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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, 2003
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 by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes _X_ No __
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date: 13,060,015 shares of Common
Stock, no par value, as of October 31, 2003.
1
KENDLE INTERNATIONAL INC.
INDEX
Page
----
Part I. Financial Information
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets -September 30, 2003
and December 31, 2002 3
Condensed Consolidated Statements of Operations - Three
Months Ended September 30, 2003 and 2002; Nine Months Ended
September 30, 2003 and 2002 4
Condensed Consolidated Statements of Comprehensive Income (Loss) -
Three Months Ended September 30, 2003 and 2002; Nine Months
Ended September 30, 2003 and 2002 5
Condensed Consolidated Statements of Cash Flows - Nine
Months Ended September 30, 2003 and 2002 6
Notes to Condensed Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 16
Item 3. Quantitative and Qualitative Disclosure About Market Risk 30
Item 4. Controls and Procedures 30
Part II. Other Information 31
Item 1. Legal Proceedings 31
Item 2. Changes in Securities and Use of Proceeds 31
Item 3. Defaults upon Senior Securities 31
Item 4. Submission of Matters to a Vote of Security Holders 31
Item 5. Other Information 31
Item 6. Exhibits and Reports on Form 8-K 31
Signatures 32
Exhibit Index 33
2
KENDLE INTERNATIONAL INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data) September 30, December 31,
2003 2002
--------- ---------
(unaudited) (note 1)
ASSETS
Current assets:
Cash and cash equivalents $ 15,339 $ 12,671
Available for sale securities 10,424 17,304
Accounts receivable 44,718 47,050
Other current assets 10,391 7,343
--------- ---------
Total current assets 80,872 84,368
--------- ---------
Property and equipment, net 17,924 19,028
Goodwill, net 22,794 22,033
Other indefinite-lived intangible assets 15,000 15,000
Other assets 12,649 14,968
--------- ---------
Total assets $ 149,239 $ 155,397
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current portion of obligations under capital leases $ 874 $ 843
Current portion of amounts outstanding under credit facilities 3,000 3,000
Trade payables 4,508 5,883
Advance billings 17,738 22,313
Other accrued liabilities 14,999 10,878
--------- ---------
Total current liabilities 41,119 42,917
--------- ---------
Obligations under capital leases, less current portion 1,096 1,643
Convertible note 4,000 6,000
Long-term debt 7,500 9,750
Other noncurrent liabilities 850 727
--------- ---------
Total liabilities 54,565 61,037
--------- ---------
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; 13,070,651 and
12,861,510 shares issued and 13,050,754 and 12,841,613
outstanding at September 30, 2003 and December 31, 2002, respectively 75 75
Additional paid in capital 135,010 134,266
Accumulated deficit (39,681) (37,478)
Accumulated other comprehensive loss:
Net unrealized holding gain (loss) on available for sale securities 1 (6)
Unrealized loss on interest rate swap (458) (566)
Foreign currency translation adjustment 120 (1,538)
--------- ---------
Total accumulated other comprehensive loss (337) (2,110)
Less: Cost of common stock held in treasury, 19,897 shares at
September 30, 2003 and December 31, 2002, respectively (393) (393)
--------- ---------
Total shareholders' equity 94,674 94,360
--------- ---------
Total liabilities and shareholders' equity $ 149,239 $ 155,397
========= =========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
KENDLE INTERNATIONAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(in thousands, except per share data) For the Three Months Ended For the Nine Months Ended
September 30, September 30,
------------------------- -------------------------
2003 2002 2003 2002
--------- --------- --------- ---------
Net service revenues $ 40,424 $ 40,966 $ 116,101 $ 128,581
Reimbursable out-of-pocket revenues 12,716 11,468 38,642 35,997
--------- --------- --------- ---------
Total revenues 53,140 52,434 154,743 164,578
--------- --------- --------- ---------
Costs and expenses:
Direct costs 22,404 23,900 68,573 76,438
Reimbursable out-of-pocket costs 12,716 11,468 38,642 35,997
Selling, general and
administrative expenses 13,833 11,321 39,322 36,032
Depreciation and amortization 2,244 2,141 6,656 6,196
Severance and office consolidation costs 897 321 1,473 321
--------- --------- --------- ---------
52,094 49,151 154,666 154,984
--------- --------- --------- ---------
Income from operations 1,046 3,283 77 9,594
Other income (expense):
Interest income 67 173 266 474
Interest expense (251) (361) (799) (907)
Other (162) 128 (586) 186
Investment impairment -- -- (405) (1,938)
Gain on debt extinguishment -- -- 558 --
--------- --------- --------- ---------
Income (loss) before income taxes 700 3,223 (889) 7,409
Income tax expense 356 1,320 1,314 3,756
--------- --------- --------- ---------
Net income (loss) $ 344 $ 1,903 $ (2,203) $ 3,653
========= ========= ========= =========
Income (loss) per share data:
Basic:
Net income (loss) per share $ 0.03 $ 0.15 $ (0.17) $ 0.29
========= ========= ========= =========
Weighted average shares 13,013 12,777 12,943 12,707
Diluted:
Net income (loss) per share $ 0.03 $ 0.14 $ (0.17) $ 0.28
========= ========= ========= =========
Weighted average shares 13,244 13,441 12,943 13,188
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
KENDLE INTERNATIONAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(UNAUDITED)
(in thousands) For the Three Months Ended For the Nine Months Ended
September 30, September 30,
-------------------------- -------------------------
2003 2002 2003 2002
------- ------- ------- -------
Net income (loss) $ 344 $ 1,903 $(2,203) $ 3,653
------- ------- ------- -------
Other comprehensive income (loss):
Foreign currency translation adjustment 243 (63) 1,658 1,411
Net unrealized holding gains (losses) on
available for sale securities arising
during the period, net of tax 3 (7) 7 (32)
Net unrealized holding gains (losses) on
interest rate swap agreement 116 (564) 108 (564)
------- ------- ------- -------
Comprehensive income (loss) $ 706 $ 1,269 $ (430) $ 4,468
======= ======= ======= =======
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,
-----------------------
2003 2002
-------- --------
Net cash provided by operating activities $ 4,233 $ 17,083
-------- --------
Cash flows from investing activities:
Proceeds from sales and maturities of available for sale securities 54,207 28,401
Purchases of available for sale securities (47,341) (31,463)
Acquisitions of property and equipment (3,120) (5,441)
Additions to software costs (1,428) (1,661)
Acquisition of businesses, less cash acquired -- (7,942)
Other 10 --
-------- --------
Net cash provided by (used in) investing activities 2,328 (18,106)
-------- --------
Cash flows from financing activities:
Net proceeds (repayments) under credit facilities (2,250) 2,301
Net repayments - book overdraft (5) (470)
Repayment of convertible note (1,442) --
Proceeds from exercise of stock options 192 294
Payments on capital lease obligations (635) (605)
Other (65) (32)
-------- --------
Net cash (used in) provided by financing activities (4,205) 1,488
-------- --------
Effects of exchange rates on cash and cash equivalents 312 220
Net increase in cash and cash equivalents 2,668 685
Cash and cash equivalents:
Beginning of period 12,671 6,016
-------- --------
End of period $ 15,339 $ 6,701
======== ========
Supplemental schedule of noncash investing and financing activities:
Acquisition of Businesses:
Fair value of assets acquired (net of cash acquired) $ -- $ 19,165
Fair value of liabilities assumed -- (1,131)
Common stock issued -- (4,092)
Convertible debt issued -- (6,000)
-------- --------
Net cash payments $ -- $ 7,942
======== ========
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. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Basis of Presentation
- ---------------------
The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with accounting principles generally accepted
in the United States of America 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 accounting principles
generally accepted in the United States of America 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 and nine months ended September 30,
2003 are not necessarily indicative of the results that may be expected for the
year ending December 31, 2003. For further information, refer to the
consolidated financial statements and notes thereto included in the Form 10-K
for the year ended December 31, 2002 filed by Kendle International Inc. ("the
Company") with the Securities and Exchange Commission.
