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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
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FORM 10-Q
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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
ACT OF 1934
For the transition period from ______ to _______
Commission File Number 0-24249
PDI, INC.
(Exact name of Registrant as specified in its charter)
Delaware 22-2919486
----------------------------------- ----------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
Saddle River Executive Centre
1 Route 17 South
Saddle River, New Jersey 07458
------------------------------
(Address of principal executive offices)
(201) 258-8450
--------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No[_]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act.)
Yes [X] No[_]
As of October 29, 2004 the Registrant had a total of 14,687,469 shares of Common
Stock, $.01 par value, outstanding.
INDEX
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PDI, INC.
PART I. FINANCIAL INFORMATION
-----------------------------
Page
Item 1. Consolidated Financial Statements (unaudited)
Balance Sheets
September 30, 2004 and December 31, 2003............................3
Statements of Operations -- Three and Nine Months
Ended September 30, 2004 and 2003...................................4
Statements of Cash Flows -- Nine Months
Ended September 30, 2004 and 2003...................................5
Notes to Consolidated Interim Financial Statements..................6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations................................23
Item 3. Quantitative and Qualitative Disclosures
About Market Risk......................................Not Applicable
Item 4. Controls and Procedures............................................38
PART II. OTHER INFORMATION
- --------------------------
Item 1. Legal Proceedings..................................................39
Item 6. Exhibits...........................................................40
SIGNATURES....................................................................41
2
PDI, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
(unaudited)
September 30, December 31,
2004 2003
--------- ---------
ASSETS
Current assets:
Cash and cash equivalents .......................... $ 77,284 $ 113,288
Short-term investments ............................. 29,032 1,344
Inventory, net ..................................... -- 43
Accounts receivable, net of allowance for
doubtful accounts of $349 and $749 as of
September 30, 2004 and December 31, 2003,
respectively ..................................... 22,932 40,885
Unbilled costs and accrued profits on contracts
in progress ...................................... 2,442 4,041
Deferred training and other program costs .......... 1,656 1,643
Other current assets ............................... 10,836 8,847
Deferred tax asset ................................. 3,900 11,053
--------- ---------
Total current assets ................................. 148,082 181,144
Net property and equipment ........................... 18,369 14,494
Deferred tax asset ................................... 6,797 7,304
Goodwill ............................................. 21,759 11,132
Other intangible assets .............................. 20,021 1,648
Other long-term assets ............................... 3,833 3,901
--------- ---------
Total assets ......................................... $ 218,861 $ 219,623
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ................................... $ 3,394 $ 8,689
Accrued returns .................................... 4,602 22,811
Accrued incentives ................................. 17,149 20,486
Accrued salaries and wages ......................... 8,897 9,031
Unearned contract revenue .......................... 9,809 3,604
Restructuring accruals ............................. 321 744
Income taxes and other accrued expenses ............ 15,422 15,770
--------- ---------
Total current liabilities ............................ 59,594 81,135
Total long-term liabilities .......................... -- --
--------- ---------
Total liabilities .................................... 59,594 81,135
--------- ---------
Commitments and Contingencies (note 13)
Stockholders' equity:
Preferred stock, $.01 par value, 5,000,000 shares
authorized, no shares issued and outstanding ..... -- --
Common stock, $.01 par value, 100,000,000 shares
authorized: shares issued and outstanding,
September 30, 2004 - 14,625,537, and
December 31, 2003 - 14,387,126; 161,115 and
136,178 restricted shares issued and
outstanding at September 30, 2004 and
December 31, 2003, respectively .................. 148 145
Additional paid-in capital ........................... 115,492 109,531
Retained earnings .................................... 45,990 29,505
Accumulated other comprehensive income ............... 47 25
Unamortized compensation costs ....................... (2,300) (608)
Treasury stock, at cost: 5,000 shares ................ (110) (110)
--------- ---------
Total stockholders' equity ........................... 159,267 138,488
--------- ---------
Total liabilities & stockholders' equity ............. $ 218,861 $ 219,623
========= =========
The accompanying notes are an integral part
of these financial statements
3
PDI, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------- ----------------------
