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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, 2004
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
KENDLE INTERNATIONAL INC.
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
Ohio 31-1274091
- --------------------------------------------------------------------------------
(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: 13,234,300 shares of Common
Stock, no par value, as of October 28, 2004.
1
KENDLE INTERNATIONAL INC.
INDEX
Page
----
Part I. Financial Information
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets - September 30, 2004
and December 31, 2003 3
Condensed Consolidated Statements of Operations - Three Months
Ended September 30, 2004 and 2003; Nine Months Ended
September 30, 2004 and 2003 4
Condensed Consolidated Statements of Comprehensive Income (Loss) -
Three Months Ended September 30, 2004 and 2003; Nine Months
Ended September 30, 2004 and 2003 5
Condensed Consolidated Statements of Cash Flows - Nine
Months Ended September 30, 2004 and 2003 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 27
Item 4. Controls and Procedures 28
Part II. Other Information 28
Item 1. Legal Proceedings 28
Item 2. Changes in Securities and Use of Proceeds 28
Item 3. Defaults upon Senior Securities 28
Item 4. Submission of Matters to a Vote of Security Holders 28
Item 5. Other Information 28
Item 6. Exhibits and Reports on Form 8-K 28
Signatures 30
Exhibit Index 31
2
KENDLE INTERNATIONAL INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
September 30, December 31,
(in thousands, except share data) 2004 2003
- --------------------------------- ------------- -------------
(unaudited) (note 1)
ASSETS
Current assets:
Cash and cash equivalents $ 8,750 $ 21,750
Restricted cash 173 1,777
Available for sale securities 10,326 8,881
Accounts receivable 50,948 41,573
Other current assets 12,708 9,947
------------- -------------
Total current assets 82,905 83,928
------------- -------------
Property and equipment, net 15,452 17,607
Goodwill, net 24,874 25,404
Other finite-lived intangible assets 703 821
Other indefinite-lived intangible assets 15,000 15,000
Other assets 9,848 11,655
------------- -------------
Total assets $ 148,782 $ 154,415
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current portion of obligations under capital leases $ 737 $ 827
Current portion of amounts outstanding under credit facilities 3,774 3,000
Convertible note 1,500 -
Trade payables 6,786 5,601
Advance billings 16,853 21,243
Other accrued liabilities 14,410 14,734
------------- -------------
Total current liabilities 44,060 45,405
------------- -------------
Obligations under capital leases, less current portion 724 926
Convertible note - 4,000
Long-term debt 4,500 6,750
Other noncurrent liabilities 988 965
------------- -------------
Total liabilities 50,272 58,046
------------- -------------
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; 13,251,839 and
13,079,912 shares issued and 13,231,942 and 13,060,015
outstanding at September 30, 2004 and December 31, 2003, respectively 75 75
Additional paid in capital 136,055 135,034
Accumulated deficit (37,684) (39,168)
Accumulated other comprehensive income:
Net unrealized holding gain (loss) on available for sale securities (33) 1
Unrealized loss on interest rate swap (160) (350)
Foreign currency translation adjustment 650 1,170
------------- -------------
Total accumulated other comprehensive income 457 821
Less: Cost of common stock held in treasury, 19,897 shares at
September 30, 2004 and December 31, 2003, respectively (393) (393)
------------- -------------
Total shareholders' equity 98,510 96,369
------------- -------------
Total liabilities and shareholders' equity $ 148,782 $ 154,415
============= =============
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
KENDLE INTERNATIONAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
For the Three Months Ended For the Nine Months Ended
September 30, September 30,
-------------------------- -------------------------
(in thousands, except per share data) 2004 2003 2004 2003
- ------------------------------------- ---------- ---------- ---------- ----------
Net service revenues $ 42,920 $ 40,424 $ 124,923 $ 116,101
Reimbursable out-of-pocket revenues 8,776 12,716 31,774 38,642
---------- ---------- ---------- ----------
Total revenues 51,696 53,140 156,697 154,743
---------- ---------- ---------- ----------
Costs and expenses:
Direct costs 23,794 22,404 71,276 68,573
Reimbursable out-of-pocket costs 8,776 12,716 31,774 38,642
Selling, general and
administrative expenses 14,973 13,833 43,640 39,322
Depreciation and amortization 2,237 2,244 6,806 6,656
Severance and office consolidation costs - 897 302 1,473
---------- ---------- ---------- ----------
49,780 52,094 153,798 154,666
---------- ---------- ---------- ----------
Income from operations 1,916 1,046 2,899 77
Other income (expense):
Interest income 101 67 265 266
Interest expense (158) (251) (573) (799)
Other (509) (162) (224) (586)
Investment impairment - - - (405)