The condensed consolidated balance sheet at December 31, 2002 has been
derived from the audited financial statements at that date but does not include
all of the information and notes required by accounting principles generally
accepted in the United States of America for complete financial statements.
Net Income (Loss) Per Share Data
- --------------------------------
Net income (loss) per basic share is computed using the weighted
average common shares outstanding. Net income (loss) per diluted share is
computed using the weighted average common shares and potential common shares
outstanding.
The net income (loss) used in computing net income (loss) per diluted
share has been calculated as follows:
(in thousands) Three Months Ended Three Months Ended
September 30, 2003 September 30, 2002
---------------------------- ------------------------
Net income per Statements of
Operations $ 344 $1,903
Add: after-tax interest expense on
convertible note -- 35
------ ------
Net income for diluted earnings per share
calculation $ 344 $1,938
7
(in thousands) Nine Months Ended Nine Months Ended
September 30, 2003 September 30, 2002
---------------------------- -----------------------
Net income (loss) per Statements of
Operations $(2,203) $3,653
The weighted average shares used in computing net income (loss) per diluted
share have been calculated as follows:
(in thousands) Three Months Ended Three Months Ended
September 30, 2003 September 30, 2002
---------------------------- ------------------------
Weighted average common shares
Outstanding 13,013 12,777
Stock options 231 350
Convertible note -- 314
---------------------------- ------------------------
Weighted average shares 13,244 13,441
---------------------------- ------------------------
(in thousands) Nine Months Ended Nine Months Ended
September 30, 2003 September 30, 2002
---------------------------- ------------------------
Weighted average common shares
Outstanding 12,943 12,707
Stock options -- 481
---------------------------- ------------------------
Weighted average shares 12,943 13,188
---------------------------- ------------------------
Options to purchase approximately 1,800,000 and 2,150,000 shares of
common stock were outstanding during the three and nine months ended September
30, 2003, respectively, but were not included in the computation of earnings per
diluted share because the effect would be antidilutive.
Options to purchase approximately 1,338,000 and 907,000 shares of
common stock were outstanding during the three and nine months ended September
30, 2002, respectively, but were not included in the computation of earnings per
diluted share because the effect would be antidilutive.
Stock-Based Compensation
- ------------------------
The Company accounts for stock options issued to associates in
accordance with Accounting Principles Board Opinion (APB) No. 25, "Accounting
for Stock Issued to Employees." Under APB No. 25, the Company recognizes expense
based on the intrinsic value of the options. The Company has adopted the
disclosure requirements of Statement of Financial Accounting Standards (SFAS)
No. 123, "Accounting for Stock-Based Compensation," as amended by SFAS No. 148,
"Accounting for Stock-Based Compensation - Transition and Disclosure" which
requires compensation expense to be disclosed based on the fair value of the
options granted at the date of grant.
8
Had the Company adopted SFAS No. 123 for expense recognition purposes,
the amount of compensation expense that would have been recognized in the first
nine months of 2003 and 2002 would have been approximately $3.7 million in both
periods. The Company's pro-forma net income (loss) per diluted share would have
been adjusted to the amounts below:
(in thousands, except per share data) Three Months Ended Three Months Ended
September 30, 2003 September 30, 2002
------------------ ------------------
PRO FORMA NET INCOME (LOSS):
As reported $ 344 $ 1,903
Less: pro forma adjustment for
stock-based compensation, net of tax (907) (1,022)
--------- ---------
Pro-forma net income (loss) $ (563) $ 881
PRO-FORMA NET INCOME (LOSS) PER BASIC SHARE:
As reported $ 0.03 $ 0.15
Effect of pro forma expense $ (0.07) $ (0.08)
Pro-forma $ (0.04) $ 0.07
PRO-FORMA NET INCOME (LOSS) PER DILUTED SHARE:
As reported $ 0.03 $ 0.14
Effect of pro forma expense $ (0.07) $ (0.07)
Pro-forma $ (0.04) $ 0.07
(in thousands, except per share data) Nine Months Ended Nine Months Ended
September 30, 2003 September 30, 2002
------------------ ------------------
PRO FORMA NET INCOME (LOSS):
As reported $ (2,203) $ 3,653
Less: pro forma adjustment for
stock-based compensation, net of tax (2,909) (2,953)
--------- ---------
Pro-forma net income (loss) $ (5,112) $ 700
PRO-FORMA NET INCOME (LOSS) PER BASIC SHARE:
As reported $ (0.17) $ 0.29
Effect of pro-forma expense $ (0.23) $ (0.24)
Pro-forma $ (0.40) $ 0.05
PRO-FORMA NET INCOME (LOSS) PER DILUTED SHARE:
As reported $ (0.17) $ 0.28
Effect of pro-forma expense $ (0.23) $ (0.22)
Pro-forma $ (0.40) $ 0.06
9
New Accounting Pronouncements
- -----------------------------
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity". This
statement establishes standards for how an issuer classifies and measures
certain types of financial instruments that have characteristics of both
liabilities and equity. It requires that an issuer classify a financial
instrument that is within its scope as a liability (or an asset in some
circumstances). Many of those instruments were previously classified as equity.
