UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934.
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005
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 of (IRS Employer Identification No.)
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 by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes No X
----- -----
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date: 14,039,587 shares of Common
Stock, no par value, as of October 25, 2005.
1
KENDLE INTERNATIONAL INC.
INDEX
Page
----
Part I. Financial Information
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets -September 30, 2005
and December 31, 2004 3
Condensed Consolidated Statements of Operations - Three
Months Ended September 30, 2005 and 2004; Nine Months
Ended September 30, 2005 and 2004 4
Condensed Consolidated Statements of Comprehensive Income
(Loss) - Three Months Ended September 30, 2005 and 2004;
Nine Months Ended September 30, 2005 and 2004 5
Condensed Consolidated Statements of Cash Flows - Nine
Months Ended September 30, 2005 and 2004 6
Notes to Condensed Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 14
Item 3. Quantitative and Qualitative Disclosure About Market Risk 27
Item 4. Controls and Procedures 27
Part II. Other Information 28
Item 1. Legal Proceedings 28
Item 2. Unregistered Sales of Equity 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 28
Signatures 29
Exhibit Index 30
2
KENDLE INTERNATIONAL INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
September 30, December 31,
2005 2004
------------- ------------
(in thousands, except share data) (unaudited) (note 1)
ASSETS
Current assets:
Cash and cash equivalents $ 25,510 $ 17,665
Restricted cash 213 971
Available-for-sale securities 10,621 10,271
Accounts receivable 54,814 56,025
Other current assets 11,420 10,243
-------- --------
Total current assets 102,578 95,175
-------- --------
Property and equipment, net 15,441 16,821
Goodwill 24,323 26,003
Other finite-lived intangible assets 549 663
Other indefinite-lived intangible assets 15,000 15,000
Other assets 6,829 9,018
-------- --------
Total assets $164,720 $162,680
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current portion of obligations under capital leases $ 392 $ 740
Current portion of amounts outstanding under credit facilities 3,000 3,000
Convertible note -- 1,500
Trade payables 7,055 9,169
Advance billings 19,403 24,924
Other accrued liabilities 15,820 15,128
-------- --------
Total current liabilities 45,670 54,461
-------- --------
Obligations under capital leases, less current portion 526 863
Long-term debt 1,500 3,750
Other noncurrent liabilities 1,139 831
-------- --------
Total liabilities 48,835 59,905
-------- --------
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;
13,961,379 and 13,262,826 shares issued and 13,941,482 and
13,242,929 outstanding at September 30, 2005 and
December 31, 2004, respectively 75 75
Additional paid in capital 144,566 136,111
Accumulated deficit (28,615) (35,596)
Accumulated other comprehensive:
Net unrealized holding losses on available-for-sale
securities (54) (49)
Unrealized gains (losses) on interest rate swap 1 (92)
Foreign currency translation adjustment 305 2,719
-------- --------
Total accumulated other comprehensive income 252 2,578
Less: Cost of common stock held in treasury, 19,897 shares at
September 30, 2005 and December 31, 2004 (393) (393)
-------- --------
Total shareholders' equity 115,885 102,775
-------- --------
Total liabilities and shareholders' equity $164,720 $162,680
======== ========
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 For the Nine Months
Ended September 30, Ended September 30,
-------------------- -------------------
2005 2004 2005 2004
------- ------- -------- --------
(in thousands, except per share data)
Net service revenues $51,581 $42,920 $149,233 $124,923
Reimbursable out-of-pocket revenues 12,865 8,776 34,936 31,774
------- ------- -------- --------
Total revenues 64,446 51,696 184,169 156,697
------- ------- -------- --------
Costs and expenses:
Direct costs 27,451 23,794 80,329 71,276
Reimbursable out-of-pocket costs 12,865 8,776 34,936 31,774
Selling, general and
administrative expenses 16,738 14,973 50,634 43,640
Depreciation and amortization 1,851 2,237 6,228 6,806
Severance and office consolidation costs -- -- -- 302
------- ------- -------- --------
58,905 49,780 172,127 153,798
------- ------- -------- --------
Income from operations 5,541 1,916 12,042 2,899
Other income (expense):
Interest income 234 101 674 265
Interest expense (92) (158) (380) (573)
Other (370) (509) (77) (224)
Gain on debt extinguishment -- -- 300 597
------- ------- -------- --------
Income before income taxes 5,313 1,350 12,559 2,964
Income tax expense 1,919 750 5,578 1,480
------- ------- -------- --------
Net income $ 3,394 $ 600 $ 6,981 $ 1,484
======= ======= ======== ========
Income per share data:
Basic:
Net income per share $ 0.25 $ 0.05 $ 0.52 $ 0.11
======= ======= ======== ========
Weighted average shares 13,633 13,231 13,413 13,141
Diluted:
Net income per share $ 0.24 $ 0.04 $ 0.50 $ 0.11
======= ======= ======== ========
Weighted average shares 14,258 13,413 13,926 13,373
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
KENDLE INTERNATIONAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(UNAUDITED)
For the Three Months Ended For the Nine Months Ended
September 30, September 30,
-------------------------- -------------------------
2005 2004 2005 2004
------ ------ ------- ------
(in thousands)
Net income $3,394 $ 600 $ 6,981 $1,484
------ ------ ------- ------
Other comprehensive income:
Foreign currency translation adjustment 126 549 (2,414) (520)