Gain on debt extinguishment - - 597 558
---------- ---------- ---------- ----------
Income (loss) before income taxes 1,350 700 2,964 (889)
Income tax expense 750 356 1,480 1,314
---------- ---------- ---------- ----------
Net income (loss) $ 600 $ 344 $ 1,484 $ (2,203)
========== ========== ========== ==========
Income (loss) per share data:
Basic:
Net income (loss) per share $ 0.05 $ 0.03 $ 0.11 $ (0.17)
========== ========== ========== ==========
Weighted average shares 13,231 13,013 13,141 12,943
Diluted:
Net income (loss) per share $ 0.04 $ 0.03 $ 0.11 $ (0.17)
========== ========== ========== ==========
Weighted average shares 13,413 13,244 13,373 12,943
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)
For the Three Months Ended For the Nine Months Ended
September 30, September 30,
-------------------------- -------------------------
(in thousands) 2004 2003 2004 2003
- -------------- ---------- ---------- ---------- ----------
Net income (loss) $ 600 $ 344 $ 1,484 $ (2,203)
---------- ---------- ---------- ----------
Other comprehensive income (loss):
Foreign currency translation adjustment 549 243 (520) 1,658
Net unrealized holding gains (losses) on
available for sale securities arising
during the period, net of tax 20 3 (34) 7
Net unrealized holding gains on
interest rate swap agreement 8 116 190 108
---------- ---------- ---------- ----------
Comprehensive income (loss) $ 1,177 $ 706 $ 1,120 $ (430)
========== ========== ========== ==========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
KENDLE INTERNATIONAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
For the Nine Months Ended
September 30,
-------------------------
(in thousands) 2004 2003
- -------------- ---------- ----------
Net cash (used in) provided by operating activities $ (4,239) $ 4,233
---------- ----------
Cash flows from investing activities:
Proceeds from sales and maturities of available for sale securities 7,889 54,207
Purchases of available for sale securities (9,419) (47,341)
Acquisitions of property and equipment (2,094) (3,120)
Additions to software costs (1,282) (1,428)
Other 15 10
---------- ----------
Net cash (used in) provided by investing activities (4,891) 2,328
---------- ----------
Cash flows from financing activities:
Net repayments under credit facilities (1,472) (2,250)
Net repayments - book overdraft (75) (5)
Repayment of convertible note (1,903) (1,442)
Proceeds from exercise of stock options 135 192
Payments on capital lease obligations (668) (635)
Other - (65)
---------- ----------
Net cash used in financing activities (3,983) (4,205)
---------- ----------
Effects of exchange rates on cash and cash equivalents 113 312
Net increase in cash and cash equivalents (13,000) 2,668
Cash and cash equivalents:
Beginning of period 21,750 12,671
---------- ----------
End of period $ 8,750 $ 15,339
========== ==========
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, 2004 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2004. For further information, refer to the consolidated financial
statements and notes thereto included in the Form 10-K for the year ended
December 31, 2003 filed by Kendle International Inc. ("the Company") with the
Securities and Exchange Commission.
The condensed consolidated balance sheet at December 31, 2003 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:
Three Months Ended Three Months Ended
(in thousands) September 30, 2004 September 30, 2003
-------------- ------------------ ------------------
Net income per Statements of Operations $600 $344
---- ----
Net income for diluted earnings per share
calculation $600 $344
7
Nine Months Ended Nine Months Ended
(in thousands) September 30, 2004 September 30, 2003
-------------- ------------------ ------------------
Net income (loss) per Statements of Operations $1,484 $(2,203)
------ -------
Net income (loss) for diluted earnings per
share calculation $1,484 $(2,203)
The weighted average shares used in computing net income (loss) per diluted
share have been calculated as follows:
Three Months Ended Three Months Ended
(in thousands) September 30, 2004 September 30, 2003
-------------- ------------------ ------------------
Weighted average common shares
outstanding 13,231 13,013
Stock options 182 231
------ ------
Weighted average shares 13,413 13,244
------ ------
Nine Months Ended Nine Months Ended
(in thousands) September 30, 2004 September 30, 2003
-------------- ------------------ ------------------
Weighted average common shares
outstanding 13,141 12,943
Stock options 232 --
------ ------
Weighted average shares 13,373 12,943
------ ------
Options to purchase approximately 1,500,000 and 1,400,000 shares of common stock
were outstanding during the three and nine months ended September 30, 2004 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 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.
Potential shares to be issued upon conversion of the convertible note 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
8
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.