SFAS No. 150 is effective for financial instruments entered into or modified
after May 31, 2003 and otherwise is effective at the beginning of the first
interim period beginning after June 15, 2003. The company adopted the standard
on July 1, 2003. The adoption of SFAS No. 150 had no material effect on the
Company's consolidated financial position or results of operations.
In January 2003, the Emerging Issues Task Force (EITF) issued EITF
Issue 00-21, "Revenue Arrangements with Multiple Deliverables," which requires
companies to determine whether an arrangement involving multiple deliverables
contains more than one unit of accounting. In applying EITF Issue 00-21, revenue
arrangements with multiple deliverables should be divided into separate units of
accounting if the deliverables in the arrangement meet certain criteria.
Arrangement consideration should be allocated among the separate units of
accounting based on their relative fair values. This issue is effective for
revenue arrangements entered into in fiscal periods beginning after June 15,
2003. The adoption of this statement did not have a material impact on the
Company's consolidated financial statements.
In January 2003, the Financial Accounting Standards Board (FASB) issued
Interpretation No. 46 (FIN 46), "Consolidation of Variable Interest Entities."
FIN 46 requires a variable interest entity to be consolidated by a company if
that company is subject to a majority of the risk of loss from the variable
interest entity's activities or entitled to receive a majority of the entity's
residual returns or both. A variable interest entity is a corporation,
partnership, trust, or any other legal structure used for business purposes that
either (a) does not have equity investors with voting rights or (b) has equity
investors that do not provide sufficient financial resources for the entity to
support its activities. A variable interest entity often holds financial assets,
including loans or receivables, real estate or other property. A variable
interest entity may be essentially passive or it may engage in research and
development or other activities on behalf of another company. The consolidation
requirements of FIN 46 apply immediately to variable interest entities created
after January 31, 2003. The consolidation requirements apply to older entities
in the first fiscal year or interim period beginning after June 15, 2003.
Certain of the disclosure requirements apply to all financial statements issued
after January 31, 2003, regardless of when the variable interest entity was
established. The adoption of this statement did not have a material impact on
the Company's consolidated financial statements.
In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure, an Amendment of SFAS No.
123." SFAS No. 148 provides transition guidance for those companies that elect
to voluntarily adopt the accounting provisions of SFAS No. 123, "Accounting for
Stock-Based Compensation." SFAS No. 148 also mandates certain new disclosures
that are incremental to those required by SFAS No. 123. SFAS No. 148 is
effective for fiscal years ending after December 15, 2002. The Company has
adopted the disclosure requirements of SFAS No. 148. At this time the Company
does not plan to adopt the accounting provisions of SFAS No. 123 and will
continue to account for stock options in accordance with APB No. 25, "Accounting
for Stock Issued to Employees."
10
In July 2002, the 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 EITF 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 is
required for exit or disposal activities of the Company initiated after December
31, 2002, with earlier adoption encouraged. The Company has adopted SFAS No.
146.
2. ACQUISITION:
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.
The aggregate purchase price was approximately $18.2 million, including
approximately $8.1 million in cash (including acquisition costs), 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. In June of 2003, the Company and the shareholders of
CPR entered into Note Prepayment Agreements. See Note 5, Debt for further
discussion regarding these agreements.
Valuation of Common Stock issued in the acquisition 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.
The goodwill and the intangible asset acquired in the acquisition are
deductible for income tax purposes over a 15-year period.
The following unaudited pro forma results of operations assume the
acquisition occurred at the beginning of 2002:
(in thousands, except per share data) Nine Months Ended
September 30, 2002
-------------------------
Net service revenues $129,382
Net income $3,791
Net income per diluted share $0.29
Weighted average shares 13,252
11
The pro forma financial information is not necessarily indicative of
the operating results that would have occurred had the acquisition been
consummated as of January 1, 2002, nor are they necessarily indicative of future
operating results.
3. OFFICE CONSOLIDATION AND EMPLOYEE SEVERANCE:
In August, 2003, the Company initiated a workforce realignment plan
which immediately eliminated approximately 65 positions from its global
workforce. In the third quarter of 2003, the Company recorded a pre-tax charge
of approximately $897,000 for severance and outplacement benefits relating to
this workforce realignment. Approximately $845,000 was paid during the third
quarter and at September 30, 2003 approximately $52,000 remains accrued and is
reflected in Other Accrued Liabilities on the Company's Condensed Consolidated
Balance Sheet. The remaining $52,000 is expected to be paid out in the fourth
quarter of 2003. Costs relating to this program are reflected in the line item
entitled Severance and Office Consolidation Costs in the Company's Condensed
Consolidated Statements of Operations.
In order to bring its cost structure more in line with the then current
revenue projections, in the first quarter of 2003, the Company recorded a
pre-tax charge of approximately $690,000 for severance and outplacement benefits
relating to a workforce reduction program which impacted approximately 17
employees. In the second quarter of 2003, the Company recorded an adjustment to
reduce this charge by $106,000 as a result of lower than expected severance
costs related to the workforce reduction. Approximately $57,000 was paid during
the third quarter of 2003 pertaining to this workforce reduction, and at
September 30, 2003 approximately $28,000 remains accrued and is reflected in
Other Accrued Liabilities on the Company's Condensed Consolidated Balance Sheet.
The remaining $28,000 will be paid in the fourth quarter of 2003. Costs relating
to this program are reflected in the line item entitled Severance and Office
Consolidation Costs in the Company's Condensed Consolidated Statements of
Operations.
On August 29, 2002, the Company committed to a plan that consolidated
its three New Jersey offices into one central office, located in Cranford, New
Jersey. At that time, the Company maintained separate offices in Princeton,
Cranford and Ft. Lee, New Jersey. The leases in the Ft. Lee and Princeton
offices expired during the fourth quarter of 2002 and the first quarter of 2003,
respectively. The Company vacated 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 eliminated approximately 22 full-time positions.
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. In the first quarter
of 2003, the Company incurred an additional $52,000 in costs relating to the
office consolidation. As of September 30, 2003, $31,000 remains accrued and is
reflected in Other Accrued Liabilities in the Company's Condensed Consolidated
Balance Sheet.