Net unrealized holding gains (losses) on
available-for-sale securities arising
during the period, net of tax 2 20 (5) (34)
Net unrealized holding gains on
interest rate swap agreement 16 8 93 190
------ ------ ------- ------
Comprehensive income $3,538 $1,177 $ 4,655 $1,120
====== ====== ======= ======
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,
-------------------------
2005 2004
------- --------
(in thousands)
Net cash provided by (used in) operating activities $10,509 $ (5,783)
------- --------
Cash flows from investing activities:
Proceeds from sales and maturities of
available-for-sale securities 3,485 7,889
Purchases of available-for-sale securities (3,915) (9,419)
Acquisitions of property and equipment (3,579) (2,094)
Cash provided by restricted cash 676 1,544
Additions to software costs (158) (1,282)
Other 18 15
------- --------
Net cash used in investing activities (3,473) (3,347)
------- --------
Cash flows from financing activities:
Net repayments under credit facilities (2,187) (1,472)
Net repayments - book overdraft (389) (75)
Repayment of convertible note (1,200) (1,903)
Other (31) --
Proceeds from exercise of stock options 5,419 135
Payments on capital lease obligations (597) (668)
------- --------
Net cash provided by (used in) financing activities 1,015 (3,983)
------- --------
Effects of exchange rates on cash and cash equivalents (206) 113
Net increase (decrease) in cash and cash equivalents 7,845 (13,000)
Cash and cash equivalents:
Beginning of period 17,665 21,750
------- --------
End of period $25,510 $ 8,750
======= ========
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.
Certain amounts reflected in the prior years Condensed Consolidated Financial
Statements have been reclassified to be comparable with the current year.
Operating results for the three and nine months ended September 30, 2005 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2005. For further information, refer to the Consolidated Financial
Statements and notes thereto included in the Form 10-K for the year ended
December 31, 2004 filed by Kendle International Inc. ("the Company") with the
Securities and Exchange Commission.
The condensed consolidated balance sheet at December 31, 2004 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.
Cash and Cash Equivalents, Including Restricted Cash
In the Company's condensed consolidated statement of cash flows for the nine
months ended September 30, 2005, the Company changed the classification of
changes in restricted cash balances to present such changes as an investing
activity. The Company previously presented such changes as an operating
activity. In the accompanying consolidated statements of cash flows for the
period from January 01, 2004 to September 30, 2004, the Company reclassified
changes in restricted cash balances to be consistent with the Company's 2005
presentation which resulted in a $1.5 million increase in investing cash flows
and a corresponding decrease in operating cash flows from the amounts previously
reported.
Net Income Per Share Data
Net income per basic share is computed using the weighted average common shares
outstanding. Net income per diluted share is computed using the weighted average
common shares and potential common shares outstanding.
The net income used in computing net income per diluted share has been
calculated as follows:
7
Three Months Ended Three Months Ended
September 30, 2005 September 30, 2004
------------------ ------------------
(in thousands)
Net income per Statements of
operations $3,394 $600
------ ----
Net income for diluted earnings per
share calculation $3,394 $600
Nine Months Ended Nine Months Ended
September 30, 2005 September 30, 2004
------------------ ------------------
(in thousands)
Net income per Statements of
operations $6,981 $1,484
------ ------
Net income for diluted earnings per
share calculation $6,981 $1,484
The weighted average shares used in computing net income per diluted share have
been calculated as follows:
Three Months Ended Three Months Ended
September 30, 2005 September 30, 2004
------------------ ------------------
(in thousands)
Weighted average common shares
Outstanding 13,633 13,231
Stock options 625 182
------ ------
Weighted average shares 14,258 13,413
------ ------
Nine Months Ended Nine Months Ended
September 30, 2005 September 30, 2004
------------------ ------------------
(in thousands)
Weighted average common shares
Outstanding 13,413 13,141
Stock options 513 232
------ ------
Weighted average shares 13,926 13,373
------ ------
Options to purchase approximately 50,000 and 300,000 shares of common stock were
outstanding during the three and nine months ended September 30, 2005 but were
not included in the computation of earnings per diluted share because the effect
would be antidilutive.
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
effect would be antidilutive.
8
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.
On May 12, 2005, the Compensation Committee amended the vesting schedule of a
total of approximately 140,000 options outstanding that met the following
criteria:
1) Outstanding/unvested as of May 12, 2005
2) Have an option price greater than $11.73 (fair market value on May 12,
2005)
3) Were granted between May 1, 2001 and May 1, 2002.
All unvested shares that met the above criteria, with the exception of options
held by any executive officer of the company, were immediately vested as of May
12, 2005. The Compensation Committee decided to accelerate the vesting schedule
of these options primarily to enhance employee appreciation of the importance of
focusing on increasing shareholder value and to avoid expensing the options upon
adoption of SFAS 123(R).