Had the Company adopted SFAS No. 123 for expense recognition purposes, the
amount of compensation expense that would have been recognized in the third
quarter of 2004 and 2003 would have been approximately $1.0 million and $1.2
million, respectively. The amount of compensation expense that would have been
recognized in the first nine months of 2004 and 2003 would have been
approximately $3.0 million and $3.7 million, respectively. The Company's
pro-forma net income (loss) per diluted share would have been adjusted to the
amounts below:
Three Months Three Months
Ended September Ended September
(in thousands, except per share data) 30, 2004 30, 2003
------------------------------------- --------------- ---------------
PRO FORMA NET INCOME (LOSS):
As reported $ 600 $ 344
Less: pro forma adjustment for
stock-based compensation, net of tax (759) (907)
--------------- ---------------
Pro-forma net loss $ (159) $ (563)
PRO-FORMA NET INCOME (LOSS) PER BASIC SHARE:
As reported $ 0.05 $ 0.03
Effect of pro forma expense $ (0.06) $ (0.07)
Pro-forma $ (0.01) $ (0.04)
PRO-FORMA NET INCOME (LOSS) PER DILUTED SHARE:
As reported $ 0.04 $ 0.03
Effect of pro forma expense $ (0.05) $ (0.07)
Pro-forma $ (0.01) $ (0.04)
Nine Months Nine Months
Ended September Ended September
(in thousands, except per share data) 30, 2004 30, 2003
------------------------------------- --------------- ---------------
PRO FORMA NET INCOME (LOSS):
As reported $ 1,484 $ (2,203)
Less: pro forma adjustment for
stock-based compensation, net of
tax (2,302) (2,909)
--------------- ---------------
Pro-forma net income (loss) $ (818) $ (5,112)
PRO-FORMA NET INCOME (LOSS) PER BASIC SHARE:
As reported $ 0.11 $ (0.17)
Effect of pro-forma expense $ (0.17) $ (0.23)
Pro-forma $ (0.06) $ (0.40)
9
PRO-FORMA NET INCOME (LOSS) PER DILUTED SHARE:
As reported $ 0.11 $ (0.17)
Effect of pro-forma expense $ (0.17) $ (0.23)
Pro-forma $ (0.06) $ (0.40)
New Accounting Pronouncements
In November 2003, during discussions on EITF Issue 03-01, "The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments", the
EITF reached a consensus which requires quantitative and qualitative disclosures
for debt and marketable equity securities classified as available-for-sale or
held-to-maturity under Statements 115 and 224 that are impaired at the balance
sheet date but for which an other-than-temporary impairment has not been
recognized. The consensus on quantitative and qualitative disclosures is
effective for fiscal years ending after December 15, 2003 and comparative
information for earlier periods presented is not required. At the March 2004
EITF meeting, the Task Force reached a consensus on a three-step impairment
model. Except for disclosure requirements already in place, the Issue 03-01
consensus will be effective prospectively for all relevant current and future
investments in reporting periods beginning after June 15, 2004. The adoption of
this standard has no material effect on the Company's consolidated financial
statements.
In January 2003, the Financial Accounting Standards Board (FASB) issued FIN 46,
Consolidation of Variable Interest Entities. FIN 46 clarifies the application of
Accounting Research Bulletin No. 51, Consolidated Financial Statements, to
certain entities in which equity investors do not have the characteristics of a
controlling financial interest or do not have sufficient equity at risk for the
entity to finance its activities without additional subordinated financial
support from other parties. FIN 46 will require the consolidation of a variable
interest entity whereby an enterprise will absorb a majority of the entity's
expected losses if they occur, receive a majority of the entity's expected
residual returns if they occur, or both. In December 2003, the FASB issued FIN
46R, Consolidation of Variable Interest Entities, an interpretation of ARB 51
(as revised December 2003). The primary objectives of FIN 46R are to provide
guidance on the identification of entities for which control is achieved through
means other than through voting rights (Variable Interest Entities) and how to
determine when and which business enterprise should consolidate the Variable
Interest Entity (the Primary Beneficiary). The disclosure requirements of FIN
46R are required in all financial statements issued after March 15, 2004, if
certain conditions are met. The Company does not have any variable interest
entities and therefore, FIN 46R did not impact its financial statements.
2. ACQUISITION:
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 $3.6 million in cash,
including acquisition costs.
The following unaudited pro forma results of operations assume the acquisition
occurred at the beginning of 2003:
10
Nine Months Ended
(in thousands, except per share data) September 30, 2003
- ------------------------------------- -------------------
Net service revenues $ 121,760
Net loss $ (1,391)
Net loss per diluted share $ (0.11)
Weighted average shares 12,943
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, 2003, nor are they necessarily indicative of future operating
results.
3. OFFICE CONSOLIDATION AND EMPLOYEE SEVERANCE:
In the first quarter of 2004, in order to align its resources to meet customer
need and demand projections, the Company implemented a workforce realignment
plan which resulted in a pre-tax charge of approximately $254,000 for severance
and outplacement benefits. An additional $48,000 in net costs (composed of
approximately $80,000 in additional costs offset by a reduction to the liability
of approximately $32,000) was incurred in the second quarter of 2004 relating to
this plan. The workforce realignment plan impacted approximately 3 percent of
the Company's North American workforce. Payments during the first nine months of
2004 totaled $302,000 and no amounts remain accrued at September 30, 2004.
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 $882,000 was paid during the third and
fourth quarters of 2003 and at September 30, 2004, approximately $15,000 remains
accrued and is reflected in Other Accrued Liabilities on the Company's Condensed
Consolidated Balance Sheet. The remaining accrual of $15,000 is expected to be
paid out in the fourth quarter of 2004.
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 $680,000 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. No amounts remain accrued at September 30, 2004. 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.