2004 2003 2004 2003
-------- ------- -------- --------
(restated) (restated)
Revenue
Service ............................................... $ 92,525 $94,470 $277,666 $245,111
Product, net ............................................. (3) 81 (1,034) 197
-------- ------- -------- --------
Total revenue ..................................... 92,522 94,551 276,632 245,308
-------- ------- -------- --------
Cost of goods and services
Program expenses (including related party amounts of
$0 and $653 for the quarters ended September 30, 2004
and 2003, respectively and $180 and $1,287 for the
nine months ended September 30, 2004 and 2003,
respectively) ....................................... 68,127 70,085 203,670 182,227
Cost of goods sold ..................................... 10 952 244 1,097
-------- ------- -------- --------
Total cost of goods and services .................. 68,137 71,037 203,914 183,324
-------- ------- -------- --------
Gross profit ............................................. 24,385 23,514 72,718 61,984
Compensation expense ..................................... 8,409 9,297 26,549 27,294
Other selling, general and administrative expenses ....... 6,941 7,676 19,089 20,714
Restructuring and other related expenses ................ -- -- -- (270)
Litigation settlement .................................... -- -- -- 2,100
-------- ------- -------- --------
Total operating expenses .......................... 15,350 16,973 45,638 49,838
-------- ------- -------- --------
Operating income ......................................... 9,035 6,541 27,080 12,146
Other income, net ........................................ 231 246 860 741
-------- ------- -------- --------
Income before provision for taxes ........................ 9,266 6,787 27,940 12,887
Provision for income taxes ............................... 3,799 2,605 11,455 5,115
-------- ------- -------- --------
Net income ............................................... $ 5,467 $ 4,182 $ 16,485 $ 7,772
======== ======= ======== ========
Basic net income per share ............................... $ 0.37 $ 0.29 $ 1.13 $ 0.55
======== ======= ======== ========
Diluted net income per share ............................. $ 0.37 $ 0.29 $ 1.11 $ 0.54
======== ======= ======== ========
Basic weighted average number of shares outstanding ...... 14,621 14,252 14,538 14,202
======== ======= ======== ========
Diluted weighted average number of shares outstanding .... 14,933 14,543 14,873 14,349
======== ======= ======== ========
The accompanying notes are an integral part
of these financial statements
4
PDI, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
Nine Months Ended
September 30,
-----------------------
2004 2003
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income ................................................................ $ 16,485 $ 7,772
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization .................................... 4,272 4,428
Reserve for inventory obsolescence and bad debt .................. 54 2,041
Loss on disposal of assets ....................................... 264 --
Deferred taxes, net .............................................. 7,660 --
Stock compensation costs ......................................... 1,135 403
Other changes in assets and liabilities:
Decrease in accounts receivable .................................. 19,665 1,823
Decrease (increase) in inventory ................................. 43 (363)
Decrease (increase) in unbilled costs ............................ 1,599 (1,106)
(Increase) in deferred training .................................. (13) (596)
(Increase) decrease in other current assets ...................... (457) 15,807
Decrease in other long-term assets ............................... 68 140
(Decrease) in accounts payable ................................... (5,779) (209)
(Decrease) in accrued returns .................................... (18,208) (5,733)
(Decrease) increase in accrued liabilities ....................... (3,471) 7,760
(Decrease) in restructuring liability ............................ (423) (4,225)
Increase (decrease) in unearned contract revenue ................. 3,392 (800)
(Increase) decrease in income taxes and other accrued expenses ... (1,593) 1,473
-------- --------
Net cash provided by operating activities ................................. 24,693 28,615
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES
(Purchases) sales of short-term investments ......................... (27,665) 4,279
Cash paid for acquisition, including closing costs .................. (28,394) --
Purchase of property and equipment .................................. (7,774) (1,482)
-------- --------
Net cash (used in) provided by investing activities ....................... (63,833) 2,797
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES
Net proceeds from exercise of stock options ......................... 3,136 886
-------- --------
Net cash provided by financing activities ................................. 3,136 886
-------- --------
Net (decrease) increase in cash and cash equivalents ...................... (36,004) 32,298
Cash and cash equivalents - beginning ..................................... 113,288 66,827
-------- --------
Cash and cash equivalents - ending ........................................ $ 77,284 $ 99,125
======== ========
The accompanying notes are an integral part
of these financial statements
5
PDI, INC.