The amounts accrued for the workforce reduction and office
consolidation costs are detailed as follows:
Employee Facilities Other Total
Severance
--------- ---------- ----- -----
Liability at December 31, 2002 $ 73 $ 44 $ 40 $ 157
Amounts accrued 1,639 -- -- 1,639
Amounts paid (1,490) (25) -- (1,515)
Non-Cash charge -- (4) -- (4)
Adjustment to liability (142) (4) (20) (166)
Liability at September 30, 2003 $ 80 $ 11 $ 20 $ 111
12
4. GOODWILL AND OTHER INTANGIBLE ASSETS:
Identifiable intangible assets as of December 31, 2002 and September
30, 2003 are composed of:
(in thousands)
Goodwill Indefinite-lived
Intangible Asset
---------- ----------------
Balance at 12/31/02 $ 22,033 $ 15,000
Less: Tax benefit to reduce goodwill (291) --
Add: Exchange rate fluctuations 1,052 --
Balance at 9/30/03 $ 22,794 $ 15,000
5. 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 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 revolving credit loan 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.
Under terms of the Facility, revolving loans are convertible into term
loans within the Facility if used for acquisitions. The Facility contains
various restrictive financial covenants, including the maintenance of certain
fixed coverage and leverage ratios.
At March 31, 2003, the Company fell below the minimum permitted Fixed
Charge coverage ratio. The Company and the banks amended the minimum permitted
Fixed Charge coverage ratio for the first quarter of 2003 and future periods. In
addition, as part of the amendment:
- The amount available under the revolving credit loan is
reduced from $23 million to the lesser of $10 million or 50%
of the Company's Eligible Receivables, as defined.
13
- Until the Company's Fixed Charge Coverage Ratio returns to
levels specified in the original agreement, the applicable
percentage applied to the interest rate on the Company's
borrowing under the Facility is increased by 0.75%.
- The term loan is collateralized by a pledge of the Company's
domestic cash and cash equivalents and any amounts
outstanding under the revolving credit loan are
collateralized by the Company's Eligible Receivables, as
defined, and any remaining domestic cash and cash
equivalents above the amounts pledged as security under the
term loan.
- The Company must maintain a ratio of cash, cash equivalents
and available-for-sale securities held in the United States
to principal amounts outstanding under the Company's term
loan of at least 1.1 to 1.0.
In the third quarter of 2003 the Company reached an agreement in
principle with the banks to amend the Fixed Charge Coverage ratio from a rolling
four quarters calculation to a calculation based on the results of each
individual quarter. The company expects to sign the amendment with the banks in
the 4th quarter.
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).
At September 30, 2003, no amounts were outstanding under the Company's
revolving credit loan, $10.5 million was outstanding under the term loan, and no
amounts were outstanding under the $5.0 million Multicurrency Facility. Interest
is payable on the term loan at a rate of 6.57%. Principal payments of $750,000
are due on the term loan on the last business day of each quarter through March
2007.
Effective July 1, 2002, the Company entered into an interest rate swap
agreement 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
agreement, the interest rate on the term loan is fixed at 4.32% plus the
applicable margin (currently 2.25%). 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 Accumulated Other Comprehensive Loss on the Condensed
Consolidated Balance Sheet. At September 30, 2003, approximately $458,000 has
been recorded in Accumulated Other Comprehensive Loss to reflect a decrease in
the fair market value of the swap.
With the acquisition of CPR the Company entered into a $6.0 million
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.
14
In June of 2003, the Company and the shareholders of CPR entered into
Note Prepayment Agreements. Under the Note Prepayment Agreements, the Company
agreed to satisfy its payment obligations under the $6.0 million convertible
note by making a series of four payments between June 30, 2003 and January 10,
2005. The four payments are to be initiated either by the Company through the
exercise of a "call" option or the CPR shareholders through the exercise of a
"put" option. If the four put or call options are exercised, the Company would
pay $4.5 million to fully settle the $6.0 million note. Gains resulting from
this early extinguishment of debt will be recorded when paid as a gain in the
Company's Consolidated Statements of Operations. At June 30, 2003 the CPR
shareholders exercised their put option and the Company paid $1.4 million to
settle $2.0 million of the $6.0 million convertible note. A gain of
approximately $558,000 has been recorded in the second quarter of 2003 in the
Company's Condensed Consolidated Statements of Operations.
6. SUBSEQUENT EVENT:
On October 1, 2003, the Company completed its acquisition of Mexican
CRO Estadisticos y Clinicos Asociados, S.A. (ECA). ECA is a Phase I-IV contract
research organization located in Mexico City, Mexico. With the acquisition, the
Company has expanded its capability to conduct clinical trials in Latin America.
The Company acquired substantially all the assets and assumed certain
liabilities of ECA for a purchase price of approximately $3.2 million in cash
plus acquisition costs. The Company is in the process of finalizing the purchase
price allocation.
15
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, 2003, 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.
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 as units are
completed multiplied by the 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.
The Company includes amounts paid to investigators and other out-of-pocket costs
as reimbursable out-of-pocket revenues and reimbursable out-of-pocket costs in
the Condensed Consolidated Statements of Operations. 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 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 CRO industry in general continues to be dependent on the research
and development activities of the principal pharmaceutical and biotechnology
companies as major customers, and the Company believes this dependence will
continue. The loss of business from any of the major customers could have a
material adverse affect on the Company.
16
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 consolidated 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, consisting of signed
contracts and letters of intent, 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 service revenues included in the backlog.
RESULTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 2002
Net Service Revenues
--------------------
Net service revenues decreased approximately $542,000, or 1%, to $40.4
million in the third quarter of 2003 from $41.0 million in the third quarter of
2002. Foreign currency exchange rate fluctuations accounted for a 5% increase in
net service revenues in the third quarter of 2003 compared to 2002. Net service
revenues in North America declined by approximately $4.7 million, or 15.6%, from
the third quarter of 2002 to the corresponding period in 2003 due to an overall
slowdown in new business in North America and in particular, a slowdown in new
business from two of the Company's largest customers which recently merged. The
decline in North American net service revenues was offset somewhat by an
increase in net service revenues in both the European and Asia-Pacific regions,
which increased $3.6 million or 35.9% and $603,000 or 71.2%, respectively, from
the same period of the prior year. In addition, in the third quarter of 2003,
net service revenue recorded on contracts where costs paid to investigators and
other out-of-pocket costs are fixed by the contract terms and recorded as direct
costs and net service revenues decreased by approximately $600,000.
Approximately 37% of the Company's net service revenues were derived
from operations outside of North America in the third quarter of 2003 compared
to 26% in the corresponding period in 2002. The top five customers based on net
service revenues contributed approximately 52% of net service revenues during
the third quarter of 2003 compared to approximately 50% of net service revenues
during the third quarter of 2002. Net service revenues from Pfizer Inc.