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 2005 and 2004 would have been approximately $0.5 million and $1.0
million, respectively. The amount of compensation expense that would have been
recognized in the first nine months of 2005 and 2004 would have been
approximately $4.5 million and $3.0 million, respectively. Approximately $2.2
million of the $4.5 million in compensation expense that would have been
recognized for the nine months ended September 30, 2005 resulted from the
amendment made to the vesting schedule. 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
30, 2005 30, 2004
--------------- ---------------
(in thousands, except per share data)
PRO FORMA NET INCOME (LOSS):
As reported $3,394 $ 600
Less: pro forma adjustment for
stock-based compensation, net of tax (363) (759)
------ ------
Pro-forma net income (loss) $3,031 $ (159)
PRO-FORMA NET INCOME (LOSS) PER BASIC SHARE:
As reported $ 0.25 $ 0.05
Effect of pro forma expense $(0.03) $(0.06)
Pro-forma $ 0.22 $(0.01)
9
PRO-FORMA NET INCOME (LOSS) PER DILUTED SHARE:
As reported $ 0.24 $ 0.04
Effect of pro forma expense $(0.03) $(0.05)
Pro-forma $ 0.21 $(0.01)
Nine Months Nine Months
Ended September Ended September
30, 2005 30, 2004
--------------- ---------------
(in thousands, except per share data)
PRO FORMA NET INCOME (LOSS):
As reported $ 6,981 $ 1,484
Less: pro forma adjustment for stock-based
compensation, net of tax (3,439) (2,302)
------- -------
Pro-forma net income (loss) $ 3,542 $ (818)
PRO-FORMA NET INCOME (LOSS) PER BASIC SHARE:
As reported $ 0.52 $ 0.11
Effect of pro-forma expense $ (0.26) $ (0.17)
Pro-forma $ 0.26 $ (0.06)
PRO-FORMA NET INCOME (LOSS) PER DILUTED SHARE:
As reported $ 0.50 $ 0.11
Effect of pro-forma expense $ (0.25) $ (0.17)
Pro-forma $ 0.25 $ (0.06)
New Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 123, "Share-Based Payment" (SFAS
123(R)). SFAS 123(R) requires that compensation costs relating to share-based
payment transactions be recognized in the financial statements. The cost will be
measured based on the fair value of the equity or liability instruments issued.
SFAS 123(R) covers a range of shared-based compensation arrangements, including
stock options, restricted stock plans, performance-based awards, stock
appreciation rights and employee stock purchase plans. The Company currently
uses the Black-Scholes option pricing model to value options and is currently
assessing which model may be used in the future under the new statement. In
addition to determining the fair value model to be used, the Company will also
be required to determine the transition method to be used at the date of
adoption. The allowed transition methods include prospective and retroactive
adoption options. The prospective method requires that compensation expense be
recorded for all unvested stock options at the beginning of the first quarter
following the adoption of SFAS 123(R), while the retroactive methods would
record compensation expense for all unvested stock options beginning with the
first period restated. The Company is in the process of evaluating the impact
SFAS 123(R) will have on its Consolidated Financial Statements.
10
In April 2005, the Securities and Exchange Commission announced the adoption of
a new rule that amends the effective date of SFAS 123(R). The effective date of
the new standard under these new rules for the Company's Consolidated Financial
Statements is January 1, 2006.
In May 2005, the FASB issued FASB Statement 154, "Accounting Changes and Error
Corrections" which replaces APB Opinion No. 20, "Accounting Changes" and FASB
Statement 3 "Reporting Accounting Changes in Interim Financial Statements." This
statement changes the requirements for the accounting for and reporting of a
change in accounting principle. This statement applies to all voluntary changes
in accounting principle. It also applies to changes required by an accounting
pronouncement in the unusual instances that the pronouncement does not include
specific transition provisions. This statement requires voluntary changes in
accounting principles be recognized retrospectively to prior periods' financial
statements, rather than recognition in the net income of the current period.
Retrospective application requires restatements of prior period financial
statements as if that accounting principle had always been used. This statement
carries forward without change the guidance contained in Opinion 20 for
reporting the correction of an error in previously issued financial statements
and a change in accounting estimate. The provisions of FASB Statement 154 are
effective for accounting changes and corrections of error made in fiscal years
beginning after December 15, 2005.
Statement No. 153, "Exchanges of Non-monetary Assets", an amendment of APB
Opinion No. 29, "Accounting for Non-monetary Transactions" is based on the
principle that exchanges of non-monetary assets should be measured based on the
fair value of the assets exchanged. Further, the amendments eliminate the narrow
exception for non-monetary exchanges of similar productive assets and replace it
with a broader exception for exchanges of non-monetary assets that do not have
commercial substance. The Statement is effective for non-monetary asset
exchanges occurring in fiscal periods beginning after June 15, 2005. Earlier
application is permitted for non-monetary asset exchanges occurring in fiscal
periods beginning after the date of issuance. The application of FAS-153 did not
have any impact on earnings and financial position.