NOTES TO INTERIM FINANCIAL STATEMENTS - CONTINUED
(UNAUDITED)
1. BASIS OF PRESENTATION
The accompanying unaudited interim consolidated financial statements and
related notes should be read in conjunction with the consolidated financial
statements of PDI, Inc. and its subsidiaries (the "Company" or "PDI") and
related notes as included in the Company's Amended Annual Report on Form 10-K/A
for the year ended December 31, 2003 as filed with the Securities and Exchange
Commission. The unaudited interim consolidated financial statements of the
Company have been prepared in accordance with generally accepted accounting
principles (GAAP) for interim financial reporting and the instructions to Form
10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of
the information and footnotes required by GAAP for complete financial
statements. The unaudited interim consolidated financial statements include all
adjustments (consisting of normal recurring adjustments) which, in the judgment
of management, are necessary for a fair presentation of such financial
statements. Operating results for the three month and nine month periods ended
September 30, 2004 are not necessarily indicative of the results that may be
expected for the year ending December 31, 2004. Certain prior period amounts
have been reclassified to conform with the current presentation with no effect
on financial position, net income or cash flows.
1B. RESTATEMENT OF CONSOLIDATED FINANCIAL STATEMENTS
We have restated our previously issued consolidated financial statements
for the three and nine months ended September 30, 2003 (the previously issued
financial statements) to apply the provisions of EITF 01-14, "Income Statement
Characterization of Reimbursement Received for `Out-of-Pocket' Expenses
Incurred". (EITF 01-14) In September 2004, the Company became aware that it
should have been applying EITF 01-04 to the previously issued financial
statements. In accordance with EITF 01-14, direct reimbursements received by us
from our clients for certain costs incurred should have been included as part of
revenue with an identical increase to cost of goods and services, rather than
being netted against cost of goods and services. Revenue and cost of goods and
services in the previously issued financial statements were increased by $8.3
million for the quarter ended September 30, 2003, and $20.2 million for the nine
months ended September 30, 2003. EITF 01-14, which was issued in late 2001, was
applicable for years beginning in 2002, and also required reclassification of
all previous periods for comparative purposes.
This restatement does not affect previously reported gross profit,
operating income, net income, cash flows from operations or earnings per share.
Additionally, there is no effect on the consolidated balance sheets,
consolidated statements of cash flows or consolidated statements of
stockholders' equity for the previously issued financial statements. A summary
of the effects of the restatement to reclassify these amounts is as follows:
QUARTER ENDED NINE MONTHS ENDED
30-SEP-03 30-SEP-03
---------------------- ----------------------
AS AS
PREVIOUSLY AS PREVIOUSLY AS
REPORTED RESTATED REPORTED RESTATED
---------- -------- ---------- --------
CONSOLIDATED STATEMENTS
OF OPERATIONS:
Service revenue $86,200 $94,470 $224,888 $245,112
Product revenue 81 81 197 197
------- ------- -------- --------
TOTAL REVENUE 86,281 94,551 225,085 245,309
------- ------- -------- --------
Program expenses 61,815 70,085 162,004 182,228
Cost of goods sold 952 952 1,097 1,097
------- ------- -------- --------
TOTAL COST OF GOODS
AND SERVICES 62,767 71,037 163,101 183,325
------- ------- -------- --------
GROSS PROFIT $23,514 $23,514 $ 61,984 $ 61,984
------- ------- -------- --------
6
PDI, INC.
NOTES TO INTERIM FINANCIAL STATEMENTS - CONTINUED
(UNAUDITED)
2. REVENUE RECOGNITION
The paragraphs that follow describe the guidelines that the Company
adheres to in accordance with GAAP when recognizing revenue and cost of goods
and services in financial statements. In accordance with GAAP, service revenue
and product revenue and their respective direct costs have been shown separately
on the consolidated statements of operations.