(including the former Pharmacia Inc.) accounted for approximately 29% of total
third quarter 2003 net service revenues compared to approximately 32% of total
third quarter 2002 net service revenues. The Company's net service revenues from
Pfizer Inc. are derived from numerous projects that vary in size, duration and
therapeutic indication. No other customer accounted for more than 10% of the net
service revenues for the quarter in either year presented.
Reimbursable Out-of-Pocket Revenues
-----------------------------------
Reimbursable out-of-pocket revenues fluctuate from period to period,
primarily due to the level of investigator activity in a particular period.
Reimbursable out-of-pocket revenues increased 11% to $12.7 million in the third
quarter of 2003 from $11.5 million in the corresponding period of 2002.
17
Operating Expenses
------------------
Direct costs decreased approximately $1.5 million, or 6%, from $23.9
million in the third quarter 2002 to $22.4 million in the third quarter 2003.
Direct costs expressed as a percentage of net service revenues were 55.4% for
the three months ended September 30, 2003 compared to 58.3% for the three months
ended September 30, 2002. The improvement in direct costs is due to the lower
use of outside contractors working on Company contracts as well as the workforce
realignment and other cost containment measures implemented in the third quarter
of 2003. In addition, the decrease in direct costs is a result of lower
investigator and out-of-pocket costs of approximately $600,000 on contracts
where these costs are fixed by the contract terms.
Reimbursable out-of-pocket costs increased 11% to $12.7 million in the
third quarter of 2003 from $11.5 million in the corresponding period of 2002.
Selling, general and administrative expenses increased $2.5 million, or
22%, from $11.3 million in the third quarter of 2002 to $13.8 million in the
same quarter of 2003. Foreign currency exchange rate fluctuations accounted for
a 3% increase in selling, general and administrative expenses in the third
quarter of 2003 compared to the comparable period of 2002. The remaining
increase is primarily due to broad-based employee incentive compensation amounts
accrued in the third quarter of 2003. Selling, general and administrative
expenses expressed as a percentage of net service revenues were 34.2% for the
three months ended September 30, 2003 compared to 27.6% for the corresponding
2002 period. The increase in SG&A costs as a percentage of net service revenues
is due to the increase in SG&A due to the incentive compensation accrual.
Depreciation and amortization expense increased by $103,000 or, 4.8%,
in the third quarter of 2003 compared to the third quarter of 2002. The increase
is primarily due to increased depreciation and amortization relating to the
Company's capital expenditures.
In the third quarter of 2003, the Company recorded a charge of
approximately $897,000 for severance and outplacement costs in connection with a
workforce realignment plan implemented in August. Approximately $845,000 was
paid during the quarter in connection with this realignment plan. As of
September 30, 2003, approximately $52,000 remains accrued and is expected to be
paid in the fourth quarter of 2003. In the third quarter of 2002, the Company
recorded a charge of approximately $321,000 for costs associated with
consolidating its three New Jersey offices into one central location.
Other Income (Expense)
----------------------
Other Income (Expense) was an expense of approximately $346,000 in the
third quarter of 2003 compared to an expense of approximately $60,000 in the
third quarter of 2002. The decrease in Other Income is primarily due to foreign
exchange losses of approximately $116,000 in the third quarter of 2003 compared
to exchange rate gains of approximately $77,000 in the corresponding period of
2002 as well as lower interest income in the third quarter of 2003 due to lower
worldwide interest rates on investments.
Income Taxes
------------
The Company reported tax expense at an effective rate of 50.9% in the
quarter ended September 30, 2003, compared to tax expense at an effective rate
of 41.0% in the quarter ended
18
September 30, 2002. In the fourth quarter of 2002, the Company recorded a full
valuation allowance against net operating losses incurred in certain European
subsidiaries of the Company. Since Kendle operates on a global basis, the
effective tax rate varies from quarter to quarter based on the locations that
generate the pre-tax earnings or losses.
Net Income
----------
Including the effects of the severance and outplacement costs (items
totaling an after-tax expense of $547,000, or $0.04 per diluted share) the net
income for the quarter ended September 30, 2003, was approximately $344,000, or
$0.03 per diluted share. Including the effect of the office consolidation costs
(an after-tax expense of $193,000, or $0.02 per diluted share) the net income
for the third quarter of 2002 was approximately $1,903,000 or $0.14 per diluted
share.
NINE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
2002
Net Service Revenues
--------------------
Net service revenues decreased by approximately $12.5 million or, 10%,
to $116.1 million in the first nine months of 2003 from $128.6 million in the
first nine months of 2002. Foreign currency exchange rate fluctuations accounted
for a 4% increase in net service revenues in the first nine months of 2003
compared to the comparable period of 2002. Net service revenues in North America
for the nine months ended September 30, 2003 declined by approximately $17.1
million or 18.1% from the same period of the prior year. This decline has been
offset somewhat by increases in net service revenues in both the European and
Asia/Pacific regions, which increased by approximately $3.4 million or 10.7% and
$1.3 million or 52%, respectively. The decline in North American net service
revenues is due to an overall slowdown in new business in North America and in
particular, a slowdown in new business from two of the Company's largest
customers which recently merged. Additionally, contract delays and cancellations
adversely affected net service revenues in the first nine months of 2003,
primarily in the first half of 2003 and to a lesser extent the last three
months, compared to the corresponding period in 2002. Finally, in 2003 net
service revenue recorded on contracts where costs paid to investigators and
other out-of-pocket costs are fixed by the contract terms and recorded as direct
costs and net service revenues decreased by approximately $3.3 million.
Approximately 33% of the Company's net service revenues were derived from
operations outside of North America in the first nine months of 2003 compared to
27% in the corresponding period in 2002. The top five customers based on net
service revenues contributed approximately 49% of net service revenues during
the first nine months of 2003 compared to 46% of net service revenues during the
first nine months of 2002. Net service revenues from Pfizer Inc. (including the
former Pharmacia Inc.) accounted for approximately 29% of total net service
revenues for both the nine months ended September 30, 2003 and 2002. The
Company's net service revenues from Pfizer Inc. are derived from numerous
projects that vary in size, duration and therapeutic indication. No other
customer accounted for more than 10% of the net service revenues in either
period presented.
Reimbursable Out-of-Pocket Revenues
-----------------------------------
Reimbursable out-of-pocket revenues fluctuate from period to period,
primarily due to the level of investigator activity in a particular period.