In December 2004, the FASB issued FASB Staff Position (FSP) No. 109-2,
"Accounting and Disclosure Guidance for the Foreign Earnings Repatriation
Provision within the American Jobs Creation Act of 2004." The FSP provides
guidance under FAS No. 109, "Accounting for Income Taxes," with respect to
recording the potential impact of the repatriation provision of the American
Jobs Creation Act of 2004 (the "Jobs Act") on enterprises' income tax expense
and deferred tax liability. The Jobs Act, enacted on October 22, 2004, creates a
temporary incentive for U.S. corporations to repatriate undistributed income
earned abroad by providing an 85 percent dividends received deduction for
certain dividends from controlled foreign corporations. FSP No. 109-2 states
that companies are allowed time beyond the financial reporting period of
enactment to evaluate the effect of the Jobs Act on its plan for reinvestment or
repatriation of foreign earnings for purposes of applying FAS No. 109. The
Company has evaluated the effects of the repatriation provision and does not
plan to repatriate undistributed income earned abroad. Therefore, the provisions
of FSP 109-2 have no material effect on the Company's Consolidated Financial
Statements.
2. 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
11
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 in 2004 totaled $302,000 and no amounts remain
accrued at September 30, 2005.
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. In the third quarter of 2005, the Company recorded an
additional $70,000 in costs related to on-going arbitration proceedings for an
individual whose position was eliminated as a result of the realignment plan.
Approximately $85,000 remains accrued and is reflected in Other Accrued
Liabilities on the Company's Condensed Consolidated Balance Sheet.
The amounts accrued for the workforce reduction and office consolidation costs
are detailed as follows:
Employee
Severance
---------
(in thousands)
Liability at December 31, 2004 $15
Amounts accrued 70
Amounts paid --
Adjustment to liability --
Liability at September 30, 2005 $85
3. GOODWILL AND OTHER INTANGIBLE ASSETS:
Non-amortizable intangible assets at September 30, 2005 and December 31, 2004
are composed of:
Indefinite-lived
Goodwill Intangible
-------- ----------------
(in thousands)
Balance at 12/31/04 $26,003 $15,000
Foreign currency fluctuations (1,388) --
Tax benefit to reduce goodwill (292) --
------- -------
Balance at 9/30/05 $24,323 $15,000
======= =======
Amortizable intangible assets at September 30, 2005 and December 31, 2004 are
composed of:
12
Customer Non-Compete Internally-Developed
Relationships Agreements Software
------------- ----------- --------------------
(in thousands)
Balance at 12/31/04 $346 $317 $ 5,097
Additional amounts acquired -- -- 158
Dispositions -- -- (11)
2005 amortization (28) (86) (1,719)
---- ---- -------
Balance at 9/30/05 $318 $231 $ 3,525
==== ==== =======
Internally-developed software is included in other assets within the condensed
consolidated financial statements.
Amortization expense for the next five years relating to these amortizable
intangible assets is estimated to be as follows:
(in thousands)
Remainder of 2005: $ 477
2006: $1,511
2007: $1,079
2008: $ 525
2009: $ 257
Thereafter: $ 225
------
Total $4,074
======
4. DEBT:
In May 2005, the Company entered into the Second Amended and Restated Credit
Agreement (the "Facility") that replaced the previous credit agreement. 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 Facility is composed of a $20.0 million revolving credit loan that expires
in May of 2008. The existing term loan is carried over from the previous
agreement and matures in March of 2007.
The revolving credit loan bears interest at a rate equal to either (a) The LIBOR
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 existing 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 new five year
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 of September 30, 2005.
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
13
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, 2005, no amounts were outstanding under the Company's revolving
credit loan, $4.5 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 5.8% and on the Multicurrency Facility at
a rate of 6.75%. 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 1.50%). 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, 2005, approximately
$1,000 has been recorded in Accumulated Other Comprehensive Income to reflect
the unrealized gain of the swap compared to the unrealized loss of approximately
$92,000 at December 31, 2004.
With the acquisition of Clinical and Pharmacologic Research, Inc. (CPR) in 2002,
the Company entered into a $6.0 million convertible note payable to the
shareholders of CPR. The principal balance was 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 had not been converted at the
Maturity Date, the Company had the option to extend the Maturity Date of the
note for another three years. The note bore interest at an annual rate of 3.80%
from January 29, 2002 through the Maturity Date. Interest was payable
semi-annually.
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 were initiated either by the Company through the exercise of a
"call" option or by the CPR shareholders through the exercise of a "put" option.
Gains resulting from this early extinguishment of debt were recorded when paid
as a gain in the Company's Condensed Consolidated Statements of Operations. In
the first quarter of 2005, the Company paid approximately $1.2 million to settle
the remaining $1.5 million of the convertible note that was outstanding at
December 31, 2004. A gain of $300,000 has been recorded in the first quarter of
2005 in the Company's Condensed Consolidated Statements of Operations. No
amounts remain outstanding under this convertible note at September 30, 2005.
Total gains resulting from early extinguishment of debt under the Note
Prepayment Agreement were approximately $1.5 million.
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, 2005 and should be read in conjunction therewith. The
Company's results of operations for a
14
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 biopharmaceutical
companies. The Company is managed in one reportable segment encompassing
contract services related to Phase I through IV clinical trials.
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. Finally, at one
of the Company's subsidiaries, the contracts are of a short-term nature and
revenue is recognized under the completed contract method of accounting.
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.
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.