Historically, the Company has derived a significant portion of its service
revenue from a limited number of clients. Concentration of business in the
pharmaceutical services industry is common and the industry continues to
consolidate. As a result, the Company is likely to continue to experience
significant client concentration in future periods. For the three months ended
September 30, 2004, and 2003 the Company's three largest clients who each
individually represented 10% or more of its service revenue, accounted for
approximately, in the aggregate, 74.4%, and 72.4%, respectively, of the
Company's service revenue. For the nine months ended September 30, 2004, and
2003 the Company's two largest clients who each accounted for 10% or more of its
service revenue totaled, in the aggregate, 64.9%, and 67.0%, respectively, of
the Company's service revenue.
Service Revenue and Program Expenses
------------------------------------
Service revenue is earned primarily by performing product detailing
programs and other marketing and promotional services under contracts. Revenue
is recognized as the services are performed and the right to receive payment for
the services is assured. Revenue is recognized net of any potential penalties
until the performance criteria relating to the penalties have been achieved.
Performance incentives, as well as termination payments, are recognized as
revenue in the period earned and when payment of the bonus, incentive or other
payment is assured. Under performance based contracts, revenue is recognized
when the performance based parameters are achieved.
Program expenses consist primarily of the costs associated with executing
product detailing programs, performance based contracts or other sales and
marketing services identified in the contract. Program expenses include
personnel costs and other costs associated with executing a product detailing or
other marketing or promotional program, as well as the initial direct costs
associated with staffing a product detailing program. Such costs include, but
are not limited to, facility rental fees, honoraria and travel expenses, sample
expenses and other promotional expenses. Personnel costs, which constitute the
largest portion of program expenses, include all labor related costs, such as
salaries, bonuses, fringe benefits and payroll taxes for the sales
representatives and sales managers and professional staff who are directly
responsible for executing a particular program. Initial direct program costs are
those costs associated with initiating a product detailing program, such as
recruiting, hiring, and training the sales representatives who staff a
particular product detailing program. All personnel costs and initial direct
program costs, other than training costs, are expensed as incurred for service
offerings. Product detailing, marketing and promotional expenses related to the
detailing of products the Company distributes are recorded as a selling expense
and are included in other selling, general and administrative expenses in the
consolidated statements of operations.
7
PDI, INC.
NOTES TO INTERIM FINANCIAL STATEMENTS - CONTINUED
(UNAUDITED)
Reimbursable Out-of-pocket Expenses
-----------------------------------
Reimbursable out-of-pocket expenses include those relating to out-of
pocket expenses and other similar costs, for which we are reimbursed at cost
from our clients. In accordance with EITF 01-14 reimbursements received for
out-of-pocket expenses incurred are characterized as revenue and an identical
amount is included as cost of goods and services in the consolidated statements
of operations. Out-of-pocket expenses for the three and nine month periods ended
September 30, 2004 were $5.4 million and $18.0 million, respectively.
Out-of-pocket expenses for the three and nine month periods ended September 30,
2003 were $8.3 million and $20.2 million, respectively.
Training and Other Initial Direct Costs
---------------------------------------
Training costs include the costs of training the sales representatives and
managers on a particular product detailing program so that they are qualified to
properly perform the services specified in the related contract. For all
contracts, training costs are deferred and amortized on a straight-line basis
over the shorter of the life of the contract to which they relate or 12 months.
When the Company receives a specific contract payment from a client upon
commencement of a product detailing program expressly to compensate the Company
for recruiting, hiring and training services associated with staffing that
program, such payment is deferred and recognized as revenue in the same period
that the recruiting and hiring expenses are incurred and amortization of the
deferred training is expensed. When the Company does not receive a specific
contract payment for training, all revenue is deferred and recognized over the
life of the contract.
Product Revenue and Cost of Goods Sold
--------------------------------------
Product revenue is recognized when products are shipped and title is
transferred to the customer. Product revenue for the three and nine month
periods ended September 30, 2004 was negative, primarily from the adjustment to
the Ceftin returns reserve, as discussed in Note 5 to the consolidated financial
statements, net of the sale of the Xylos wound care products. Product revenue of
$81,000 and $197,000 for the three and nine month periods ended September 30,
2003 was primarily from the sale of the Xylos wound care products.
Cost of goods sold includes all expenses for product distribution costs,
acquisition and manufacturing costs of the product sold.