Reimbursable out-of-pocket revenues
19
increased 7.4% to $38.6 million in the nine months ended September 30, 2003 from
$36.0 million in the corresponding period of 2002.
Operating Expenses
------------------
Direct costs decreased by approximately $7.9 million, or 10%, from
$76.4 million in the first nine months of 2002 to $68.6 million in the first
nine months of 2003. The change in direct costs is the result of an 11% decrease
in organic direct costs. Acquisitions did not have a material impact on direct
costs in the period. Foreign currency exchange rate fluctuations accounted for a
5% increase in direct costs in the first nine months of 2003 compared to the
comparable period of 2002. The decline in direct costs is due to the lower use
of outside contractors working on Company contracts as well as the workforce
realignment and other cost containment measures implemented in 2003. In
addition, the decrease in organic direct costs is a result of lower investigator
and out-of-pocket costs of approximately $3.3 million on contracts where these
costs are fixed by the contract terms. Direct costs expressed as a percentage of
net service revenues were 59.1% for the nine months ended September 30, 2003
compared to 59.4% for the nine months ended September 30, 2002.
Reimbursable out-of-pocket costs increased 7.4% to $38.6 million in the
first nine months of 2003 from $36.0 million in the corresponding period of
2002.
Selling, general and administrative expenses increased by approximately
$3.3 million, or 9.1%, from $36.0 million in the first nine months of 2002 to
$39.3 million in the first nine months of 2003. The change in selling, general
and administrative expenses is principally the result of a 9% increase in
organic SG&A costs. Acquisitions did not have a material impact on SG&A costs in
the period. Foreign currency exchange rate fluctuations accounted for a 4%
increase in selling, general and administrative expenses in the first nine
months of 2003 compared to the comparable period of 2002. The remaining increase
is due primarily to broad-based employee incentive compensation amounts accrued
in the third quarter of 2003. Selling, general and administrative expenses
expressed as a percentage of net service revenues were 33.9% for the nine months
ended September 30, 2003 compared to 28.0% for the corresponding 2002 period.
The increase in SG&A costs as a percentage of net service revenues is due to the
increase in SG&A expense as discussed above and a smaller net service revenue
base.
Depreciation and amortization expense increased by approximately
$460,000 or 7% in the nine months ending September 30, 2003 compared to the
corresponding period of 2002. The increase is primarily due to increased
depreciation and amortization relating to the Company's capital expenditures.
In the first quarter of 2003, in order to bring its cost structure more
in line with the then current revenue projections, the Company recorded a charge
of approximately $690,000 for severance and outplacement benefits relating to a
workforce reduction program which impacted approximately 1 percent of its total
workforce. In the second quarter of 2003, the Company recorded an adjustment to
reduce this charge by approximately $106,000 as a result of lower than expected
severance costs related to the workforce reduction. In the third quarter of
2003, the Company recorded a charge of approximately $897,000 for severance and
outplacement costs in connection with a workforce realignment plan implemented
in August. In the third quarter of 2002, the Company recorded a charge of
approximately $321,000 for costs associated with consolidating its three New
Jersey offices into one central location.
20
Other Income (Expense)
----------------------
Other Income (Expense) was an expense of approximately $966,000 in the
first nine months of 2003 compared to an expense of approximately $2.2 million
in the first nine months of 2002. In the second quarter of 2003, the Company
made a partial early repayment on its $6 million convertible note and recorded a
gain from this early partial debt extinguishment of approximately $558,000.
Additionally, during the quarter, the Company determined that its investment in
KendleWits, its 50 percent-owned joint venture in the People's Republic of
China, was permanently impaired and accordingly recorded a $405,000 non-cash
impairment charge to reduce the carrying value of this investment to zero. In
addition, in the first nine months of 2003 the Company incurred foreign currency
transaction losses of approximately $415,000 primarily as a result of the
British pound and United States dollar weakening against the euro. In the second
quarter of 2002, the Company recorded a $1.9 million non-cash charge to
write-off its investment in Digineer, Inc., a healthcare consulting and software
development company that during the quarter adopted a plan to cease operations.
In the first nine months of 2002, the Company incurred foreign currency
transaction gains of approximately $174,000.
Income Taxes
------------
The Company reported tax expense at an effective rate of 147.8% in the
nine months ended September 30, 2003, compared to tax expense at an effective
rate of 50.7% in the nine months ended September 30, 2002. In the fourth quarter
of 2002, the Company recorded a full valuation allowance against net operating
losses incurred in certain European subsidiaries of the Company. Since Kendle
operates on a global basis, the effective tax rate varies from quarter to
quarter based on the locations that generate the pre-tax earnings or losses. The
write-off of the Digineer investment in 2002 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 recorded a valuation
allowance against the deferred tax asset relating to the Digineer loss and no
income tax benefit was recorded.
Net Income (Loss)
-----------------
Including the effect of the severance charges and office consolidation
costs, the write-off of the investment in KendleWits and the gain from debt
extinguishment (items with an aggregate after-tax effect of approximately $1.1
million or $0.08 per share), the net loss for the nine months in 2003 was $2.2
million, or $0.17 per basic and diluted share compared with net income of $3.7
million, or $0.28 per diluted share including the write-off of the Digineer
investment and office consolidation costs (items with an aggregate after-tax
effect of $2.1 million or $0.16 per diluted share) during the same period a year
ago.
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents increased by $2.7 million for the nine months
ended September 30, 2003, primarily as a result of cash provided by operating
and investing activities of $4.2 million and $2.3 million, respectively, offset
by cash used in financing activities of $4.2 million. Net cash provided by
operating activities primarily resulted from the net loss adjusted for non-cash
expenses and a decrease in accounts receivable offset partially by a decrease in
advance billings. In the first nine months of 2002, net cash provided by
operating activities was $17.1 million, primarily resulting from net income
adjusted for non-cash activity and a decrease in accounts receivable ($9.9
million).
21
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,
was approximately $27.0 million at September 30, 2003, and $24.7 million at
December 31, 2002.
Financing activities for the nine months ended September 30, 2003,
consisted primarily of scheduled repayments relating to the Company's Facility
(defined below) amounting to $2.3 million and a partial early repayment of the
Company's convertible debt (see below) of $1.4 million.
Investing activities for the nine months ended September 30, 2003,
consisted primarily of net proceeds from the sale and maturity of available for
sale securities of $6.9 million offset by capital expenditures of approximately
$4.5 million.