15
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 Condensed 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 as well as awarded projects for which the
contract is actively being negotiated, 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, 2005 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 2004
Net Service Revenues
Net service revenues increased approximately $8.7 million, or 20%, to $51.6
million in the third quarter of 2005 from $42.9 million in the third quarter of
2004. The 20% increase in net service revenues was due entirely to organic
revenue growth. Foreign currency exchange rate fluctuations had minimal impact
on third quarter 2005 revenue compared to third quarter 2004. In the third
quarter of 2005, net service revenues in the North American and European regions
increased by approximately $4.5 million or 18% and $4.3 million or 27%,
respectively, from the same period of the prior year. The growth in net service
revenues is primarily due to the Company's expanding customer base in both North
America and Europe. The increase in European revenues includes increased demand
for Phase I services at the Company's Phase I unit located in Utrecht, The
Netherlands.
Approximately 42% of the Company's net service revenues were derived from
operations outside of North America in the third quarter of 2005 compared to 41%
in the corresponding period in 2004. The top five customers based on net service
revenues contributed approximately 34% of net service revenues during the third
quarter of 2005 compared to approximately 39% of net service revenues during the
third quarter of 2004. Net service revenues from Pfizer Inc. accounted for
approximately 13% of total third quarter 2005 net service revenues compared to
approximately 21% of total third quarter 2004 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
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 47% to $12.9 million in the third quarter of
2005 from $8.8 million in the corresponding period of 2004.
Operating Expenses
16
Direct costs increased approximately $3.7 million, or 15%, to $27.5 million in
the third quarter of 2005 from $23.8 million in the third quarter of 2004.
Foreign currency exchange rate fluctuations had minimal impact on direct costs
in the third quarter of 2005 compared to 2004. The growth in direct costs
relates directly to the increase in net service revenues in the third quarter of
2005, including specifically increased use of outside contractors. Direct costs
expressed as a percentage of net service revenues were 53.2% for the three
months ended September 30, 2005 compared to 55.4% for the three months ended
September 30, 2004. The decrease in direct costs as a percentage of net service
revenues is attributable to increased utilization of billable associates during
the third quarter of 2005 as well as a larger revenue base to absorb fixed
costs.
Reimbursable out-of-pocket costs increased 47% to $12.9 million in the third
quarter of 2005 from $8.8 million in the corresponding period of 2004.
Selling, general and administrative expenses increased $1.7 million, or 12%,
from $15.0 million in the third quarter of 2004 to $16.7 million in the same
quarter of 2005. Foreign currency exchange rate fluctuations had no impact on
the increase in selling, general and administrative expenses in the third
quarter of 2005 compared to the comparable period of 2004. The increase is
primarily due to increases in employee-related costs due to the Company's
increase in headcount. The increase in employee-related costs is comprised of
general salary increases and corresponding payroll tax and benefit increases as
well as an increase in sales commissions and profit-sharing accrual. Selling,
general and administrative expenses expressed as a percentage of net service
revenues were 32.4% for the three months ended September 30, 2005 compared to
34.9% for the corresponding 2004 period.
Depreciation and amortization expense decreased by $386,000 in the third quarter
of 2005 compared to the third quarter of 2004. This decrease was due to a
reduction in depreciation expense as fixed assets come to the end of their
depreciable life as well as a slowdown in additions to fixed assets as compared
to prior periods.
Other Income (Expense)
Other Income (Expense) was expense of approximately $228,000 in the third
quarter of 2005 compared to expense of approximately $566,000 in the third
quarter of 2004. Interest expense decreased by approximately $66,000 in the
third quarter of 2005 compared to the third quarter of 2004 due to decreased
debt outstanding in the third quarter of 2005. Interest income increased by
approximately $133,000 in the third quarter of 2005 due to larger cash and
investment balances in the quarter as well as a general increase in interest
rates in the third quarter of 2005 compared to the third quarter of 2004. The
available-for-sale securities balance averaged $10.6 million in the third
quarter of 2005 compared to $10.3 million in the third quarter of 2004. Foreign
exchange rate gains and losses were a loss of approximately $450,000 in the
third quarter of 2004 compared to a loss of $346,000 in the third quarter of
2005.
Income Taxes
The Company reported tax expense at an effective rate of 36.1% in the quarter
ended September 30, 2005, compared to tax expense at an effective rate of 55.6%
in the quarter ended September 30, 2004. The Company continues to maintain full
valuation allowances against the net operating losses incurred in some of its
subsidiaries. The primary reason for the drop in the
17
effective rate in 2005 is due to earnings growth in 2005 compared to 2004 in
those locations with full valuation allowances. Because 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, 2005 was approximately $3.4
million or $0.25 per basic and $0.24 per diluted share compared to net income
for the quarter ended September 30, 2004 of approximately $600,000, or $0.05 per
basic and $0.04 per diluted share.
NINE MONTHS ENDED SEPTEMBER 30, 2005 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
2004
Net Service Revenues
Net service revenues increased 19% to $149.2 million in the first nine months of
2005 from $124.9 million in the first nine months of 2004. The 19% increase in
net service revenues was due entirely to organic growth. Foreign currency
exchange rate fluctuations accounted for a 1% increase in net service revenues
in the first nine months of 2005 compared to the first nine months of 2004. In
the first nine months of 2005, net service revenues in the North American and
European regions increased by approximately $10.4 million or 14% and $14.1
million or 31%, respectively, from the same period of the prior year. The growth
in net service revenues is primarily due to the Company's expanding customer
base in both North America and Europe, including an increased demand for the
Company's Phase I services in the Netherlands.