The amounts accrued for the workforce reduction and office consolidation costs
are detailed as follows:
11
Employee
(in thousands) Severance
- ------------------------------ ---------
Liability at December 31, 2003 $ 15
Amounts accrued 334
Amounts paid (302)
Adjustment to liability (32)
Liability at September 30, 2004 $ 15
4. GOODWILL AND OTHER INTANGIBLE ASSETS:
Non-amortizable intangible assets at September 30, 2004 and December 31, 2003
are composed of:
(in thousands)
Indefinite-lived
Goodwill Intangible
--------- ---------------
Balance at 12/31/03 $ 25,404 $ 15,000
Foreign currency fluctuations (226) --
Tax benefit to reduce goodwill (291) --
Purchase accounting
adjustment for 2003
acquisition (13) --
--------- ---------------
Balance at 9/30/04 $ 24,874 $ 15,000
========= ===============
Amortizable intangible assets at September 30, 2004 and December 31, 2003 are
composed of:
(in thousands)
Customer Non-Compete
Relationships Agreements
------------- -----------
Balance at 12/31/03 $ 389 $ 432
2004 amortization (31) (87)
------------ -----------
Balance at 9/30/04 $ 358 $ 345
============ ===========
Amortization expense for the next five years relating to these amortizable
intangible assets is estimated to be as follows:
(in thousands)
Remainder of 2004: $ 39
2005: $153
12
2006: $149
2007: $117
2008: $ 28
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. Certain provisions of this Facility have been
subsequently amended. The Facility is composed of a revolving credit loan that
expires in May of 2005 and a $15.0 million term loan that matures in March of
2007. 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. The Company is in compliance with the financial
covenants contained in the Facility (as amended) as of September 30, 2004.
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, 2004, no amounts were outstanding under the Company's revolving
credit loan, $7.5 million was outstanding under the term loan, and $774,000 was
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 value of the swap are recorded in
Accumulated Other Comprehensive Loss on the Condensed Consolidated Balance
Sheet. At September 30, 2004, approximately $160,000 has been recorded in
Accumulated Other Comprehensive Loss to reflect a decrease in the fair value of
the swap compared to a decrease in the fair value of approximately $350,000 at
December 31, 2003.
With the acquisition of Clinical and Pharmacologic Research, Inc. (CPR), the
Company entered into a $6.0 million convertible note payable to the shareholders
of CPR. The principal balance is
13
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 extinguishment of debt will be recorded when paid as a gain in the
Company's Condensed Consolidated Statements of Operations. In the first quarter
of 2004, the CPR shareholders again exercised their put option and the Company
paid approximately $750,000 to settle $1.0 million of the then remaining $4.0
million of the convertible note that was outstanding at December 31, 2003. A
gain of $254,000 has been recorded in the first quarter of 2004 in the Company's
Condensed Consolidated Statements of Operations. Similarly, in the second
quarter of 2004, the CPR shareholders exercised their put option and the Company
paid approximately $1.2 million to settle $1.5 million of the remaining $3.0
million of the convertible note that was outstanding at March 31, 2004. A gain
of $343,000 has been recorded in the second quarter of 2004 in the Company's
Condensed Consolidated Statements of Operations. The balance which remains
outstanding under this convertible note at September 30, 2004 is $1.5 million.
The Company intends to continue to repay this convertible note ahead of its
original scheduled maturity.
14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION 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, 2004, 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 consulting and organizational meeting
management and publications services on a contract basis to the pharmaceutical
and biotechnology industries. The Company is managed in one reportable segment
encompassing Phase I through IV contract services.
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 is entered into and the balance is received in installments over the
contract's duration, in most cases on a milestone achievement basis. Net service
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. When estimates
indicate a loss, such loss is provided in the current period in its entirety.
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 expenses 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 an allocation
of 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.
15
Depreciation and amortization expenses consist of depreciation and amortization
costs recorded on a straight-line method over the estimated useful life of the
property or equipment and internally developed software.
The CRO industry in general continues to be dependent on the research and
development efforts 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 its major customers could have a material adverse
effect on the Company.
The Company's results of operations are subject to volatility due to a variety
of factors. The cancellation or delay of contracts and cost overruns could have
short-term adverse affects 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, 2004 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 2003
Net Service Revenues
Net service revenues increased approximately $2.5 million, or 6%, to $42.9
million in the third quarter of 2004 from $40.4 million in the third quarter of
2003. The 6% increase in net service revenues was composed of growth from
acquisitions of 3% and an increase in organic net service revenues of 3%.
Foreign currency exchange rate fluctuations accounted for a 4% increase in net
service revenues in the third quarter of 2004 compared to 2003. In the third
quarter of 2004, net service revenues in the European and Asia-Pacific regions
increased by approximately $2.2 million or 16% and $437,000 or 30%,
respectively, from the same period of the prior year. Net service revenues in
North America remained approximately the same from the third quarter of 2003 to
the corresponding period in 2004. Net service revenues in North America were
impacted by a slowdown in new business from two of the Company's largest
customers which completed a merger in 2003 offset by increased business activity
from new customers in the first nine months of 2004.
Approximately 41% of the Company's net service revenues were derived from
operations outside of North America in the third quarter of 2004 compared to 37%
in the corresponding period in 2003. The top five customers based on net service
revenues contributed approximately 39% of net service revenues during the third
quarter of 2004 compared to approximately 52% of net service revenues during the
third quarter of 2003. Net service revenues from Pfizer Inc. (including the
former Pharmacia Inc.) accounted for approximately 21% of total third quarter
2004 net service revenues compared to approximately 29% of total third quarter
2003 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 period presented.
