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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
EXCHANGE ACT OF 1934.
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002
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 000-23019
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KENDLE INTERNATIONAL INC.
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
Ohio 31-1274091
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(State or other jurisdiction (IRS Employer Identification No.)
of incorporation or organization)
441 Vine Street, Suite 1200, Cincinnati, Ohio 45202
- --------------------------------------------------------------------------------
(Address of principal executive offices) Zip Code
Registrant's telephone number, including area code (513) 381-5550
----------------------------
- --------------------------------------------------------------------------------
(Former name or former address, if changed since last report)
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 and 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 the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date: 12,804,597 shares of Common
Stock, no par value, as of October 31, 2002.
1
KENDLE INTERNATIONAL INC.
INDEX
Page
Part I. Financial Information
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets -September 30, 2002
and December 31, 2001 3
Condensed Consolidated Statements of Income - Three
Months Ended September 30, 2002 and 2001; Nine Months
Ended September 30, 2002 and 2001 4
Condensed Consolidated Statements of Comprehensive Income -
Three Months Ended September 30, 2002 and 2001; Nine Months
Ended September 30, 2002 and 2001 5
Condensed Consolidated Statements of Cash Flows - Nine
Months Ended September 30, 2002 and 2001 6
Notes to Condensed Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 15
Item 3. Quantitative and Qualitative Disclosure About Market Risk 28
Item 4. Controls and Procedures 28
Part II. Other Information 29
Item 1. Legal Proceedings 29
Item 2. Changes in Securities and Use of Proceeds 29
Item 3. Defaults upon Senior Securities 29
Item 4. Submission of Matters to a Vote of Security Holders 29
Item 5. Other Information 29
Item 6. Exhibits and Reports on Form 8-K 29
Signatures 30
Exhibit Index 35
2
KENDLE INTERNATIONAL INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data) September 30, December 31,
2002 2001
------------- ------------
(unaudited) (note 1)
ASSETS
Current assets:
Cash and cash equivalents $ 6,701 $ 6,016
Available for sale securities 22,045 19,508
Accounts receivable 51,036 59,611
Other current assets 8,986 5,305
--------- ---------
Total current assets 88,768 90,440
--------- ---------
Property and equipment, net 18,783 16,407
Goodwill 89,320 86,094
Other indefinite-lived intangible assets 15,000 --
Other assets 9,293 11,110
--------- ---------
Total assets $ 221,164 $ 204,051
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current portion of obligations under capital leases $ 781 $ 660
Current portion of amounts outstanding under credit facilities 6,369 14,195
Trade payables 5,728 6,502
Advance billings 18,950 18,951
Other accrued liabilities 11,862 13,468
--------- ---------
Total current liabilities 43,690 53,776
--------- ---------
Obligations under capital leases, less current portion 1,619 1,362
Convertible note 6,000 --
Long-term debt 10,500 --
Other noncurrent liabilities 7,673 6,606
--------- ---------
Total liabilities 69,482 61,744
--------- ---------
Commitments and contingencies
Shareholders' equity:
Preferred stock -- no par value; 100,000 shares authorized; no shares
issued and outstanding
Common stock -- no par value; 45,000,000 shares authorized; 12,798,551 and
12,399,406 shares issued and 12,778,654 and 12,382,126
outstanding at September 30, 2002 and December 31, 2001, respectively 75 75
Additional paid in capital 133,936 128,986
Retained earnings 20,975 17,322
Accumulated other comprehensive loss:
Net unrealized holding gains on available for sale securities 3 35
Net unrealized holding loss on interest rate swap agreement (564) --
Foreign currency translation adjustment (2,350) (3,761)
--------- ---------
Total accumulated other comprehensive loss (2,911) (3,726)
Less: Cost of common stock held in treasury, 19,897 and 17,280 shares at
September 30, 2002 and December 31, 2001, respectively (393) (350)
--------- ---------
Total shareholders' equity 151,682 142,307
--------- ---------
Total liabilities and shareholders' equity $ 221,164 $ 204,051
========= =========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
KENDLE INTERNATIONAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
(in thousands, except per share data) For the Three Months Ended For the Nine Months Ended
September 30, September 30,
-------------------------- --------------------------
2002 2001 2002 2001
--------- --------- --------- ---------
Net service revenues $ 40,966 $ 39,439 $ 128,581 $ 110,353
Reimbursable out-of-pocket revenues 11,468 8,252 35,997 28,726
--------- --------- --------- ---------
Total revenues 52,434 47,691 164,578 139,079
--------- --------- --------- ---------
Costs and expenses:
Direct costs 23,900 23,641 76,438 67,284
Reimbursable out-of-pocket costs 11,468 8,252 35,997 28,726
Selling, general and
administrative expenses 11,321 11,350 36,032 32,008
Depreciation and amortization 2,141 2,535 6,196 7,335
Office consolidation costs 321 -- 321 --
--------- --------- --------- ---------
49,151 45,778 154,984 135,353
--------- --------- --------- ---------
Income from operations 3,283 1,913 9,594 3,726
Other income (expense):
Interest income 173 217 474 721
Interest expense (361) (238) (907) (617)
Other 128 215 186 253
Investment impairment -- -- (1,938) --
--------- --------- --------- ---------
Income before income taxes 3,223 2,107 7,409 4,083
Income tax expense 1,320 934 3,756 1,770
--------- --------- --------- ---------
Net income $ 1,903 $ 1,173 $ 3,653 $ 2,313
========= ========= ========= =========
Income per share data:
Basic:
Net income per share $ 0.15 $ 0.09 $ 0.29 $ 0.19
========= ========= ========= =========
Weighted average shares 12,777 12,350 12,707 12,210
Diluted:
Net income per share $ 0.14 $ 0.09 $ 0.28 $ 0.18
========= ========= ========= =========
Weighted average shares 13,441 13,044 13,188 12,803
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
KENDLE INTERNATIONAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(UNAUDITED)
(in thousands) For the Three Months Ended For the Nine Months Ended
September 30, September 30,
-------------------------- -------------------------
2002 2001 2002 2001
------- ------- ------- -------
Net income $ 1,903 $ 1,173 $ 3,653 $ 2,313
------- ------- ------- -------
Other comprehensive income:
Foreign currency translation adjustment (63) 943 1,411 (555)
Net unrealized holding gains (losses) on
available for sale securities arising
during the period, net of tax (7) 34 (32) 154
Reclassification adjustment for holding
losses included in net income, net of tax -- (21) -- 5
------- ------- ------- -------
Net change in unrealized holding gains
(losses) on available for sale securities (7) 13 (32) 159
Net unrealized holding gains (losses) on
interest rate swap agreement (564) -- (564) --
------- ------- ------- -------
Comprehensive income $ 1,269 $ 2,129 $ 4,468 $ 1,917
======= ======= ======= =======
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
KENDLE INTERNATIONAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(in thousands) For the Nine Months Ended
September 30,
--------------------------
2002 2001
-------- --------
Net cash provided by operating activities $ 17,083 $ 3,670
-------- --------
Cash flows from investing activities:
Proceeds from sales and maturities of available for sale securities 28,401 34,276
Purchases of available for sale securities (31,463) (34,824)
Acquisitions of property and equipment (5,441) (3,173)
Additions to software costs (1,661) (2,356)
Acquisition of businesses, less cash acquired (7,942) (10,789)
Contingent purchase price paid in connection with prior acquisition -- (2,144)
Other -- (5)
-------- --------
Net cash used in investing activities (18,106) (19,015)
-------- --------
Cash flows from financing activities:
Net proceeds under credit facilities 2,301 14,450
Net proceeds (repayments) - book overdraft (470) 393
Proceeds from exercise of stock options 294 458
Payments on capital lease obligations (605) (667)
Other (32) (14)
-------- --------
Net cash provided by financing activities 1,488 14,620
-------- --------
Effects of exchange rates on cash and cash equivalents 220 (258)
Net increase (decrease) in cash and cash equivalents 685 (983)
Cash and cash equivalents:
Beginning of period 6,016 6,709
-------- --------
End of period $ 6,701 $ 5,726
======== ========
Supplemental schedule of noncash investing and financing activities:
- --------------------------------------------------------------------
Issuance of Common Stock in connection with contingent
purchase price relating to prior acquisition $ -- $ 796
======== ========
Issuance of Common Stock in connection with Employee
Stock Purchase Plan $ 431 $ 388
======== ========
Acquisition of Businesses:
Fair value of assets acquired (net of cash acquired) $ 19,165 $ 16,474
Fair value of liabilities assumed (1,131) (1,812)
Common stock issued (4,092) (3,873)
Convertible debt issued (6,000) --
-------- --------
Net cash payments $ 7,942 $ 10,789
======== ========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
6
KENDLE INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION:
The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with generally accepted accounting principles
for interim financial information and the instructions to Form 10-Q and Article
10 of Regulation S-X. Accordingly, they do not include all of the information
and notes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring adjustments) considered necessary for a fair presentation
have been included. Operating results for the three months and nine months ended
September 30, 2002 are not necessarily indicative of the results that may be
expected for the year ending December 31, 2002. For further information, refer
to the consolidated financial statements and notes thereto included in the Form
10-K for the year ended December 31, 2001 filed by Kendle International Inc.