Approximately 43% of the Company's net service revenues were derived from
operations outside of North America in the first nine months of 2005 compared to
40% in the corresponding period of 2004. The top five customers based on net
service revenues contributed approximately 35% of net service revenues during
the first nine months of 2005 compared to approximately 41% of net service
revenues during the first nine months of 2004. Net service revenues from Pfizer
Inc. accounted for approximately 16% of total net service revenues in the nine
months ended September 30, 2005 compared to approximately 21% of total net
service revenues in the same period of 2004. 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 the first nine months of 2005 or 2004.
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 10.0% to $34.9 million in the nine months ended
September 30, 2005 from $31.8 million in the corresponding period of 2004.
Operating Expenses
Direct costs increased by 13% from $71.3 million in the first nine months of
2004 to $80.3 million in the first nine months of 2005. Foreign currency
exchange rate fluctuations accounted for a 2% increase in direct costs in the
first nine months of 2005 compared to 2004. The remaining growth in direct costs
relates directly to the increase in net service revenues in the first nine
months of 2005, including increased use of outside contractors to support the
Company's
18
increased project activity. Direct costs expressed as a percentage of net
service revenues were 53.8% for the nine months ended September 30, 2005
compared to 57.1% for the nine months ended September 30, 2004. The decrease in
direct costs as a percentage of net service revenues is attributable to
increased utilization of billable associates during the nine month period ended
September 30, 2005 as well as a larger revenue base to absorb fixed costs.
Reimbursable out-of-pocket costs increased 10.0% to $34.9 million in the nine
months ended September 30, 2005 from $31.8 million in the corresponding period
of 2004.
Selling, general and administrative expenses increased from $43.6 million in the
first nine months of 2004 to $50.6 million in the first nine months of 2005.
Foreign currency exchange rate fluctuations accounted for a 1% increase in
selling, general and administrative expenses in the first nine months of 2005
compared to the comparable period of 2004. The increase is primarily due to
costs associated with the Company's marketing efforts in 2005 and increases in
employee-related costs. The increase in employee-related costs is comprised of
general salary increases and corresponding payroll tax increases as well as an
increase in sales commissions, profit-sharing accrual and costs for recruiting
new associates. Selling, general and administrative expenses expressed as a
percentage of net service revenues were 33.9% for the nine months ended
September 30, 2005 compared to 34.9% for the corresponding 2004 period.
Depreciation and amortization expense decreased by 9% in the nine months ending
September 30, 2005 compared to the corresponding period of 2004. This decrease
was due to a reduction in depreciation expense as fixed assets come to the end
of their depreciable life as well as a slowdown in additions to fixed assets as
compared to prior periods.
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. No expenses related to workforce realignment plans
were incurred in 2005. No amounts remain accrued at September 30, 2005.
Other Income (Expense)
Other Income (Expense) was income of $517,000 for the first nine months of 2005
compared to income of approximately $65,000 in the first nine months of 2004.
Interest expense decreased by approximately $193,000 in the first nine months of
2005 compared to the first nine months of 2004 due to decreased debt outstanding
in the nine months ended September 30, 2005. Interest income increased by
approximately $409,000 in the first nine months of September 2005 due to larger
cash and investment balances as well as a general increase in interest rates in
2005 compared to 2004. The available-for-sale securities balance averaged $10.2
million for the nine months ended September 30, 2005 compared to $9.3 million
for the nine months ended September 30, 2004. 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 compared to a gain of
$300,000 on partial early repayment of debt in the first nine months of 2005.
The convertible note was fully paid as of January 31, 2005.
Income Taxes
19
The Company reported tax expense at an effective rate of 44.4% in the nine
months ended September 30, 2005 compared to tax expense at an effective rate of
49.9% in the nine months ended September 30, 2004. In the second quarter of
2005, the Company recorded a one-time, non-cash charge of approximately $1.2
million, net of federal income tax effect, to reflect the write-off of deferred
state income tax assets due to a change in Ohio state tax law enacted on June
30, 2005. The one-time charge results from adoption of a comprehensive change in
Ohio corporate tax laws that provides for the phase-in of a Commercial
Activities Tax (CAT) on gross receipts. Concurrent with the phase-in of the CAT,
the Ohio income tax, net worth tax, and personal property tax will be phased
out. The Company anticipates that the net effect of this tax law change will
benefit the Company's earnings in future years. The Company continues to
maintain full valuation allowances against net operating losses incurred in
certain European subsidiaries of the Company. The primary reason for the drop in
the effective rate in 2005 is due to earnings growth in 2005 compared to 2004 in
those locations with full valuation allowances. Because 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
Net income for the nine months ended September 30, 2005 was approximately $7.0
million, or $0.50 per diluted share and $0.52 per basic share compared to net
income of approximately $1.5 million or $0.11 per basic and diluted share for
the nine months ended September 30, 2004.