Reimbursable Out-of-Pocket Revenues
16
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 decreased 31.0% to $8.8 million in the third quarter of
2004 from $12.7 million in the corresponding period of 2003.
Operating Expenses
Direct costs increased approximately $1.4 million, or 6%, to $23.8 million in
the third quarter of 2004 from $22.4 million in the third quarter of 2003. The
6% increase in direct costs was composed of growth from an acquisition of 2% and
4% organic growth. Foreign currency exchange rate fluctuations accounted for a
4% increase in direct costs in the third quarter of 2004 compared to 2003.
Direct costs expressed as a percentage of net service revenues were 55.4% for
both the three months ended September 30, 2004 and the three months ended
September 30, 2003.
Reimbursable out-of-pocket costs decreased 31.0% to $8.8 million in the third
quarter of 2004 from $12.7 million in the corresponding period of 2003.
Selling, general and administrative expenses increased $1.2 million, or 8%, from
$13.8 million in the third quarter of 2003 to $15.0 million in the same quarter
of 2004. The 8% increase in SG&A was composed of growth from an acquisition of
3% and organic growth of 5%. Foreign currency exchange rate fluctuations
accounted for a 3% increase in selling, general and administrative expenses in
the third quarter of 2004 compared to the comparable period of 2003. The
remainder of the increase is primarily due to costs associated with compliance
with the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley), specifically compliance
with Section 404, Management Assessment of Internal Controls over Financial
Reporting, incurred in the third quarter of 2004. Selling, general and
administrative expenses expressed as a percentage of net service revenues were
34.9% for the three months ended September 30, 2004 compared to 34.2% for the
corresponding 2003 period.
Depreciation and amortization expense decreased by $7,000 in the third quarter
of 2004 compared to the third quarter of 2003.
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 $15,000 remains accrued at
September 30, 2004 relating to this plan.
Other Income (Expense)
Other Income (Expense) was expense of approximately $566,000 in the third
quarter of 2004 compared to an expense of approximately $346,000 in the third
quarter of 2003. The decrease in Other Income is primarily due to foreign
exchange rate losses of approximately $450,000 in the third quarter of 2004
compared to foreign exchange rate losses of approximately $116,000 in the
corresponding period of 2003. Interest expense decreased by approximately
$93,000 in the third quarter of 2004 compared to the third quarter of 2003 due
to decreased debt outstanding in the third quarter of 2004.
17
Income Taxes
The Company reported tax expense at an effective rate of 55.6% in the quarter
ended September 30, 2004, compared to tax expense at an effective rate of 50.9%
in the quarter ended September 30, 2003. The Company continues to record full
valuation allowances 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
The net income for the quarter ended September 30, 2004 was approximately
$600,000 or $0.05 per basic and $0.04 per diluted share. For the quarter ended
September 30, 2003, including the effects of the charge for severance and
outplacement costs, (items totaling expense of approximately $547,000, or $0.04
per share), net income for the quarter ended September 30, 2003 was
approximately $344,000 or $0.03 per basic and diluted share.
NINE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
2003
Net Service Revenues
Net service revenues increased 8% to $124.9 million in the first nine months of
2004 from $116.1 million in the first nine months of 2003. The 8% increase in
net service revenues was composed of growth from an acquisition of 3% and an
increase in organic net service revenues of 5%. Foreign currency exchange rate
fluctuations accounted for a 5% increase in net service revenues in the first
nine months of 2004 compared to the first nine months of 2003. In the first nine
months of 2004, net service revenues in the European and Asia-Pacific regions
increased by approximately $9.9 million or 28% and $1.7 million or 46%,
respectively, from the same period of the prior year. Net service revenues in
North America declined by approximately $2.7 million, or 4%, from the first nine
months of 2003 to the corresponding period in 2004 due primarily to a slowdown
in new business from two of the Company's largest customers which completed a
merger in 2003.
Approximately 40% of the Company's net service revenues were derived from
operations outside of North America in the first nine months of 2004 compared to
33% in the corresponding period of 2003. The top five customers based on net
service revenues contributed approximately 41% of net service revenues during
the first nine months of 2004 compared to approximately 49% of net service
revenues during the first nine months of 2003. Net service revenues from Pfizer
Inc. (including the former Pharmacia Inc.) accounted for approximately 21% of
total net service revenues in the first nine months of 2004 compared to
approximately 29% of total net service revenues in the first nine months of
2003. 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 the
first nine months of either 2004 or 2003.
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 decreased
18
17.8% to $31.8 million in the nine months ended September 30, 2004 from $38.6
million in the corresponding period of 2003.
Operating Expenses
Direct costs increased by 4% from $68.6 million in the first nine months of 2003
to $71.3 million in the first nine months of 2004. The 4% increase in direct
costs was composed of organic growth of 2% and growth from an acquisition of 2%.