("the Company") with the Securities and Exchange Commission.
The condensed consolidated balance sheet at December 31, 2001 has been
derived from the audited financial statements at that date but does not include
all of the information and notes required by generally accepted accounting
principles for complete financial statements.
2. NET INCOME PER SHARE DATA:
Net income per basic share is computed using the weighted average
common shares outstanding. Net income per diluted share is computed using the
weighted average common shares and potential common shares outstanding.
The weighted average shares used in computing net income per diluted
share have been calculated as follows:
(in thousands) Three Months Ended Three Months Ended
September 30, 2002 September 30, 2001
------------------ ------------------
Weighted average common shares
outstanding 12,777 12,350
Stock options 350 663
Convertible note 314 --
Contingently issuable shares -- 31
------ ------
Weighted average shares 13,441 13,044
7
(in thousands) Nine Months Ended Nine Months Ended
September 30, 2002 September 30, 2001
------------------ ------------------
Weighted average common shares
outstanding 12,707 12,210
Stock options 481 583
Contingently issuable shares -- 10
------ ------
Weighted average shares 13,188 12,803
The net income used in computing net income per diluted share has been
calculated as follows:
(in thousands) Three Months Ended Three Months Ended
September 30, 2002 September 30, 2001
------------------ ------------------
Net income per Statements of Income $1,903 $1,173
Add: after-tax interest expense on
convertible note 35 --
------ ------
Net income for diluted EPS calculation $1,938 $1,173
(in thousands) Nine Months Ended Nine Months Ended
September 30, 2002 September 30, 2001
------------------ ------------------
Net income per Statements of Income $3,653 $2,313
Options to purchase approximately 1,338,000 and 581,000 shares of common
stock were outstanding during the three months ended September 30, 2002 and 2001
respectively, but were not included in the computation of earnings per diluted
share because the options' exercise price was greater than the average market
price of the common shares and, therefore, the effect would be antidilutive.
Options to purchase approximately 907,000 and 712,000 shares of common
stock were outstanding during the nine months ended September 30, 2002 and 2001
respectively, but were not included in the computation of earnings per diluted
share because the options' exercise price was greater than the average market
price of the common shares and, therefore, the effect would be antidilutive.
3. ACQUISITIONS:
Details of the Company's acquisitions in 2002 and 2001 are listed
below. The acquisitions have been accounted for using the purchase method of
accounting.
Valuation of Common Stock issued in the acquisitions was based on an
appraisal obtained by the Company on previously similarly structured
acquisitions, which provided for a discount of the shares due to lock-up
restrictions and the lack of registration of the shares.
On January 29, 2002, the Company acquired substantially all of the
assets of Clinical and Pharmacologic Research, Inc. (CPR) located in Morgantown,
West Virginia. CPR specializes in Phase I studies for the generic drug industry,
enabling the Company to expand into the generic drug market. Results of CPR are
included in the Company's consolidated results from the date of acquisition.
8
The aggregate purchase price was approximately $18.2 million, including
approximately $8.1 million in cash (including acquisition costs), 314,243 shares
of Common Stock valued at $4.1 million and a $6.0 million convertible
subordinated note. The note is convertible at the holders' option into 314,243
shares of the Company's Common Stock at any time before January 29, 2005, the
Maturity Date.
The following summarizes the fair values of the assets acquired and
liabilities assumed at the date of acquisition. The intangible asset represents
one customer contract, the fair value of which was determined by a third party
valuation. The intangible asset has been determined to have an indefinite life
and will not be amortized, but instead will be reviewed for impairment at least
annually. The contract was determined to have an indefinite useful life based on
the unique nature of the services provided by CPR, the limited likelihood that a
competitor would attempt to gain some of the business provided under this
contract due to the barriers to entry and the historical relationship between
CPR and the customer.
At January 29,
2002
(in thousands)
--------------
Current assets $ 1,241
Fixed assets 213
Goodwill 2,927
Intangible asset 15,000
-------
Total assets acquired 19,381
Liabilities assumed 1,131
-------
Net assets acquired $18,250
The goodwill and the intangible asset acquired in the acquisition are
deductible for income tax purposes over a 15-year period.
The former majority shareholder of CPR is no longer employed by CPR and
never was employed by Kendle, but he has provided consulting services to Kendle.
He currently also provides consulting services to the customer that accounts for
the majority of CPR's current business as provided for in the contract discussed
above.
In February 2001, the Company acquired AAC Consulting Group, Inc.
(AAC), a full service regulatory consulting firm with offices in Rockville,
Maryland. Aggregate purchase price including acquisition costs consisted of
approximately $10.9 million in cash and 374,665 shares of the Company's Common
Stock valued at $3.9 million. Results of AAC are included in the Company's
consolidated results from the date of acquisition.
The following unaudited pro forma results of operations assume the
acquisitions occurred at the beginning of 2001:
9
(in thousands) Nine Months Ended Nine Months Ended
September 30, 2002 September 30, 2001
------------------ ------------------
Net service revenues $129,382 $117,553
Net income $ 3,791 $ 3,439
Net income per diluted share $ 0.29 $ 0.26
Weighted average shares 13,534 13,511
Pro-forma net income per above $ 3,791 $ 3,439
Add: after-tax interest expense on convertible
note 103 103
Pro-forma net income for diluted EPS $ 3,894 $ 3,542
The pro forma financial information is not necessarily indicative of
the operating results that would have occurred had the acquisitions been
consummated as of January 1, 2001, nor are they necessarily indicative of future
operating results.
4. OFFICE CONSOLIDATION COSTS:
On August 29, 2002, the Company committed to a plan that will
consolidate its three New Jersey offices into one central office, located in
Cranford, New Jersey. The Company currently maintains separate offices in
Princeton, Cranford and Ft. Lee, New Jersey. The leases in the Ft. Lee and
Princeton offices expire during the fourth quarter of 2002 and the first quarter
of 2003, respectively. The Company plans to vacate these offices in the fourth
quarter in advance of the expiration of each of the respective office leases.
As part of this plan, the Company will eliminate approximately 25
full-time positions. Through September 30, 2002, the Company has eliminated 7 of
these positions. The remainder of the positions will be eliminated in the fourth
quarter of 2002.