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents increased by $7.8 million for the nine months ended
September 30, 2005 as a result of cash provided by operating activities of $10.5
million and cash provided by financing activities of $1.0 million offset by cash
used in investing activities of $3.5 million and the negative effects of
exchange rates on cash and cash equivalents of $206,000. At September 30, 2005,
cash and cash equivalents were $25.5 million. In addition, the Company has
approximately $213,000 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 provided by operating
activities for the period consisted primarily of net income adjusted for
non-cash items. The change in net operating assets used approximately $1.2
million in cash during the nine months ended September 30, 2005, primarily due
to an increase in net accounts receivable, offset by increases in income tax
payable and accrued compensation liabilities. 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 $35.4 million at
September 30, 2005, and $31.1 million at December 31, 2004.
Investing activities for the nine months ended September 30, 2005 consisted
primarily of capital expenditures of approximately $3.7 million, mostly relating
to computer equipment and software purchases, including internally developed
software.
Financing activities for the nine months ended September 30, 2005, consisted
primarily of scheduled repayments relating to the Company's credit facility of
$2.2 million and partial early repayment of the Company's convertible debt of
approximately $1.2 million offset by proceeds from stock option exercises of
approximately $5.4 million.
20
The Company had available-for-sale securities totaling $10.6 million at
September 30, 2005 compared to $10.3 million at December 31, 2004.
In May 2005, the Company entered into the Second Amended and Restated Credit
Agreement (the "Facility") that replaced the previous credit agreement. 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 Facility is composed of a $20.0 million revolving credit loan that expires
in May of 2008. The existing term loan is carried over from the previous
agreement and matures in March of 2007.
The revolving credit loan bears interest at a rate equal to either (a) The LIBOR
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 existing 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 new five year
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 of September 30, 2005.
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, 2005 no amounts were outstanding under the Company's revolving
credit loan, $4.5 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 5.8% and on the Multicurrency Facility at
a rate of 6.75%. 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 1.50%). 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, 2005, an unrealized
gain of approximately $1,000 has been recorded in Accumulated Other
Comprehensive Income to reflect the unrealized gain of the swap compared to the
unrealized loss of approximately $92,000 at December 31, 2004.
With the acquisition of CPR in 2002, the Company entered into a $6.0 million
convertible note payable to the shareholders of CPR. The principal balance was
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 had
not been converted at the Maturity Date, the Company had the
21
option to extend the Maturity Date of the note for another three years. The note
bore interest at an annual rate of 3.80% from January 29, 2002 through the
Maturity Date. Interest was payable semi-annually.
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 were initiated either by the Company through the exercise of a
"call" option or by the CPR shareholders through the exercise of a "put" option.
Gains resulting from this early extinguishment of debt were recorded in the
Company's Condensed Consolidated Statements of Operations when payments were
made by the Company. In the first quarter of 2005, the Company paid
approximately $1.2 million to settle the remaining $1.5 million of the
convertible note that was outstanding at December 31, 2004. A gain of $300,000
has been recorded in the first quarter of 2005 in the Company's Condensed
Consolidated Statements of Operations. No amounts remain outstanding under this
convertible note at September 30, 2005. Total gains resulting from early
extinguishment of debt under the Note Prepayment Agreement were approximately
$1.5 million.
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, 2005, the potential loss in fair value resulting from a
hypothetical decrease of 10% in quoted market price would be approximately $1.1
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
22
contract is denominated in a currency other than the subsidiary's local
currency, the Company recognizes a receivable at the time of invoicing at the
local currency equivalent of the foreign currency invoice amount. Changes in
exchange rates from the time the invoice is prepared until the payment from the
customer is received will result in the Company receiving either more or less in
local currency than the local currency equivalent of the invoice amount at the
time the invoice was prepared and the receivable established. This difference is
recognized by the Company as a foreign currency transaction gain or loss, as
applicable, and is reported in Other Income (Expense) in the Condensed
Consolidated Statements of Operations.
A third type of transaction risk arises from transactions denominated in
multiple currencies between any two of the Company's various subsidiary
locations. For each subsidiary, the Company maintains an intercompany receivable
and payable, which is denominated in multiple currencies. 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 under contract 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.
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
Condensed 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,
which are reported as a separate component of shareholders' equity, were
approximately $305,000 at September 30, 2005 compared to $2.7 million at
December 31, 2004.
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
23
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 are subject to change if
there are 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 a 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.
Intangible 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 and 2004 the fair value of the Company exceeded the
carrying value, resulting in no goodwill impairment charge. During the first
nine months of 2005, 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 2005, no
event or events have occurred which would indicate a need to adjust the
indefinite useful life of this asset.
Internally Developed Software
24
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 includes
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 December 2004, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 123, "Share-Based Payment" (SFAS
123(R)). SFAS 123(R) requires that compensation costs relating to share-based
payment transactions be recognized in the financial statements. The cost will be
measured based on the fair value of the equity or liability instruments issued.