Foreign currency exchange rate fluctuations accounted for the 2% increase in
organic direct costs. Direct costs expressed as a percentage of net service
revenues were 57.1% for the nine months ended September 30, 2004 compared to
59.1% for the nine months ended September 30, 2003. The decline in direct costs
as a percentage of net service revenues is primarily attributable to the mix of
direct labor involved in contracts as well as the overall mix of contracts and
an increase in net service revenues in the first nine months of 2004 compared to
the nine months of 2003.
Reimbursable out-of-pocket costs decreased 17.8% to $31.8 million in the first
nine months of 2004 from $38.6 million in the corresponding period of 2003.
Selling, general and administrative expenses increased from $39.3 million in the
first nine months of 2003 to $43.6 million in the first nine months of 2004. The
increase in selling, general and administrative expenses is the result of a 8%
organic increase in SG&A costs and a 3% increase from an acquisition. Foreign
currency exchange rate fluctuations accounted for a 4% increase in selling,
general and administrative expenses in the first nine months of 2004 compared to
the comparable period of 2003. The remainder of the increase is primarily due to
increases in healthcare related and other employee related costs and costs
related to compliance with Sarbanes-Oxley, specifically compliance with Section
404, in 2004. Selling, general and administrative expenses expressed as a
percentage of net service revenues were 34.9% for the nine months ended
September 30, 2004 compared to 33.9% for the corresponding 2003 period.
Depreciation and amortization expense increased by 2% in the nine months ending
September 30, 2004 compared to the corresponding period of 2003. The increase is
primarily due to increased depreciation and amortization relating to the
Company's capital expenditures.
In the first quarter of 2004, in order to align its resources to meet customer
need and demand projections, the Company implemented a workforce realignment
plan which resulted in a pre-tax charge of approximately $254,000 for severance
and outplacement benefits. In the second quarter of 2004, the Company incurred
an additional $48,000 in costs related to this workforce realignment plan. This
workforce realignment plan impacted approximately 3 percent of the Company's
North American workforce. All amounts related to this plan have been paid in the
second quarter of 2004 and no amounts remain accrued at September 30, 2004. In
the first quarter of 2003, the Company recorded a charge of approximately
$680,000 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. Approximately $15,000 remains accrued at September 30, 2004 relating
to this plan.
19
Other Income (Expense)
Other Income (Expense) was income of $65,000 for the first nine months of 2004
compared to expense of approximately $966,000 in the first nine months of 2003.
In the first nine months of 2004, the Company made partial early repayments on
its convertible note and recorded gains from these repayments of approximately
$597,000. In the first nine months of 2003, the Company recorded a similar gain
on partial early retirement of convertible debt of $558,000. Additionally,
during the first nine months of 2003 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
the first nine months of 2004, the Company recorded foreign exchange rate gains
of approximately $10,000 compared to foreign currency exchange rate losses of
approximately $415,000 in the same period of the prior year. These foreign
currency exchange rate gains and losses are primarily the result of fluctuations
between the British Pound and the Euro and the United States dollar and the Euro
and British Pound.
Income Taxes
The Company reported tax expense at an effective rate of 49.9% in the nine
months ended September 30, 2004 compared to tax expense at an effective rate in
excess of 100% in the nine months ended September 30, 2003. The Company
continues to record full valuation allowances 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 (Loss)
The net income for the nine months ended September 30, 2004, including the
effects of the severance charge and gain from debt extinguishment (of $177,000
or $0.02 per share), was approximately $1.5 million or $0.11 per basic and
diluted share. Including the effect of the severance charges, the write-off of
the investment in KendleWits and the gain from partial early debt extinguishment
(items totaling $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.
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents decreased by $13.0 million for the nine months ended
September 30, 2004, as a result of cash used in operating, investing and
financing activities of $4.2 million, $4.9 million and $4.0 million,
respectively. At September 30, 2004, cash and cash equivalents amounted to $8.8
million. In addition, the Company has approximately $173,000 in restricted cash
that represents cash received from customers that is segregated in a separate
Company bank account and available for use only for specific project expenses.
Net cash used in operating activities for the period consisted primarily of an
increase in accounts receivable and a decrease in advance billings. 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
20
billings, was approximately $34.1 million at September 30, 2004, and $20.3
million at December 31, 2003.
Investing activities for the nine months ended September 30, 2004, consisted
primarily of capital expenditures of approximately $3.4 million, primarily
relating to computer equipment, software and $1.3 million of internally
developed software, and net purchases of available for sale securities of
approximately $1.5 million.
Financing activities for the nine months ended September 30, 2004, consisted
primarily of scheduled repayments relating to the Company's credit facility of
$2.3 million offset by borrowing on the Company's European Multicurrency
Facility of approximately $800,000 and partial early repayments of the Company's
convertible debt (see below) of approximately $1.9 million.
The Company had available for sale securities totaling $10.3 million at
September 30, 2004 compared to $8.9 million at December 31, 2003.