In connection with the office consolidation, the Company recorded a
pre-tax charge of $321,000 in the third quarter of 2002, consisting primarily of
facility lease costs and severance and outplacement costs. As of September 30,
2002, $310,000 remains accrued and is reflected in Other Accrued Liabilities in
the Company's Balance Sheet. The amounts accrued as office consolidation costs
are detailed as follows:
(in thousands) Employee Facilities Other Total
Severance
---- ---- ---- ----
Amount Accrued $172 $ 97 $ 52 $321
Amount Paid -- -- 11 11
---- ---- ---- ----
Liability at Sept.30, 2002 $172 $ 97 $ 41 $310
5. GOODWILL AND OTHER INTANGIBLE ASSETS:
In accordance with Statement of Financial Accounting Standards (SFAS)
No. 142, "Goodwill and Other Intangible Assets", effective January 1, 2002 the
Company discontinued
10
the amortization of goodwill and other identifiable intangible assets that have
indefinite useful lives. Intangible assets that have finite useful lives will
continue to be amortized over their useful lives.
The impact of discontinuing amortization of goodwill with indefinite
lived intangible assets on net income, basic and diluted earnings per share for
the quarter ended September 30, 2001 is approximately $638,000, or $0.05 per
share on a basic and fully diluted basis. The impact of discontinuing
amortization of goodwill with indefinite lived intangible assets on net income,
basic and diluted earnings per share for the nine months ended September 30,
2001 is approximately $1.8 million or $0.15 per basic share and $0.14 per fully
diluted share. Adjusted net income, basic and diluted earnings per share for the
three months ended September 30, 2001 was approximately $1.8 million or $0.15
per basic share and $0.14 per fully diluted share. Adjusted net income, basic
and diluted earnings per share for the nine months ended September 30, 2001 was
approximately $4.2 million or $0.34 per share on a basic and $0.32 per share on
a fully diluted basis.
Identifiable intangible assets as of September 30, 2002 and December
31, 2002 are composed of:
(in thousands) Sept. 30, 2002 Dec. 31, 2001
Carrying Carrying
Amount Amount
Non-amortizable intangible assets:
Goodwill $ 89,320 $ 86,094
Customer contract 15,000 --
Amortizable intangible assets -- --
-------- --------
Total $104,320 $ 86,094
6. DEBT:
In June 2002, the Company entered into an Amended and Restated Credit
Agreement (the "Facility") that replaced the previous credit facility that would
have expired in October 2003. The Facility is composed of a $23.0 million
revolving credit loan that expires in three years and a $15.0 million term loan
that matures in five years. The Facility is in addition to an existing $5.0
million Multicurrency Facility that is renewable annually and is used in
connection with the Company's European operations. The $23.0 million facility
bears interest at a rate equal to either (a) The Eurodollar Rate plus the
Applicable Percentage (as defined) or (b) the higher of the Federal Fund's Rate
plus 0.5% or the Bank's Prime Rate. The $15.0 million term loan bears interest
at a rate equal to the higher of the Federal Funds Rate plus 0.5% and the Prime
Rate or an Adjusted Eurodollar Rate (as defined in the agreement which is
included under Exhibit 10.23 in the Company's Form 10-Q for the quarter period
ended June 30, 2002).
The $5.0 million facility is composed of a euro overdraft facility up
to the equivalent of $3.0 million and a pound sterling overdraft facility up to
the equivalent of $2.0 million. This Multicurrency Facility bears interest at a
rate equal to either (a) the rate published by the European Central Bank plus a
margin (as defined) or (b) the Bank's Base Rate (as determined by the bank
having regard to prevailing market rates) plus a margin (as defined). Under
terms of the credit agreement, revolving loans are convertible into term loans
within the facility if used for acquisitions. The facilities contain various
restrictive financial covenants, including the maintenance of certain fixed
coverage and leverage ratios and minimum net worth levels. At
11
September 30, 2002, no amounts were outstanding under the Company's $23 million
revolving credit loan, $13.5 million was outstanding under the term loan, and
$3.4 million was outstanding under the $5.0 million Multicurrency Facility.
Interest is payable on the term loan at a rate of 5.82% and on the $3.4 million
outstanding under the Multicurrency Facility at a weighted average rate of 4.8%.
Principal payments of $750,000 are due on the term loan on the last business day
of each quarter through March of 2007.
Effective July 1, 2002 the Company entered into an interest rate swap
to fix the interest rate on the $15.0 million term loan. The swap is designated
as a cash flow hedge under the guidelines of SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities." Under the swap, the interest
rate on the term loan is fixed at 4.32% plus a margin of 1.5%. The swap is in
place through the life of the term loan, ending on March 31, 2007. Changes in
fair market value of the swap are recorded in Other Comprehensive Income on the
Balance Sheet. At September 30, 2002, approximately $564,000 has been recorded
in Other Comprehensive Income to reflect a decrease in the fair market value of
the swap.
With the acquisition of CPR the Company entered into a $6,000,000
convertible note payable to the shareholders of CPR. The principal balance is
convertible at the holders' option into 314,243 shares of the Company's Common
Stock at any time through January 29, 2005 (the Maturity Date). If the note has
not been converted at the Maturity Date, the Company has the option to extend
the Maturity Date of the note for another three years. The note bears interest
at an annual rate of 3.80% from January 29, 2002 through the Maturity Date.
Interest is payable semi-annually. If the Maturity Date is extended, the
interest rate will be reset on January 29, 2005 at an annual rate of interest
equal to the yield of a three-year United States Treasury Note.
7. INVESTMENT
In January 1999, the Company acquired a minority interest in Digineer,
Inc. (Digineer, formerly known as Component Software International, Inc.), a
healthcare consulting and software development company, for approximately $1.6
million in cash and 19,995 shares of the Company's common stock. This investment
has been accounted for under the cost method.
During the second quarter of 2002, Digineer adopted a plan to cease
operations. As a result of this action, the Company determined that its
investment in Digineer was impaired. In the second quarter of 2002, the Company
recorded a $1.9 million non-cash charge in "Other Income/(Expense)" to reflect
the write-off of this investment. The write-off is a capital loss for income tax
purposes and is deductible only to the extent the Company generates capital
gains in the future to offset this loss. The Company has recorded a valuation
allowance against the deferred tax asset relating to the Digineer write-off and
no income tax benefit has been recorded.
8. SEGMENT INFORMATION
Effective January 1, 2002, the Company integrated the medical
communications group into its Phase IV product and services offering. As a
result, the Company is now managed under a single operating segment referred to
as contract research services, which encompasses Phase I through IV services.
Prior to January 1, 2002, the Company was managed through two operating
segments, namely the contract research services group and the medical
communications group. The contract research services group includes clinical
trial management, clinical data management,
12
statistical analysis, medical writing, medical affairs and marketing, and
regulatory consultation. The medical communications group, which included only
Health Care Communications, Inc. (HCC) acquired in 1999, provided
organizational, meeting management and publication services to professional
organizations and pharmaceutical companies. Effective January 1, 2002, the
Company launched a new strategic initiative, Medical Affairs Medical Marketing
(MAMM). The MAMM service offering is intended to provide a more comprehensive
Phase IV product to the Company's core customers, including post-marketing
activities such as publications and symposia in support of new product launches.
As a result, the former medical communications group was integrated into MAMM
and certain of HCC's unique services have been restructured to be in alignment
with the Company's Phase IV services strategy.
9. NEW ACCOUNTING PRONOUNCEMENTS:
In July 2002, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 146, "Accounting for Exit or Disposal Activities." SFAS No. 146
addresses the recognition, measurement, and reporting of costs that are
associated with exit and disposal activities, including costs related to
terminating a contract that is not a capital lease and termination benefits that
employees who are involuntarily terminated receive under the terms of a one-time
benefit arrangement that is not an ongoing benefit arrangement or an individual
deferred-compensation contract. SFAS No. 146 supersedes Emerging Issues Task
Force Issue No. 94-3, Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred
in a Restructuring) and requires liabilities associated with exit and disposal
activities to be expensed as incurred. SFAS No. 146 will be required for exit or
disposal activities of the Company initiated after December 31, 2002, with
earlier adoption encouraged.
