the year ended December 31, 2010.

Recently Issued Accounting Standards

In May 2011, the Financial Account Standards Board, or FASB, issued updated fair value measurement and disclosure guidance that clarifies how to measure fair value and requires additional disclosures regarding Level 3 fair value measurements, as well as any transfers between Level 1 and Level 2 fair value measurements. The updated accounting guidance is effective for fiscal years and interim periods beginning on or after December 15, 2011 on a prospective basis. We are currently evaluating the impact of adopting the updated fair value guidance, and we do not expect the adoption to have a material impact on our consolidated condensed financial statements.

In June 2011, the FASB amended the manner in which an entity presents the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single, continuous statement of comprehensive income or in two separate but consecutive statements. The amendment eliminates the option to present the components of other comprehensive income as part of the statement of equity. The amendment is effective for fiscal years and interim periods beginning on or after December 15, 2011 on a retrospective basis. The

 

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adoption of this guidance will not change the previously reported amounts of comprehensive income but will change our presentation of comprehensive income in the consolidated condensed financial statements for the period ending March 31, 2012.

Recently Adopted Accounting Standards

In October 2009, the FASB issued a new accounting standard related to accounting for revenue arrangements with multiple deliverables. This standard applies to all deliverables in contractual arrangements in all industries in which the vendor will perform multiple revenue-generating activities. This standard also addresses the unit of accounting for an arrangement involving multiple deliverables and how arrangement consideration should be allocated. This standard was effective on January 1, 2011 on a prospective basis. The adoption of this standard did not have a material impact on our consolidated condensed financial statements, other than requiring additional disclosures.

In March 2010, the FASB issued a new accounting standard, the objective of which is to establish a revenue recognition model for contingent consideration that is payable upon the achievement of an uncertain future event, referred to as a milestone. This standard applies to milestones in single or multiple-deliverable arrangements involving research and development transactions and was effective on January 1, 2011 on a prospective basis. The adoption of this standard did not have a material impact on our consolidated condensed financial statements, other than requiring additional disclosures.

In April 2011, the FASB issued an accounting standard update clarifying the guidance as to whether a restructuring of accounts receivable constitutes a troubled debt restructuring. The guidance applies to modifications of receivables when a debtor is experiencing financial difficulties. The updated guidance was effective on July 1, 2011 on a retrospective basis to January 1, 2011. The adoption of this standard did not have a material impact on our consolidated condensed financial statements as we did not modify any of our receivables.

Income Taxes

Because we conduct operations on a global basis, our effective tax rate has and will continue to depend upon the geographic distribution of our pretax earnings among locations with varying tax rates. Our profits are also impacted by changes in the tax rates and tax laws of the various tax jurisdictions as applied to certain items of income and loss recognized for U.S. GAAP purposes. In particular, as the geographic mix of our pretax earnings among various tax jurisdictions changes, our effective tax rate might vary from period to period. The effective rate will also change due to the discrete recognition of tax benefits when tax positions are effectively settled or as a result of specific transactions, such as the receipt of nontaxable research benefits.

Inflation

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

Potential Liability and Insurance

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

 

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Potential Volatility of Quarterly Operating Results and Stock Price

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

 

   

the timing and level of new business authorizations;

   

project cancellations;

   

the timing of the initiation and progress of significant projects;

   

our dependence on a small number of industries and clients;

   

our ability to properly manage our growth or contraction in our business;

   

our ability to recruit and retain experienced personnel, including a new CEO;

   

the timing and amount of costs associated with integrating acquisitions;

   

the timing and extent of new government regulations;

   

impairment of investments or intangible assets;

   

variability of equity method investments;

   

litigation costs;

   

the timing of the opening of new offices;

   

the timing of other internal expansion costs;

   

exchange rate fluctuations between periods;

   

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

   

pricing pressure in the market for our services;

   

rapid technological change;

   

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

   

intellectual property risks.

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

Fluctuations in quarterly results, actual or anticipated changes in our dividend policy or stock repurchase plan or other factors, including recent general economic and financial market conditions, could affect the market price of our common stock. These factors include ones beyond our control, such as announcements by competitors, stock market speculation about us, changes in revenue and earnings estimates by analysts, market conditions in our industry, disclosures by product development partners and actions by regulatory authorities with respect to potential drug candidates, changes in pharmaceutical, biotechnology and medical device industries and the government sponsored clinical research sector and general economic conditions. Any effect on our common stock could be unrelated to our longer-term operating performance. For further details, see “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2010.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

We are exposed to foreign currency risk by virtue of our international operations. We derived 42.5% and 45.3% of our net revenue for the three months ended June 30, 2010 and 2011, respectively, from operations outside the United States. We generally reinvest funds generated by each subsidiary in the country where they are earned. Accordingly, we are exposed to adverse movements in foreign currencies, predominately in the pound sterling, euro, Brazilian real and Argentina peso.