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. Certain provisions of this Facility have been
subsequently amended. The Facility is composed of a revolving credit loan that
expires in May of 2005 and a $15.0 million term loan that matures in March of
2007. 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. The Company is in compliance with the financial
covenants contained in the Facility (as amended) as of September 30, 2004.
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, 2004, no amounts were outstanding under the Company's revolving
credit loan, $7.5 million was outstanding under the term loan, and $774,000 was
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 Statement of Financial Accounting
Standards (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
21
place through the life of the term loan, ending on March 31, 2007. Changes in
fair value of the swap are recorded in Accumulated Other Comprehensive Loss on
the Condensed Consolidated Balance Sheet. At September 30, 2004, approximately
$160,000 has been recorded in Accumulated Other Comprehensive Loss to reflect a
decrease in the fair value of the swap compared to a decrease in the fair value
of approximately $350,000 at December 31, 2003.
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 extinguishment of debt will be recorded when paid as a gain in the
Company's Condensed Consolidated Statements of Operations. In the first quarter
of 2004, the CPR shareholders again exercised their put option and the Company
paid approximately $750,000 to settle $1.0 million of the then remaining $4.0
million of the convertible note that was outstanding at December 31, 2003. A
gain of $254,000 has been recorded in the first quarter of 2004 in the Company's
Condensed Consolidated Statements of Operations. Similarly, in the second
quarter of 2004, the CPR shareholders exercised their put option and the Company
paid approximately $1.2 million to settle $1.5 million of the remaining $3.0
million of the convertible note that was outstanding at March 31, 2004. A gain
of $343,000 was recorded in the second quarter of 2004 in the Company's
Condensed Consolidated Statements of Operations. The balance which remains
outstanding under this convertible note at September 30, 2004 is $1.5 million.
The Company intends to continue to repay this convertible note ahead of its
original scheduled maturity. The final repayment would occur in the first
quarter of 2005.
ADDITIONAL CONSIDERATIONS
On July 15, 2002, two of the Company's major customers, Pharmacia Corp. 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 21% of the Company's net service revenues for the nine
months ended September 30, 2004 and approximately 21% of the Company's September
30, 2004, 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 awards
received from Pfizer increased during the second half of 2003 and the first nine
months of 2004, the level of awards received has not reached pre-merger levels.
The Company has seen the level of business from Pfizer increase in the second
and third quarters of 2004, but there is no assurance that the level of business
received will meet or exceed the business amounts the Company received from
Pharmacia Corp. and Pfizer Inc. in periods prior to the merger. If the level of
22
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 years.
In accordance with Section 404 of the Sarbanes-Oxley Act of 2002, we are and
have been in the process of documenting, evaluating and testing our internal
control systems to allow management to report on, and our independent auditors
to test and attest to, the adequacy of our internal controls over financial
reporting as of December 31, 2004. A significant amount of management time and
resources are being expended in this effort. Although the Company's review
continues with the goal of completion by the specified deadline, circumstances
may impede the Company's ability to comply in a timely manner with all
requirements of Section 404 as there is no precedent available by which to
measure the adequacy of compliance.
MARKET RISK
Interest Rates
The Company is exposed to changes in interest rates on its available for sale
securities and amounts outstanding under the Facility and Multicurrency
Facility. Available for sale securities are recorded at fair value in the
condensed consolidated financial statements. These securities are exposed to
market price risk, which also takes into account interest rate risk. At
September 30, 2004, 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 Management's Discussion and
Analysis of Financial Condition and Results of Operations.
Foreign Currency
The Company operates on a global basis and is therefore exposed to various types
of currency risks. Two specific transaction risks arise from the nature of the
contracts the Company executes with its customers. From time to time contracts
are denominated in a currency different than the particular 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 subsidiary's expenses are incurred. As a result, the subsidiary's
net service revenues and resultant net income or loss can be affected by
fluctuations in exchange rates.
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
23
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
Condensed Consolidated Statements of Operations.
A third type of transaction risk arises from transactions denominated in
multiple currencies between the Company's various subsidiary locations. The
Company maintains an intercompany receivable and payable among its various
subsidiaries, which is denominated in multiple currencies, at the end of any
given period. Changes in exchange rates from the time the intercompany
receivable/payable balance arises until the balance is settled or measured for
reporting purposes, results in exchange rate gains and losses. This intercompany
receivable/payable arises when work is performed by a Kendle location in one
country on behalf of a Kendle location in a different country that has
contracted with the customer. Additionally, there are occasions when funds are
transferred between subsidiaries for working capital purposes. The foreign
currency transaction gain or loss is reported in Other Income (Expense) in the
Condensed Consolidated Statements of Operations.
In 2004, the Company recorded exchange rate losses of approximately $450,000 in
the quarter ended September 30, 2004 and exchange rate gains of approximately
$10,000 for the nine months ended September 30, 2004.
The Company's condensed 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 subsidiaries' U.S. dollar balance sheet and
is necessary to keep the foreign subsidiaries' balance sheet stated in U.S.
dollars in balance. Foreign currency translation adjustments, reported as a
separate component of shareholders' equity were approximately $648,000 at
September 30, 2004 compared to $1.2 million at December 31, 2003.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make significant
estimates and assumptions that affect the reported condensed consolidated
financial statements for a particular period. Actual results could differ from
those estimates.