In November 2001, FASB issued EITF 01-14, "Income Statement
Characterization of Reimbursements Received for Out-of-Pocket Expenses
Incurred." The EITF requires reimbursements for out-of-pocket expenses incurred
to be characterized as revenue and expenses in the Statements of Operations. The
Company implemented this rule beginning in the first quarter of 2002 and, as
such, has reclassified all periods presented. The implementation of the new
guidelines has no impact on income from operations or net income.
In October 2001, FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." SFAS No. 144 supercedes SFAS No.
121 "Accounting for the Impairment of Long-Lived Assets to be Disposed of" and
certain provisions of APB Opinion No. 30, "Reporting the Results of Operations -
Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary,
Unusual and Infrequently Occurring Events and Transactions." SFAS No. 144
establishes a single model for the impairment of long-lived assets and broadens
the presentation of discontinued operations. The adoption of this statement in
the first quarter of 2002 did not have an impact on the Company's consolidated
financial statements.
In July 2001, FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets" that requires that all intangible assets determined to have an
indefinite useful life no longer be amortized but instead be reviewed at least
annually for impairment. The Company adopted SFAS No. 142 as of January 1, 2002,
as required. The Company analyzed goodwill for impairment at the reporting unit
level at the beginning of 2002 and found no goodwill impairment. The Company
will analyze goodwill on an annual basis, or more frequently as circumstances
warrant.
13
In July 2001, FASB issued SFAS No. 141, "Business Combinations" that
requires all business combinations initiated after June 30, 2001 to be accounted
for using the purchase method. The Company has adopted SFAS No. 141 and the
adoption did not have an impact on the Company's results of operations or its
financial position.
14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND
RESULTS OF OPERATIONS
The information discussed below is derived from the Condensed
Consolidated Financial Statements included in this Form 10-Q for the three and
nine months ended September 30, 2002 and should be read in conjunction
therewith. The Company's results of operations for a particular quarter may not
be indicative of results expected during subsequent quarters or for the entire
year.
COMPANY OVERVIEW
Kendle International Inc. (the "Company") is an international contract
research organization (CRO) that provides integrated clinical research services
including clinical trial management, clinical data management, statistical
analysis, medical writing, regulatory consultation and organizational meeting
management and publications services on a contract basis to the pharmaceutical
and biotechnology industries. Prior to January 1, 2002, the Company had been
managed through two reportable segments, the Phase I through IV contract
research services group, which among other services, includes investigator
meetings, pharmacoeconomics, post-marketing surveillance, and labeling studies,
and the medical communications group. Effective January 1, 2002, the Company
launched a new strategic initiative, Medical Affairs Medical Marketing (MAMM).
The MAMM service offering is intended to provide a more comprehensive Phase IV
product to the Company's customers, including post-marketing activities such as
publications and symposia in support of new product launches. As a result, the
former medical communications group is now being managed as part of MAMM and
their service capabilities have been incorporated into the Company's overall
Phase IV suite of products. As such the medical communications group, which had
principally focused on organizational, meeting management and publication
services for professional organizations and pharmaceutical companies has been
restructured and integrated with the contract research services group.
The Company's contracts are generally fixed price, with some variable
components, and range in duration from a few months to several years. A contract
typically requires a portion of the contract fee to be paid at the time the
contract becomes effective and the balance is received in installments over the
contract's duration, in most cases on a milestone achievement basis. Net
revenues from contracts are generally recognized on the percentage of completion
method, measured principally by the total costs incurred as a percentage of
estimated total costs for each contract. The estimated total costs of contracts
are reviewed and revised periodically throughout the lives of the contracts with
adjustments to revenues resulting from such revisions being recorded on a
cumulative basis in the period in which the revisions are made. The Company also
performs work under time-and-materials contracts, recognizing revenue as hours
are worked based on the hourly billing rates for each contract. Additionally,
the Company recognizes revenue under units-based contracts by multiplying units
completed by the applicable contract per-unit price.
The Company incurs costs in excess of contract amounts in
subcontracting with third-party investigators as well as other out-of-pocket
costs. These out-of-pocket costs are reimbursable by the Company's customers.
Effective January 1, 2002 in connection with the implementation of EITF 01-14,
"Income Statement Characterization of Reimbursements Received for Out-of-Pocket
Expenses Incurred," the Company includes amounts paid to investigators and other
out-of-pocket costs as reimbursable out-of-pocket revenues and reimbursable
out-of-pocket expenses in the Consolidated Statements of Operations. The Company
implemented this rule beginning in the first quarter of 2002 and, as such has
reclassified all periods presented. In certain contracts, these costs are fixed
by the contract terms, so the Company recognizes these costs as part of net
service revenues and direct costs.
Direct costs consist of compensation and related fringe benefits for
project-related associates, unreimbursed project-related costs and indirect
costs including facilities, information systems and other costs. Selling,
general and administrative expenses consist of compensation
15
and related fringe benefits for sales and administrative associates and
professional services, as well as unallocated costs related to facilities,
information systems and other costs.
The Company's results are subject to volatility due to a variety of
factors. The cancellation or delay of contracts and cost overruns could have
immediate adverse effects on the financial statements. Fluctuations in the
Company's sales cycle and the ability to maintain large customer contracts or to
enter into new contracts could hinder the Company's long-term growth. In
addition, the Company's aggregate backlog is not necessarily a meaningful
indicator of future results. Accordingly, no assurance can be given that the
Company will be able to realize the net revenues included in the backlog.
ACQUISITIONS
In January 2002, the Company acquired the assets of Clinical and
Pharmacologic Research, Inc. (CPR), located in Morgantown, West Virginia. CPR
specializes in Phase I studies for the generic drug industry. Total acquisition
costs consisted of approximately $8.1 million in cash, 314,243 shares of the
Company's common stock valued at $4.1 million and a $6.0 million convertible
subordinated note. The note is convertible at the holders' option into 314,243
shares of the Company's common stock at any time before January 29, 2005, the
Maturity Date. If the note has not been converted at the Maturity Date, the
Company has the option to extend the Maturity Date of the note for another three
years.
The estimated fair value of the assets acquired and liabilities assumed
at the date of acquisition is as follows:
At January 29,
2002
(in thousands)
--------------
Current assets $ 1,241
Fixed assets 213
Goodwill 2,927
Intangible asset 15,000
-------
Total assets acquired 19,381
Liabilities assumed 1,131
-------
Net assets acquired $18,250
The intangible asset is based on a third-party valuation of a customer
contract acquired and has been determined to have an indefinite useful life and
will not be amortized, but instead will be reviewed for impairment at least
annually. The contract was determined to have an indefinite useful life based on
the unique nature of the services provided by CPR, the limited likelihood that a
competitor would attempt to gain some of the business provided under this
contract due to the barriers to entry and the historical relationship between
CPR and the customer.
The former majority shareholder of CPR is no longer employed by CPR and
never was employed by Kendle, but he does provide consulting services to Kendle.
16
He currently also provides consulting services to the customer that accounts for
the majority of CPR's current business as provided for in the contract discussed
above.
RESULTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 2001
Net service revenues increased 4% to $41.0 million in the third quarter
of 2002 from $39.4 million in the third quarter of 2001. Excluding the impact of
foreign currency exchange rates, net service revenues increased 1% in the third
quarter of 2002. The 4% increase in net service revenues was composed of growth
from acquisitions of 6% and a decline in organic net service revenues of 2%. In
the third quarter of 2001, the Company incurred a large amount of investigator
and other out-of-pocket costs on contracts where these types of costs were fixed
by the contract terms, and the Company recognized these costs as part of net
service revenues and direct costs. The decline in these costs and the related
revenues in the third quarter of 2002 is the primary reason for the drop in
organic net service revenues. Exclusive of these revenues, organic revenues
increased by 3% in the third quarter of 2002 compared to the corresponding
period in 2001. Approximately 26% of the Company's net service revenues were
derived from operations outside the United States in the third quarter of 2002
compared to 29% in the corresponding period in 2001. The top five customers
based on net service revenues contributed approximately 50% of net revenues
during the quarter. Net service revenues from Pharmacia Inc. accounted for
approximately 24% of total third quarter 2002 net service revenues. The
Company's net service revenues from Pharmacia Inc. are derived from numerous
projects that vary in size, duration and therapeutic indication.
Direct costs increased by 1% from $23.6 million in the third quarter
2001 to $23.9 million in the third quarter 2002. The 1% increase in direct costs
is composed of a 3% decrease in organic direct costs and a 4% increase in direct
costs due to the impact of acquisitions. The decrease in organic direct costs is
primarily a result of lower investigator and out-of-pocket costs on contracts
where these costs are fixed by the contract terms in the third quarter of 2002
compared to the third quarter of 2001, corresponding to the drop in organic net
service revenues. Excluding these investigator and out-of-pocket costs, organic
direct costs increased by 5% from the third quarter of 2001 to the third quarter
of 2002. Direct costs expressed as a percentage of net service revenues were
58.3% for the three months ended September 30, 2002 compared to 59.9% for the
three months ended September 30, 2001. In the third quarter of 2002, the Company
placed a significant emphasis on reducing the use of contractors on projects and
increasing the utilization of Kendle associates contributing to lower direct
costs as a percentage of revenue in the quarter.
Selling, general and administrative expenses decreased slightly from
$11.4 million in the third quarter of 2001 to $11.3 million in the same quarter
of 2002. The change in selling, general and administrative expenses is composed
of a 2% decline in organic SG&A costs and a 2% increase in SG&A costs due to the
impact of acquisitions. The decrease in organic SG&A costs is primarily due to a
decrease in certain discretionary expenses such as recruiting and relocation and
accrued bonus. Selling, general and administrative expenses expressed as a
percentage of net service revenues were 27.6% for the three months ended
September 30, 2002 compared to 28.8% for the corresponding 2001 period. The
decrease in SG&A costs as a percentage of net revenues is due to the spread of
these costs over a larger revenue base in the third quarter of 2002.
17
Depreciation and amortization expense decreased by 16% in the third
quarter of 2002 compared to the third quarter of 2001. The decrease is due to
the implementation of Statement of Financial Accounting Standards (SFAS) No.
142, which has eliminated the amortization of goodwill and other indefinite
lived intangible assets. See the discussion on SFAS No. 142 in the New
Accounting Pronouncements section of Management's Discussion and Analysis.
Excluding goodwill amortization in the third quarter of 2001, depreciation and
amortization expense increased by 22% in the third quarter of 2002 compared to
the third quarter of 2001. The increase is primarily due to increased
depreciation and amortization relating to the Company's capital expenditures.
On August 29, 2002, the Company committed to a plan that will
consolidate its three New Jersey offices into one central office, located in
Cranford, New Jersey. The Company currently maintains separate offices in
Princeton, Cranford and Ft. Lee, New Jersey. The leases in the Ft. Lee and
Princeton offices expire during the fourth quarter of 2002 and the first quarter
of 2003, respectively.
In connection with the office consolidation, in the third quarter of
2002 the Company recorded a pre-tax charge of $321,000, consisting primarily of
facility costs and severance and outplacement costs. Kendle expects to incur
additional costs of approximately $300,000 in the fourth quarter of 2002 and
throughout 2003, consisting primarily of costs of moving and employee
relocation, to finalize the consolidation of the offices. Total recurring annual
savings are expected to be approximately $1.2 million, with savings of
approximately $235,000 to be realized in the fourth quarter of 2002.
Including the effect of the office consolidation charge, net income for
the quarter was $1.9 million, or $0.14 per diluted share. Excluding the effects
of this charge, net income for the quarter would have been $2.1 million, or
$0.16 per diluted share compared with $1.2 million, or $0.09 per diluted share
during the same period a year ago. Eliminating goodwill amortization in 2001,
adjusted net income in the third quarter of 2001 would have been approximately
$1.8 million, or $0.14 per diluted share.
18
Net income used in calculating earnings per diluted share excluding the
impact of the office consolidation costs in the third quarter of 2002 is
calculated as follows:
Net income per Statements of Income $ 1,903
Add: after-tax effect of office consolidation costs 193
Add: after tax interest expense on convertible note 35
--------
Net income for diluted EPS calculation
(excluding office consolidation costs) $ 2,131
The weighted average shares used in computing diluted earnings per
share excluding the impact of the office consolidation costs has been calculated
as follows:
Weighted average shares outstanding: 12,777
Stock options 350
Convertible note 314
-------
Weighted average shares, excluding office
consolidation costs 13,441
The effective tax rate for the three months ending September 30, 2002
was 41.0% as compared to 44.3% for the three months ended September 30, 2001.
The decrease in the effective tax rate is primarily due to the impact of
non-deductible goodwill amortization on the effective tax rate in 2001 that was
eliminated in 2002.
NINE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
2001
Net service revenues increased 17% to $128.6 million during the first
nine months of 2002 from $110.4 million in the first nine months of 2001.
Excluding the impact of foreign currency exchange rates, net service revenues
increased 16% in the nine months of 2002. The 17% increase in net service
revenues was composed of growth from acquisitions of 9% and organic growth in
revenues of 8%. The growth in organic service revenues is primarily attributable
to the increased level of clinical development activity in 2002. Approximately
27% of the Company's net service revenues were derived from operations outside
the United States in the first nine months of 2002 compared to 31% in the
corresponding period in 2001. The top five customers based on net service
revenues contributed approximately 46% of net revenues during the first nine
months of 2002. Net service revenues from Pharmacia Inc. accounted for
approximately 20% of total nine month 2002 net service revenues. The Company's
net service revenues from Pharmacia Inc. are derived from numerous projects that
vary in size, duration and therapeutic indication.
Direct costs increased by 14% from $67.3 million in the first nine
months of 2001 to $76.4 million in the first nine months of 2002. The 14%
increase in direct costs is composed of a 5% increase in organic direct costs
and a 9% increase in direct costs due to the impact of acquisitions. The
increase in organic direct costs is primarily a result of an increase in
employee and contractor costs to support the increased revenue base. Direct
costs expressed as a percentage of net service revenues were 59.4% for the nine
months ended September 30, 2002
19
compared to 61.0% for the nine months ended September 30, 2001. The decrease in
these costs as a percentage of net service revenues is due to the mix of
contracts and services provided by the Company in the first nine months of 2002
compared to the corresponding period of 2001.
Selling, general and administrative expenses increased by 13% or $4.0
million, to $36.0 million in the first nine months of 2002 compared to $32.0
million in nine months of 2001. The 13% increase in selling, general and
administrative expenses is composed of a 9% increase in organic SG&A costs and a
4% increase in SG&A costs due to the impact of acquisitions. The increase in
organic SG&A costs is primarily due to increased employee-related costs such as
salaries, training costs and other employee costs incurred to support the larger
revenue base. Selling, general and administrative expenses expressed as a
percentage of net service revenues were 28.0% for the nine months ended
September 30, 2002 compared to 29.0% for the corresponding 2001 period. The
decrease in SG&A costs as a percentage of net revenues is as a result of the
Company's ability to leverage these costs over a higher revenue base.
Depreciation and amortization expense decreased by 16% in the nine
months ending September 30, 2002 compared to the corresponding period in 2001.