The Company had available for sale securities totaling $10.4 million at
September 30, 2003, down from $17.3 million at December 31, 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 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 revolving credit loan 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.
Under terms of the Facility, revolving loans are convertible into term
loans within the Facility if used for acquisitions. The Facility contains
various restrictive financial covenants, including the maintenance of certain
fixed coverage and leverage ratios.
At March 31, 2003, the Company fell below the minimum permitted Fixed
Charge coverage ratio. The Company and the banks amended the minimum permitted
Fixed Charge coverage ratio for the first quarter of 2003 and future periods. In
addition, changes as part of the amendment include but are not limited to the
following:
- The amount available under the revolving credit loan is
reduced from $23 million to the lesser of $10 million or 50%
of the Company's Eligible Receivables, as defined.
- Until the Company's Fixed Charge Coverage Ratio returns to
levels specified in the original agreement, the applicable
percentage applied to the interest rate on the Company's
borrowing under the Facility is increased by 0.75%.
- The term loan is collateralized by a pledge of the Company's
domestic cash and cash equivalents and any amounts
outstanding under the revolving credit loan are
collateralized by the Company's Eligible Receivables, as
defined, and any
22
remaining domestic cash and cash equivalents above the
amounts pledged as security under the term loan.
- The Company must maintain a ratio of cash, cash equivalents
and available-for-sale securities held in the United States
to principal amounts outstanding under the Company's term
loan of at least 1.1 to 1.0.
In the third quarter of 2003 the Company reached an agreement in
principle with the banks to amend the Fixed Charge Coverage ratio from a rolling
four quarters calculation to a calculation based on the results of each
individual quarter. The company expects to sign the amendment with the banks in
the 4th quarter.
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).
At September 30, 2003, no amounts were outstanding under the Company's
revolving credit loan, $10.5 million was outstanding under the term loan, and no
amounts were outstanding under the $5.0 million Multicurrency Facility. Interest
is payable on the term loan at a rate of 6.57%. Principal payments of $750,000
are due on the term loan on the last business day of each quarter through March
2007.
Effective July 1, 2002, the Company entered into an interest rate swap
agreement 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
agreement, the interest rate on the term loan is fixed at 4.32% plus the
applicable margin (currently 2.25%). 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 Accumulated Other Comprehensive Loss on the Condensed
Consolidated Balance Sheet. At September 30, 2003, approximately $458,000 has
been recorded in Accumulated Other Comprehensive Loss to reflect a decrease in
the fair market value of the swap.
With the acquisition of CPR, the Company entered into a $6.0 million
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.
In June of 2003, the Company and the shareholders of CPR entered into
Note Prepayment Agreements. Under the Note Prepayment Agreements, the Company
agreed to satisfy its payment obligations under the $6.0 million convertible
note by making a series of four payments between June 30, 2003 and January 10,
2005. The four payments are to be initiated either by the Company through the
exercise of a "call" option or by the CPR shareholders through the exercise of a
"put" option. If the four put or call options are exercised, the Company would
pay $4.5 million to fully settle the $6.0 million note. Gains resulting from
this early
23
extinguishment of debt will be recorded when paid as a gain in the Company's
Condensed Consolidated Statements of Operations. At June 30, 2003, the CPR
shareholders exercised their put option and the Company paid approximately $1.4
million to settle $2.0 million of the $6.0 million convertible note. A gain of
$558,000 has been recorded in the second quarter of 2003 in the Company's
Condensed Consolidated Statements of Operations.
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
addition, subject to the terms and conditions under its existing credit
facilities, 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 closed in the second quarter of 2003. Pharmacia and Pfizer combined
represent approximately 29% of the Company's net service revenues for both the
three and nine months ended September 30, 2003 and approximately 36% of the
Company's September 30, 2003, backlog. During the second quarter of 2003, the
Company identified a change, coinciding with the completion of the announced
merger, in the levels of business received from the combined Pfizer company.
Although the level of new business awards from Pfizer increased in the third
quarter of 2003 compared to the second quarter of 2003, the level of awards
received has not reached pre-merger levels. The Company believes that the level
of business from Pfizer will continue to increase in the fourth quarter, but
there is no assurance that the level of business received will meet or exceed
the business amounts the Company received from Pharmacia Inc. and Pfizer Inc. in
periods prior to the merger. If the level of business does not return to levels
experienced prior to the merger, failure to replace this business would have a
negative impact on the Company's results of operations and financial position in
future quarters.
On October 1, 2003, the Company completed its acquisition of Mexican
CRO Estadisticos y Clinicos Asociados, S.A. (ECA). ECA is a Phase I-IV contract
research organization located in Mexico City, Mexico. With the acquisition, the
Company has expanded its capability to conduct clinical trials in Latin America.
The Company acquired substantially all the assets and assumed certain
liabilities of ECA for a purchase price of approximately $3.2 million in cash
plus acquisition costs. The Company is in the process of finalizing the purchase
price allocation.
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
24
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,
2003, the potential loss in fair value resulting from a hypothetical decrease of
10% in quoted market price would be approximately $1.0 million.
In July 2002, the Company entered into an interest rate swap agreement
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 debt in the Liquidity and Capital 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.
The first risk occurs as revenue recognized for services rendered is denominated
in a currency different from the currency in which the location's expenses are
incurred. As a result, the location'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 location'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 Operations.
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 approximately $120,000 at September 30,
2003, compared to $(1.5 million) at December 31, 2002.
25
CRITICAL 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.
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 for each contract to determine
if the budgeted amounts are correct, and budgets are adjusted as needed. 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. Similar situations may
occur in the future. 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.
Amendments to contracts resulting in revisions to revenues and costs
are recognized in the period in which the revisions are negotiated. Included in
accounts receivable are unbilled accounts receivable, which represent revenue
recognized in excess of amounts billed.
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 accounts for employee stock options under Accounting
Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to
Employees," and its related interpretations. Under APB 25, no compensation
expense is recognized when the exercise price is equal to the market price of
the stock on the date of the grant. If the Company accounted for stock options
under SFAS 123, the Company would have to record additional compensation expense
relating to stock option grants. If the Company had to account for stock options
under SFAS 123, the Company's financial results would be materially adversely
affected by the additional compensation expense that would have to be
recognized. The compensation expense could vary significantly from period to
period based on a number of factors, including the number of stock options
granted, the expected holding period, the share price and share price volatility
and interest rate fluctuations.