Revenue Recognition
The majority of the Company's net service revenues are based on fixed-price
contracts calculated on a percentage-of-completion basis based upon 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
24
recognized. Management periodically reviews the budget on 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. When estimates indicate a loss, such loss is
provided in the current period in its entirety. The Company attempts to
negotiate contract amendments with the customer to cover services provided
outside the terms of the original contract. However, there can be no guarantee
that the customer will agree to proposed amendments, and the Company ultimately
bears the risk of cost overruns.
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 provides services 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. In
these instances, the Company recognizes these costs as direct costs with
corresponding net service revenues. Excess costs incurred above the contract
terms would negatively affect the Company's gross margin.
Accounts Receivable/Allowance for Doubtful Accounts
Billed accounts receivable represent amounts for which invoices have been sent
to customers. Unbilled accounts receivable are amounts recognized as revenue for
which invoices 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 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 Condensed Consolidated Results
of Operations or financial position.
Long-Lived Assets
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. The goodwill impairment
testing involves the use of estimates related to the fair market value of the
reporting unit and is inherently subjective. An impairment charge is recognized
for the amount, if any, by which the carrying amount of goodwill exceeds fair
value. At December 31, 2003 the fair value of the Company exceeded the carrying
value, resulting in no goodwill impairment charge. During the first nine months
of 2004, no events arose that indicated a need for an interim impairment
analysis. In addition to goodwill, the Company has a $15 million indefinite
lived intangible asset representing one customer relationship acquired in the
Company's acquisition of CPR. The intangible asset is evaluated each reporting
period to determine whether events or circumstances continue to support an
indefinite useful life. During the first nine months of 2004, no event or events
have occurred which would indicate a need to adjust the indefinite useful life
of this asset.
Internally Developed Software
25
The Company capitalizes costs incurred to internally develop software used
primarily in the Company's proprietary clinical trial and data management
systems, and amortizes these costs over the estimated 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. As with other long-lived
assets, this asset is reviewed at least annually to determine the
appropriateness of the carrying value of the asset. Assessing the fair value of
the internally developed software requires estimates and judgment on the part of
management.
Tax Valuation Allowance
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 on an
assessment that it is more likely than not 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 November 2003, during discussions on EITF Issue 03-01, "The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments", the
EITF reached a consensus which requires quantitative and qualitative disclosures
for debt and marketable equity securities classified as available-for-sale or
held-to-maturity under Statements 115 and 224 that are impaired at the balance
sheet date but for which an other-than-temporary impairment has not been
recognized. The consensus on quantitative and qualitative disclosures is
effective for fiscal years ending after December 15, 2003 and comparative
information for earlier periods presented is not required. At the March 2004
EITF meeting, the Task Force reached a consensus on a three-step impairment
model. Except for disclosure requirements already in place, the Issue 03-01
consensus will be effective prospectively for all relevant current and future
investments in reporting periods beginning after June 15, 2004. The adoption of
this standard has no material effect on the Company's consolidated financial
statements.
In January 2003, the Financial Accounting Standards Board (FASB) issued FIN 46,
Consolidation of Variable Interest Entities. FIN 46 clarifies the application of
Accounting Research Bulletin No. 51, Consolidated Financial Statements, to
certain entities in which equity investors do not have the characteristics of a
controlling financial interest or do not have sufficient equity at risk for the
entity to finance its activities without additional subordinated financial
support from other parties. FIN 46 will require the consolidation of a variable
interest entity whereby an enterprise will absorb a majority of the entity's
expected losses if they occur, receive a majority of the entity's expected
residual returns if they occur, or both. In December
26
2003, the FASB issued FIN 46R, Consolidation of Variable Interest Entities, an
interpretation of ARB 51 (as revised December 2003). The primary objectives of
FIN 46R are to provide guidance on the identification of entities for which
control is achieved through means other than through voting rights (Variable
Interest Entities) and how to determine when and which business enterprise
should consolidate the Variable Interest Entity (the Primary Beneficiary). The
disclosure requirements of FIN 46R are required in all financial statements
issued after March 15, 2004, if certain conditions are met. The Company does not
have any variable interest entities and therefore, FIN 46R did not impact its
financial statements.
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 and
biotechnology industries, changes in the financial conditions of the Company's
customers, potential mergers and acquisitions in the pharmaceutical and
biotechnology industries, 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 or from
the SEC. 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.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
See Management's Discussion and Analysis of Financial Condition and Results of
Operations.
27
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-15(e) and 15d-15(e)) 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.
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 2, 2004 the Company filed a Form 8-K to disclose the non-GAAP
financial measures included in its press release announcing its second
quarter 2004 results of
28
operations and financial condition and the reasons for including the
non-GAAP financial measures.
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 9, 2004 Candace Kendle
Chairman of the Board and Chief
Executive Officer
By: /s/ Karl Brenkert III
-------------------------------
Date: November 9, 2004 Karl Brenkert III
Senior Vice President - Chief
Financial Officer
30
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
31