The decrease is due to the implementation of SFAS No. 142, which has eliminated
the amortization of goodwill and other indefinite lived intangible assets. See
the discussion of SFAS No. 142 in the New Accounting Pronouncements section of
Management's Discussion and Analysis. Excluding goodwill amortization in the
first nine months of 2001, depreciation and amortization expense increased 22%
in the first nine months of 2002 compared to the corresponding period in 2001.
The increase is primarily due to increased depreciation and amortization
relating to the Company's capital expenditures.
In the second quarter of 2002, the Company recorded a non-recurring
$1.9 million non-cash charge to reflect the impairment write-off of its
investment in Digineer, a healthcare consulting and software development company
that during the quarter adopted a plan to cease operations. This charge is
recorded in "Other income (expense)" in the Company's Statements of Income.
On August 29, 2002, the Company committed to a plan that would
consolidate its three New Jersey offices into one central office, located in
Cranford, New Jersey. The Company currently maintains separate offices in
Princeton, Cranford and Ft. Lee, New Jersey. The leases in the Ft. Lee and
Princeton offices expire during the fourth quarter of 2002 and the first quarter
of 2003, respectively. In connection with the office consolidation, in the third
quarter of 2002 the Company recorded a pre-tax charge of $321,000, consisting
primarily of facility costs and severance and outplacement costs.
Including the effect of the investment impairment and office
consolidation charges, net income for the nine months ended September 30, 2002
was $3.7 million or $0.28 per diluted share. Excluding the effects of these
charges, net income for the nine months ended September 30, 2002 would have been
$5.8 million, or $0.44 per diluted share compared with $2.3 million, or $0.18
per diluted share during the same period a year ago. Eliminating goodwill
amortization in 2001, adjusted net income in the first nine months of 2001 would
have been approximately $4.2 million, or $0.32 per diluted share.
20
Net income for the first nine months of 2002 used in calculating
earnings per diluted share excluding the impact of the Digineer write-off and
office consolidation charge is calculated as follows:
Net income per Statements of Income $3,653
Add: Digineer write-off charge 1,938
Add: after-tax effect of office consolidation costs 193
Add: after tax interest expense on convertible note 93
------
Net income for diluted EPS calculation
(excluding office consolidation costs and $5,877
Digineer write-off)
The pro-forma weighted average shares used in computing diluted
earnings per share excluding the impact of the Digineer write-off and office
consolidation charge has been calculated as follows:
Weighted average shares outstanding: 12,707
Stock options 481
Convertible note 282
------
Weighted average shares 13,470
The effective tax rate for the nine months ending September 30, 2002
was 50.7%. The write-off of the Digineer investment is a capital loss for income
tax purposes and is deductible only to the extent the Company generates capital
gains in the future to offset this loss. The Company has recorded a valuation
allowance against the deferred tax asset relating to the Digineer write-off and
no income tax benefit has been recorded. Excluding the impact of the investment
impairment write-off, the Company's effective tax rate would have been 40.2% for
the nine months ended September 30, 2002 as compared to 43.4% for the nine
months ended September 30, 2001. The decrease in the effective tax rate is
primarily due to the impact of non-deductible goodwill amortization on the
effective tax rate in 2001 that was eliminated in 2002.
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents increased by $0.7 million for the nine months
ended September 30, 2002 primarily as a result of cash provided by operating and
financing activities of $17.1 million and $1.5 million, respectively, offset by
cash used in investing activities of $18.1 million. Net cash provided by
operating activities primarily resulted from net income adjusted for non-cash
activity and a decrease in accounts receivable. Fluctuations in accounts
receivable and advance billings occur on a regular basis as services are
performed, milestones or other billing criteria are achieved, invoices are sent
to customers, and payments for outstanding accounts receivable are collected
from customers. Such activity varies by individual customer and contract.
Accounts receivable, net of advance billings decreased to $32.1 million at
September 30, 2002 from $40.7 million at December 31, 2001.
21
Financing activities for the nine months ended September 30, 2002
consisted primarily of net borrowings of $2.3 million under the Company's credit
facilities that were used to finance the Company's acquisition of CPR.
Investing activities for the nine months ended September 30, 2002
consisted primarily of $7.9 million in costs incurred related to the Company's
acquisition of CPR, net of cash acquired, and capital expenditures of
approximately $7.1 million.
The Company had available for sale securities totaling $22.0 million at
September 30, 2002.
In June 2002, the Company entered into an Amended and Restated Credit
Agreement (the "Facility") that replaced the previous credit facility that would
have expired in October 2003. The Facility is composed of a $23.0 million
revolving credit loan that expires in three years and a $15.0 million term loan
that matures in five years. The Facility is in addition to an existing $5.0
million Multicurrency Facility that is renewable annually and is used in
connection with the Company's European operations. The $23.0 million facility
bears interest at a rate equal to either (a) The Eurodollar Rate plus the
Applicable Percentage (as defined) or (b) the higher of the Federal Fund's Rate
plus 0.5% or the Bank's Prime Rate. The $15.0 million term loan bears interest
at a rate equal to the higher of the Federal Funds Rate plus 0.5% and the Prime
Rate or an Adjusted Eurodollar Rate (as defined in the agreement which is
included under Exhibit 10.23 in the Company's Form 10-Q for the quarter period
ended June 30, 2002).
The $5.0 million Multicurrency Facility is composed of a euro overdraft
facility up to the equivalent of $3.0 million and a pound sterling overdraft
facility up to the equivalent of $2.0 million. This Multicurrency Facility bears
interest at a rate equal to either (a) the rate published by the European
Central Bank plus a margin (as defined) or (b) the Bank's Base Rate (as
determined by the bank having regard to prevailing market rates) plus a margin
(as defined). Under terms of the credit agreement, revolving loans are
convertible into term loans within the facility if used for acquisitions. The
facilities contain various restrictive financial covenants, including the
maintenance of certain fixed coverage and leverage ratios and minimum net worth
levels. At September 30, 2002, no amounts were outstanding under the Company's
$23 million revolving credit loan, $13.5 million was outstanding under the term
loan, and $3.4 million was outstanding under the $5.0 million Multicurrency
Facility. Interest is payable on the term loan at a rate of 5.82% and on the
$3.4 million outstanding under the Multicurrency Facility at a weighted average
rate of 4.8%. Principal payments of $750,000 are due on the last business day of
each quarter through March of 2007.
Effective July 1, 2002 the Company entered into an interest rate swap
to fix the interest rate on the $15.0 million term loan. The swap is designated
as a cash flow hedge under the guidelines of SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities." Under the swap, the interest
rate on the term loan is fixed at 4.32% plus a margin of 1.5%. The swap is in
place through the life of the term loan, ending on March 31, 2007. Changes in
fair market value of the swap are recorded in Other Comprehensive Income on the
Balance Sheet. At September 30, 2002, approximately $564,000 has been recorded
in Other Comprehensive Income to reflect a decrease in the fair market value of
the swap.
With the acquisition of CPR, on January 29, 2002, the Company entered
into a $6,000,000 convertible note payable to the shareholders of CPR. The
principal balance is convertible at the holders' option into 314,243 shares of
the Company's Common Stock at any
22
time through January 29, 2005 (the Maturity Date). If the note has not been
converted at the Maturity Date, the Company has the option to extend the
Maturity Date of the note for another three years. The note bears interest at an
annual rate of 3.80% from January 29, 2002 through the Maturity Date. Interest
is payable semi-annually. If the Maturity Date is extended, the interest rate
will be reset on January 29, 2005 at an annual rate of interest equal to the
yield of a three-year United States Treasury Note.