Billed accounts receivable represent amounts for which invoices have
been sent to customers. Unbilled accounts receivable are amounts recognized as
revenue for which bills have not yet been sent to customers. Advance billings
represent amounts billed or payment received for which revenues have not yet
been earned. The Company maintains an allowance for doubtful
26
accounts receivable based on historical evidence of accounts receivable
collections and specific identification of accounts receivable that might pose
collection problems. If the Company is unable to collect all or part of its
outstanding receivables, there could be a material impact to the Company's
consolidated results of operations or financial position.
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. In the fourth quarter of 2002, the Company recorded a
goodwill impairment charge of $67.7 million.
The Company has a 50% owned joint-venture investment in Beijing
KendleWits Medical Consulting Co., Ltd. (KendleWits), a company located in the
People's Republic of 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. In the second quarter of 2003, the Company
determined that its investment in KendleWits was impaired and as a result
recorded a $405,000 non-cash charge to reduce the carrying value of this
investment to zero. Future capital contributions 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.
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 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 judgment 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 (losses) among
jurisdictions with varying tax rates. These estimates include judgments 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 and a valuation allowance has been established based upon an
assessment that realization cannot be assured. The ultimate realization of this
tax benefit is dependent upon the generation of sufficient operating income in
the respective tax jurisdictions. If estimates prove inaccurate or if the tax
laws change unfavorably, significant revisions in the valuation allowance may be
required in the future.
NEW ACCOUNTING PRONOUNCEMENTS
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity". This
statement establishes standards for how an issuer classifies and measures
certain types of financial instruments that have characteristics of both
liabilities and equity. It requires that an issuer classify a financial
27
instrument that is within its scope as a liability (or an asset in some
circumstances). Many of those instruments were previously classified as equity.
SFAS No. 150 is effective for financial instruments entered into or modified
after May 31, 2003 and otherwise is effective at the beginning of the first
interim period beginning after June 15, 2003. The company adopted the standard
on July 1, 2003. The adoption of SFAS No. 150 had no material effect on the
Company's consolidated financial position or results of operations.
In January 2003, the Emerging Issues Task Force issued EITF Issue
00-21, "Revenue Arrangements with Multiple Deliverables," which requires
companies to determine whether an arrangement involving multiple deliverables
contains more than one unit of accounting. In applying EITF Issue 00-21, revenue
arrangements with multiple deliverables should be divided into separate units of
accounting if the deliverables in the arrangement meet certain criteria.
Arrangement consideration should be allocated among the separate units of
accounting based on their relative fair values. This issue is effective for
revenue arrangements entered into in fiscal periods beginning after June 15,
2003. The adoption of this statement did not have a material impact on the
Company's consolidated financial statements.
In January 2003, the Financial Accounting Standards Board (FASB) issued
Interpretation No. 46 (FIN 46), "Consolidation of Variable Interest Entities."
FIN 46 requires a variable interest entity to be consolidated by a company if
that company is subject to a majority of the risk of loss from the variable
interest entity's activities or entitled to receive a majority of the entity's
residual returns or both. A variable interest entity is a corporation,
partnership, trust, or any other legal structure used for business purposes that
either (a) does not have equity investors with voting rights or (b) has equity
investors that do not provide sufficient financial resources for the entity to
support its activities. A variable interest entity often holds financial assets,
including loans or receivables, real estate or other property. A variable
interest entity may be essentially passive or it may engage in research and
development or other activities on behalf of another company. The consolidation
requirements of FIN 46 apply immediately to variable interest entities created
after January 31, 2003. The consolidation requirements apply to older entities
in the first fiscal year or interim period beginning after June 15, 2003.
Certain of the disclosure requirements apply to all financial statements issued
after January 31, 2003, regardless of when the variable interest entity was
established. The adoption of this statement did not have a material impact on
the Company's consolidated financial statements.
In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure, an Amendment of SFAS No.
123." SFAS No. 148 provides transition guidance for those companies that elect
to voluntarily adopt the accounting provisions of SFAS No. 123, Accounting for
Stock-Based Compensation. SFAS No. 148 also mandates certain new disclosures
that are incremental to those required by SFAS No. 123. SFAS No. 148 is
effective for fiscal years ending after December 15, 2002. The Company has
adopted the disclosure requirements of SFAS No. 148. At this time the Company
does not plan to adopt the accounting provisions of SFAS No. 123 and will
continue to account for stock options in accordance with Accounting Principles
Board Opinion No. 25, "Accounting for Stock Issued to Employees."
In July 2002, the 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
28
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 is required for exit or disposal activities of the Company initiated
after December 31, 2002, with earlier adoption encouraged. The Company has
adopted SFAS No. 146.
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, 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 filings with
the Securities and Exchange Commission, copies of which are available upon
request from the Company's investor relations department. The Company's growth
and ability to achieve operational and financial goals is dependent upon its
ability to attract and retain qualified personnel. If the Company fails to hire,
retain and integrate qualified personnel, it will be difficult for the Company
to achieve its financial and operational goals. No assurance can be given that
the Company will be able to realize the net service 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.
29
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.
30
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
31.1 Certificate of Chief Executive Officer pursuant to Section 302
of the Sarbanes-Oxley Act of 2002
31.2 Certificate of Chief Financial Officer pursuant to Section 302
of the Sarbanes-Oxley Act of 2002
32.1 Certificate of Chief Executive Officer pursuant to Section 906
of the Sarbanes-Oxley Act of 2002
32.2 Certificate of Chief Financial Officer pursuant to Section 906
of the Sarbanes-Oxley Act of 2002
(b) Reports filed on Form 8-K during the quarter:
On August 5, 2003 the Company filed a Form 8-K to disclose the non-GAAP
financial measures included in its press release announcing its second
quarter results of operations and financial condition and the reasons
for including the non-GAAP financial measures.
31
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, 2003 Candace Kendle
Chairman of the Board and Chief
Executive Officer
By: /s/ Karl Brenkert III
-------------------------------
Date: November 14, 2003 Karl Brenkert III
Senior Vice President - Chief
Financial Officer
32
KENDLE INTERNATIONAL INC.
EXHIBIT INDEX
Exhibits Description
-------- -----------
31.1 Certificate of Chief Executive Officer pursuant to Section 302
of the Sarbanes-Oxley Act of 2002
31.2 Certificate of Chief Financial Officer pursuant to Section 302
of the Sarbanes-Oxley Act of 2002
32.1 Certificate of Chief Executive Officer pursuant to Section 906
of the Sarbanes-Oxley Act of 2002
32.2 Certificate of Chief Financial Officer pursuant to Section 906
of the Sarbanes-Oxley Act of 2002
33