The vast majority of our contracts are entered into by our U.S., U.K. or Singapore 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. and Singapore subsidiaries are generally denominated in U.S. dollars, pounds sterling or euros, with the majority in U.S. dollars. Although an increase in exchange rates for the pound sterling or euro relative to the U.S. dollar increases net revenue from contracts denominated in these currencies, operating income is negatively affected due to an

 

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increase in operating expenses that occurs when we convert our expenses from local currencies into the U.S. dollar equivalent.

We also have currency risk resulting from the passage of time between the recognition of revenue, 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 an unbilled receivable at the time of revenue recognition and 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 we recognize revenue until the time the client pays will result in our receiving either more or less in local currency than the amount that was originally invoiced. We recognize this difference as a foreign currency transaction gain or loss, as applicable, and report it in other income, net. If the exchange rate on accounts receivable balances denominated in pounds sterling and euros had increased by 10%, our foreign currency transaction loss would have increased by $4.0 million at June 30, 2011.

Our strategy for managing foreign currency risk relies primarily on receiving payment in the same currency used to pay expenses and other non-derivative hedging strategies. From time to time, we also enter into foreign currency hedging activities in an effort to manage our potential foreign exchange exposure. If the U.S. dollar had weakened an additional 10% relative to the pound sterling, euro, Brazilian real and Argentina peso in the second quarter of 2011, income from continuing operations, including the impact of hedging, would have been approximately $1.3 million lower for the quarter based on revenues and the costs related to our foreign operations. From time to time, we also enter into foreign currency hedging activities in an effort to manage our potential foreign exchange exposure. We have entered into hedges designed to cover a significant portion of our foreign currency exposure for 2011.

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 condensed financial results. The process by which we translate each foreign subsidiary’s financial results to U.S. dollars is as follows:

 

   

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

   

we translate balance sheet asset 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.

Although we perform services for clients located in a number of jurisdictions, we have not experienced any material difficulties in receiving funds remitted from foreign countries. However, new or modified exchange control restrictions could have an adverse effect on our financial condition. If we were to repatriate dividends from the cumulative amount of undistributed earnings in foreign entities, we would incur a tax liability not currently provided for in our consolidated condensed balance sheet.

We are exposed to changes in interest rates on our cash, cash equivalents, investments and advances to and lines of credit with related parties. We invest our cash and investments in financial instruments with interest rates based on market conditions. If the interest rates on cash, cash equivalents and investments decreased by 10%, our interest income would have decreased by approximately $0.1 million in the second quarter of 2011.

We are also exposed to market risk related to our investments in auction rate securities. For further details, see “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources” on our Form 10-K.

 

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Item 4. Controls and Procedures

Disclosure Controls and Procedures

Disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) are designed only to provide reasonable assurance that information to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our principal executive officer, namely our Executive Chairman, 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 principal executive officer, namely our Executive Chairman, 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 second quarter of 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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Part II. OTHER INFORMATION

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

Issuer purchases of equity securities

In February 2008, the Company’s Board of Directors approved a stock repurchase program authorizing the Company to repurchase up to $350.0 million of its common stock from time to time. The timing and amount of any share repurchases under this program is determined by the Company’s management based on their evaluation of market conditions and other factors. The Company is not required to repurchase any specific number of shares or to make repurchases by any certain date under this program.

As of December 31, 2010, $260.7 million remained available under the stock repurchase program. In February 2011, the Company entered into an accelerated share arrangement with Barclays Capital Inc., as agent for Barclays Bank PLC, pursuant to which the Company paid $200.0 million from cash on hand to Barclays to repurchase outstanding shares of the Company’s common stock. The cost of shares purchased through the accelerated share repurchase transaction is subject to adjustment upon final settlement. The Company did not repurchase any of its common stock during the three months ended June 30, 2011. The approximate value of shares that may yet be purchased under the plan or program is $60.7 million as of June 30, 2011.

 

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Item 6. Exhibits

 

(a) Exhibits

 

31.1    Certification of the Executive Chairman pursuant to Rule 13a-14(a)
31.2    Certification of the Chief Financial Officer pursuant to Rule 13a-14(a)
32.1    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of The Sarbanes-Oxley Act of 2002 – Executive Chairman
32.2    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of The Sarbanes-Oxley Act of 2002 – Chief Financial Officer
101    Financials provided in XBRL format

 

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SIGNATURES

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

 

          PHARMACEUTICAL PRODUCT DEVELOPMENT, INC.         
  (Registrant)
By       /s/                                 Fredric N. Eshelman                                           
  Executive Chairman
  (Principal Executive Officer)
By       /s/                                 Daniel G. Darazsdi                                             
  Chief Financial Officer
  (Principal Financial Officer)
By       /s/                                 Peter Wilkinson                                                   
  Chief Accounting Officer
  (Principal Accounting Officer)

Date: August 4, 2011

 

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