The Company's primary cash needs on both a short-term and long-term
basis are for the payment of salaries and fringe benefits, hiring and recruiting
expenses, business development costs, capital expenditures, acquisitions, and
facility related expenses. The Company believes that its existing capital
resources, together with cash flows from operations and borrowing capacity under
its Credit Facilities, will be sufficient to meet its foreseeable cash needs. In
the future, the Company will continue to consider acquiring businesses to
enhance its service offerings, therapeutic base and global presence. Any such
acquisitions may require additional external financing and the Company may from
time to time seek to obtain funds from public or private issuance of equity or
debt securities. There can be no assurance that such financing will be available
on terms acceptable to the Company.
ADDITIONAL CONSIDERATIONS
On July 15, 2002 two of the Company's major customers, Pharmacia Inc.
and Pfizer Inc. announced plans to merge in a stock-for-stock transaction. The
merger is expected to close by the end of 2002. Pharmacia and Pfizer combined
represent approximately 29% of the Company's net service revenues for the nine
months ended September 30, 2002 and approximately 32% of the Company's September
30, 2002 backlog. Since the merger announcement, the Company has not noticed a
change, as a result of the announced merger, in the levels of business received
from either of these companies. The Company is unable to predict what impact,
either positive or negative, if any, the merger will have on the current backlog
of business or on amount of business the Company will receive from the combined
companies in the future.
MARKET RISK
Interest Rates
The Company is exposed to changes in interest rates on its
available-for-sale securities and amounts outstanding under its Credit
Facilities. Available-for-sale securities are recorded at fair value in the
financial statements. These securities are exposed to market price risk, which
also takes into account interest rate risk. At September 30, 2002, the potential
loss in fair value resulting from a hypothetical decrease of 10% in quoted
market price would be approximately $2.2 million. The Company also is exposed to
interest rate changes on its variable rate borrowings. Based on the Company's
September 30, 2002 amounts outstanding under Credit Facilities, a one- percent
change in the weighted-average interest rate would change the Company's annual
interest expense by approximately $34,000.
In July 2002, the Company entered into an interest rate swap with the
intent of managing the interest rate risk on its five-year term loan. Interest
rate swap agreements are contractual agreements between two parties for the
exchange of interest payment streams on a principal amount and an agreed-upon
fixed or floating rate, for a defined period of time. See discussion of
23
debt in the Liquidity and Resources section of the Management's Discussion and
Analysis of Financial Conditions and Results of Operations.
Foreign Currency
The Company operates on a global basis and therefore is exposed to
various types of currency risks. Two specific transaction risks arise from the
nature of the contracts the Company executes with its customers because from
time to time contracts are denominated in a currency different than the
particular subsidiary's local currency. This contract currency denomination
issue is applicable only to a portion of the contracts executed by the Company's
foreign subsidiaries. The first risk occurs as revenue recognized for services
rendered is denominated in a currency different from the currency in which the
subsidiary's expenses are incurred. As a result, the subsidiary's net revenues
and resultant net income can be affected by fluctuations in exchange rates.
Historically, fluctuations in exchange rates from those in effect at the time
contracts were executed have not had a material effect upon the Company's
consolidated financial results.
The second risk results from the passage of time between the invoicing
of customers under these contracts and the ultimate collection of customer
payments against such invoices. Because the contract is denominated in a
currency other than the subsidiary's local currency, the Company recognizes a
receivable at the time of invoicing at the local currency equivalent of the
foreign currency invoice amount. Changes in exchange rates from the time the
invoice is prepared until the payment from the customer is received will result
in the Company receiving either more or less in local currency than the local
currency equivalent of the invoice amount at the time the invoice was prepared
and the receivable established. This difference is recognized by the Company as
a foreign currency transaction gain or loss, as applicable, and is reported in
other income (expense) in the consolidated statements of income.
The Company's consolidated financial statements are denominated in U.S.
dollars. Accordingly, changes in exchange rates between the applicable foreign
currency and the U.S. dollar will affect the translation of each foreign
subsidiary's financial results into U.S. dollars for purposes of reporting
consolidated financial statements. The Company's foreign subsidiaries translate
their financial results from local currency into U.S. dollars as follows: income
statement accounts are translated at average exchange rates for the period;
balance sheet asset and liability accounts are translated at end of period
exchange rates; and equity accounts are translated at historical exchange rates.
Translation of the balance sheet in this manner affects the shareholders' equity
account, referred to as the foreign currency 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. Foreign currency translation adjustments, reported as a separate
component of shareholders' equity were $(2.4) million at September 30, 2002
compared to $(3.8) million at December 31, 2001.
KEY ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make significant estimates
and assumptions that affect the reported Consolidated Financial Statements for a
particular period. Actual results could differ from those estimates.
24
The majority of the Company's revenues are based on fixed-price
contracts calculated on a percentage-of-completion basis based on assumptions
regarding the estimated total costs for each contract. Costs are incurred for
each project and compared to the estimated budgeted costs for each contract to
determine a percentage of completion on the project. The percentage of
completion is multiplied by the total contract value to determine the amount of
revenue recognized. Management reviews the budget on each contract to determine
if the budgeted amounts are correct, and budgets are adjusted as needed.
Historically, the majority of the Company's estimates have been materially
correct, but there can be no guarantee that these estimates will continue to be
accurate. As the work progresses, original estimates might be changed due to
changes in the scope of the work. The Company attempts to negotiate contract
amendments with the sponsor to cover these services provided outside the terms
of the original contract. However, there can be no guarantee that the sponsor
will agree to the proposed amendments, and the Company ultimately bears the risk
of cost overruns. In certain instances, the Company may have to commit
additional resources to existing projects, resulting in lower gross margins.
As the Company works on projects, the Company also incurs third-party
and other pass-through costs, which are typically reimbursable by its customers
pursuant to the contract. In certain contracts, however, these costs are fixed
by the contract terms. In these contracts, the Company is at risk for costs
incurred in excess of the amounts fixed by the contract terms. Excess costs
incurred above the contract terms would negatively affect the Company's gross
margin.
The Company's primary customers are concentrated in the pharmaceutical
and biotechnology industries. The Company derives a significant portion of its
revenue from a small number of large pharmaceutical companies. The Company's
revenue could be negatively impacted by changes in the operating policies or
financial condition of these companies, including potential mergers and
acquisitions involving any of these companies. Additionally, in general
customers may terminate a study at any time, which might cause unplanned periods
of excess capacity and reduced revenue and earnings.
The Company analyzes goodwill and other indefinite-lived intangible
assets to determine any potential impairment loss on an annual basis, unless
conditions exist that require an updated analysis on an interim basis. A fair
value approach is used to test goodwill for impairment. An impairment charge is
recognized for the amount, if any, by which the carrying amount of the goodwill
exceeds the fair value. Fair value is established using discounted cash flows.
The Company has a 50% owned joint-venture investment in KendleWits, a
company located in China. The Company accounts for this investment under the
equity method. To date, the Company has contributed approximately $750,000 for
the capitalization of KendleWits and the carrying value at September 30, 2002 is
approximately $500,000. Future capitalization needs will be dependent upon the
on-going capitalization needs of KendleWits and the Company's willingness to
provide additional capital. The Company is not obligated to make any additional
investment in KendleWits and currently has no plans to do so. Results of
KendleWits may vary, and are dependent upon the demand for clinical research
services in China and the ability of KendleWits to generate additional business.
The Company capitalizes costs incurred to internally develop software
used primarily in providing proprietary clinical trial and data management
services, and amortizes these costs over the useful life of the product, not to
exceed five years. Internally developed software represents
25
software in the application development stage, and there is no assurance that
the software development process will produce a final product for which the fair
value exceeds its carrying value. Internally developed software is an intangible
asset subject to impairment write-downs whenever events indicate that the
carrying value of the software may not be recoverable. Assessing the fair value
of the internally developed software requires estimates and judgement on the
part of management.