SFAS 123(R) covers a range of shared-based compensation arrangements, including
stock options, restricted stock plans, performance-based awards, stock
appreciation rights and employee stock purchase plans. The Company currently
uses the Black-Scholes option pricing model to value options and is currently
assessing which model may be used in the future under the new statement. In
addition to determining the fair value model to be used, the Company will also
be required to determine the transition method to be used at the date of
adoption. The allowed transition methods include prospective and retroactive
adoption options. The prospective method requires that compensation expense be
recorded for all unvested stock options at the beginning of the first quarter
following the adoption of SFAS 123(R), while the retroactive methods would
record compensation expense for all unvested stock options beginning with the
first period restated. The Company is in the process of evaluating the impact
SFAS 123(R) will have on its Consolidated Financial Statements.
In April 2005, the Securities and Exchange Commission announced the adoption of
a new rule that amends the effective date of SFAS 123(R). The effective date of
the new standard under these new rules for the Company's Consolidated Financial
Statements is January 1, 2006.
25
In May 2005, the FASB issued FASB Statement No. 154, "Accounting Changes and
Error Corrections" which replaces APB Opinion No. 20, "Accounting Changes" and
FASB Statement 3 "Reporting Accounting Changes in Interim Financial Statements."
This statement changes the requirements for the accounting for and reporting of
a change in accounting principle. This statement applies to all voluntary
changes in accounting principle. It also applies to changes required by an
accounting pronouncement in the unusual instances that the pronouncement does
not include specific transition provisions. This statement requires voluntary
changes in accounting principles be recognized retrospectively to prior periods'
financial statements, rather than recognition in the net income of the current
period. Retrospective application requires restatements of prior period
financial statements as if that accounting principle had always been used. This
statement carries forward without change the guidance contained in the Opinion
20 for reporting the correction of an error in previously issued financial
statements and a change in accounting estimate. The provisions of FASB Statement
154 are effective for accounting changes and corrections of error made in fiscal
years beginning after December 15, 2005.
Statement No. 153, "Exchanges of Non-monetary Assets", an amendment of APB
Opinion No. 29, "Accounting for Non-monetary Transactions" is based on the
principle that exchanges of non-monetary assets should be measured based on the
fair value of the assets exchanged. Further, the amendments eliminate the narrow
exception for non-monetary exchanges of similar productive assets and replace it
with a broader exception for exchanges of non-monetary assets that do not have
commercial substance. The Statement is effective for non-monetary asset
exchanges occurring in fiscal periods beginning after June 15, 2005. Earlier
application is permitted for non-monetary asset exchanges occurring in fiscal
periods beginning after the date of issuance. The application of FAS-153 did not
have any impact on earnings and financial position.
In December 2004, the FASB issued FASB Staff Position (FSP) No. 109-2,
"Accounting and Disclosure Guidance for the Foreign Earnings Repatriation
Provision within the American Jobs Creation Act of 2004." The FSP provides
guidance under FAS No. 109, "Accounting for Income Taxes," with respect to
recording the potential impact of the repatriation provision of the American
Jobs Creation Act of 2004 (the "Jobs Act") on enterprises' income tax expense
and deferred tax liability. The Jobs Act, enacted on October 22, 2004, creates a
temporary incentive for U.S. corporations to repatriate undistributed income
earned abroad by providing an 85 percent dividends received deduction for
certain dividends from controlled foreign corporations. FSP No. 109-2 states
that companies are allowed time beyond the financial reporting period of
enactment to evaluate the effect of the Jobs Act on its plan for reinvestment or
repatriation of foreign earnings for purposes of applying FAS No. 109. The
Company has evaluated the effects of the repatriation provision and does not
plan to repatriate undistributed income earned abroad. Therefore, the provisions
of FSP 109-2 have no material effect on the Company's Consolidated 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
26
statements to reflect events or circumstances arising after the date on which
such statements 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 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.
ITEM 4. CONTROLS AND PROCEDURES
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 the end of the period
covered by 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.
Changes in Internal Controls - During the fiscal quarter ended September 30,
2005, there were no changes in the Company's internal control over financial
reporting that have materially
27
affected, or are reasonably likely to materially affect, the Company's internal
control over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings - None
Item 2. Unregistered Sales of Equity 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 - None
Item 6. Exhibits
Exhibits - Exhibits set forth below that are on file with the Securities and
Exchange Commission are incorporated by reference as exhibits thereto.
Exhibit Filing
Number Description of Exhibit Status
- ------- ---------------------- ------
31.1 Certificate of Chief Executive Officer pursuant to Section 302 of the C
Sarbanes-Oxley Act of 2002
31.2 Certificate of Chief Financial Officer pursuant to Section 302 of the C
Sarbanes-Oxley Act of 2002
32.1 Certificate of Chief Executive Officer pursuant to Section 906 of the C
Sarbanes-Oxley Act of 2002
32.2 Certificate of Chief Financial Officer pursuant to Section 906 of the C
Sarbanes-Oxley Act of 2002
Filing
Status Description of Filing Status
- ------ ----------------------------
C Filed herewith
28
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.
Date: November 9, 2005 By: /s/ Candace Kendle
------------------------------------
Candace Kendle
Chairman of the Board and Chief
Executive Officer
Date: November 9, 2005 By: /s/ Karl Brenkert III
------------------------------------
Karl Brenkert III
Senior Vice President - Chief
Financial Officer
29
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
30