The Company estimates its tax liability based on current tax laws in
the statutory jurisdictions in which it operates. Because the Company conducts
business on a global basis, its effective tax rate has, and will continue to
depend upon the geographic distribution of its pre-tax earnings among
jurisdictions with varying tax rates. These estimates include judgements about
deferred tax assets and liabilities resulting from temporary differences between
assets and liabilities recognized for financial reporting purposes and such
amounts recognized for tax purposes. The Company has assessed the realization of
deferred tax assets based on estimates of future taxable profits and losses in
the various jurisdictions. Based on these projections and the time period for
the realization of these loss carryforwards, a valuation allowance has not been
recorded. If estimates prove inaccurate or if the tax laws change unfavorably, a
valuation allowance could be required in the future.
NEW ACCOUNTING PRONOUNCEMENTS
In July 2002, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 146, Accounting for Exit or Disposal Activities. SFAS No. 146 addresses
the recognition, measurement, and reporting of costs that are associated with
exit and disposal activities, including costs related to terminating a contract
that is not a capital lease and termination benefits that employees who are
involuntarily terminated receive under the terms of a one-time benefit
arrangement that is not an ongoing benefit arrangement or an individual
deferred-compensation contract. SFAS No. 146 supersedes Emerging Issues Task
Force Issue No. 94-3, Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred
in a Restructuring) and requires liabilities associated with exit and disposal
activities to be expensed as incurred. SFAS No. 146 will be required for exit or
disposal activities of the Company initiated after December 31, 2002, with early
adoption encouraged.
In November 2001, FASB issued EITF 01-14, "Income Statement
Characterization of Reimbursements Received for Out-of-Pocket Expenses
Incurred." The EITF requires reimbursements for out-of-pocket expenses incurred
to be characterized as revenue and expenses in the Statements of Operations. The
Company implemented this rule beginning in the first quarter of 2002 and, as
such, has reclassified all periods presented. The implementation of the new
guidelines has no impact on income from operations or net income.
In October 2001, FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." SFAS No. 144 supercedes SFAS No.
121 "Accounting for the Impairment of Long-Lived Assets to be Disposed of" and
certain provisions of APB Opinion No. 30, "Reporting the Results of Operations -
Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary,
Unusual and Infrequently Occurring Events and Transactions." SFAS No. 144
establishes a single model for the impairment of long-lived assets and broadens
the presentation of discontinued operations. The adoption of this statement did
not have an impact on the Company's consolidated financial statements.
26
In July 2001, FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets" that requires that all intangible assets determined to have an
indefinite useful life no longer be amortized but instead be reviewed at least
annually for impairment. The Company adopted SFAS No. 142 as of January 1, 2002,
as required. The Company analyzed goodwill for impairment at the reporting unit
level at the beginning of 2002 and found no goodwill impairment. The Company
will analyze goodwill on an annual basis, or more frequently as circumstances
warrant.
In July 2001, FASB issued SFAS No. 141, "Business Combinations" that
requires all business combinations initiated after June 30, 2001 to be accounted
for using the purchase method. The Company has adopted SFAS No. 141 and the
adoption did not have an impact on the Company's results of operations or its
financial position.
CAUTIONARY STATEMENT FOR FORWARD-LOOKING INFORMATION
Certain statements contained in this Form 10-Q that are not historical
facts constitute forward-looking statements, within the meaning of the Private
Securities Litigation Reform Act of 1995, and are intended to be covered by the
safe harbors created by that Act. Reliance should not be placed on
forward-looking statements because they involve known and unknown risks,
uncertainties and other factors which may cause actual results, performance or
achievements to differ materially from those expressed or implied. Any
forward-looking statement speaks only as of the date made. The Company
undertakes no obligation to update any forward-looking statements to reflect
events or circumstances arising after the date on which they are made.
Statements concerning expected financial performance, on-going business
strategies and possible future action which the Company intends to pursue to
achieve strategic objectives constitute forward-looking information.
Implementation of these strategies and the achievement of such financial
performance are each subject to numerous conditions, uncertainties and risk
factors. Factors which could cause actual performance to differ materially from
these forward-looking statements include, without limitation, factors discussed
in conjunction with a forward-looking statement, changes in general economic
conditions, competitive factors, outsourcing trends in the pharmaceutical
industry, changes in the financial conditions of the Company's customers,
potential mergers and acquisitions in the pharmaceutical industry, the Company's
ability to manage growth and to continue to attract and retain qualified
personnel, the Company's ability to complete additional acquisitions and to
integrate newly acquired businesses, the Company's ability to penetrate new
markets, competition and consolidation within the industry, the ability of joint
venture businesses to be integrated with the Company's operations, the fixed
price nature of contracts or the loss of large contracts, cancellation or delay
of contracts, the progress of ongoing projects, cost overruns, fluctuations in
the Company's sales cycle, the ability to maintain large customer contracts or
to enter into new contracts, the effects of exchange rate fluctuations, the
carrying value of and impairment of the Company's investments and the other risk
factors set forth in the Company's SEC filings, copies of which are available
upon request from the Company's investor relations department. No assurance can
be given that the Company will be able to realize the net revenues included in
backlog and verbal awards. The Company believes that its aggregate backlog and
verbal awards are not necessarily meaningful indicators of future results.
27
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
See Management's Discussion and Analysis of Financial Conditions and Results of
Operations.
ITEM 4. CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures. The Company's chief
executive officer and chief financial officer have reviewed and evaluated the
effectiveness of the Company's disclosure controls and procedures (as defined in
the Exchange Act Rules 13a-14(c) and 15d-14(c)) as of a date within ninety days
before the filing date of this quarterly report. Based on that evaluation, the
chief executive officer and the chief financial officer have concluded that the
Company's disclosure controls and procedures are effective and designed to
ensure that material information relating to the Company and the Company's
consolidated subsidiaries are made known to them by others within those
entities.
(b) Changes in internal controls. There were no significant changes in the
Company's internal controls or in other factors that could significantly affect
those controls subsequent to the date of the evaluation.
28
PART II. OTHER INFORMATION
Item 1. Legal Proceedings - None
Item 2. Changes in Securities and Use of Proceeds - None
Item 3. Defaults upon Senior Securities - Not applicable
Item 4. Submission of Matters to a Vote of Security Holders - None
Item 5. Other Information - Not applicable
Item 6. Exhibits and Reports on Form 8-K --
(a) Exhibits
99.1 Statement of Chief Executive Officer
99.2 Statement of Chief Financial Officer
(b) Reports filed on Form 8-K during the quarter:
The Company filed Form 8-K on August 29, 2002 to disclose its announced
plans to consolidate its three New Jersey offices into one central
office in Cranford, NJ.
29
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 hereunto duly authorized.
KENDLE INTERNATIONAL INC.
By: /s/ Candace Kendle
------------------------------
Date: November 14, 2002 Candace Kendle
Chairman of the Board and Chief
Executive Officer
By: /s/ Timothy M. Mooney
-------------------------------
Date: November 14, 2002 Timothy M. Mooney
Executive Vice President - Chief Financial
Officer
30
CERTIFICATIONS
I, Candace Kendle, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Kendle
International Inc.
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
3. Based on my knowledge, the financial statements and other financial
information included in this quarterly report, fairly present, in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons
performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
31
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
By: /s/ Candace Kendle
------------------------------
Date: November 14, 2002 Candace Kendle
Chairman of the Board and Chief
Executive Officer
32
CERTIFICATIONS
I, Timothy M. Mooney, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Kendle
International Inc.
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
3. Based on my knowledge, the financial statements and other financial
information included in this quarterly report, fairly present, in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons
performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
33
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
By: /s/ Timothy M. Mooney
---------------------------------
Date: November 14, 2002 Timothy M. Mooney
Executive Vice President - Chief Financial
Officer
34
KENDLE INTERNATIONAL INC.
EXHIBIT INDEX
Exhibits Description
99.1 Statement of Chief Executive Officer
99.2 Statement of Chief Financial Officer
35