3. ACQUISITION
On August 31, 2004, the Company acquired substantially all of the assets
of Pharmakon, L.L.C. ("Pharmakon") in a transaction treated as an asset
acquisition for tax purposes. The acquisition has been accounted for as a
purchase, subject to the provisions of Statement of Financial Accounting
Standards (SFAS) 141. The Company made payments to the members of Pharmakon at
closing of $27.4 million, and assumed approximately $2.6 million in net
liabilities. Additional payments of approximately $1.0 million were made as a
result of closing costs. Additionally, the members of Pharmakon can still earn
up to an additional $10 million in cash based upon achievement of certain annual
profit targets through December 2006. These payments, if made, would be added to
goodwill. In connection with this transaction, the Company has recorded $29.5
million in goodwill and other identifiable intangibles, which consists of $10.6
million in goodwill and $18.9 million in other identifiable intangible assets.
Pharmakon is a healthcare communications company focused on the marketing
of ethical pharmaceutical and biotechnology products. A primary reason for the
acquisition of Pharmakon was the advancement of the Company's goal to expand its
presence in the growing and heavily outsourced medical education market.
Pharmakon's emphasis is on the creation, design and implementation of
interactive peer persuasion programs. The successful integration of Pharmakon
and PDI will result in both companies leveraging their account relationships and
successfully cross selling their services.
8
PDI, INC.
NOTES TO INTERIM FINANCIAL STATEMENTS - CONTINUED
(UNAUDITED)
The following unaudited pro forma consolidated results of operations for
the nine-month periods ended September 30, 2004 and 2003 assume that the Company
and Pharmakon had been combined as of the beginning of the periods presented.
The pro forma results include estimates and assumptions which management
believes are reasonable. However, pro forma results are not necessarily
indicative of the results that would have occurred if the acquisition had been
consummated as of the dates indicated, nor are they necessarily indicative of
future operating results.
Nine Months Ended
September 30,
-------------------------
2004 2003
--------- ---------
(in thousands, except for per share data)
Revenue $ 289,765 $ 256,761
========= =========
Net income $ 18,622 $ 9,174
========= =========
Earnings per share $ 1.25 $ 0.64
========= =========
4. STOCK-BASED COMPENSATION
In June 2004, the Company adopted the PDI, Inc. 2004 Stock Award and
Incentive Plan (the 2004 Plan), which was approved by the Company's board of
directors in March 2004 and approved by the Company's Stockholders in June 2004.
The 2004 Plan supplements the Company's 2000 Omnibus Incentive Compensation Plan
and 1998 Stock Option Plan (the Preexisting Plans), reserving 2,896,868 shares
for options, restricted stock and a variety of other types of awards. The 2004
Plan authorizes a broad range of awards, including stock options, stock
appreciation rights, restricted stock, deferred stock, other awards based on
common stock, dividend equivalents, stock-based performance awards, cash-based
performance awards, shares issuable in lieu of rights to cash compensation and
discounted options pursuant to an employee stock purchase program. No new awards
will be authorized for grant under the Preexisting Plans, but previously
authorized awards under those plans will remain in effect. SFAS No. 123,
"ACCOUNTING FOR STOCK-BASED COMPENSATION" allows companies a choice of measuring
employee stock-based compensation expense based on either the fair value method
of accounting or the intrinsic value approach under the Accounting Pronouncement
Board (APB) Opinion No. 25. The Company accounts for these plans under the
recognition and measurement principles of APB Opinion No. 25, "ACCOUNTING FOR
STOCK ISSUED TO EMPLOYEES, AND RELATED INTERPRETATIONS." No stock option-based
employee compensation cost is reflected in net income, as all options granted
under those plans had an exercise price equal to the market value of the
underlying common stock on the date of the grant. Certain employees have
received restricted common stock, the amortization of which is reflected in net
income and was $291,000 and $856,000 for the three and nine month periods ended
September 30, 2004. Additionally, during the first quarter of 2004, the Company
accelerated the vesting of stock option grants and restricted stock grants for
certain employees which resulted in total compensation of approximately $275,000
in the quarter ended March 31, 2004. As required by SFAS No. 148, "ACCOUNTING
FOR STOCK-BASED COMPENSATION - TRANSITION AND DISCLOSURE - AN AMENDMENT OF SFAS
NO. 123", the following table shows the estimated effect on earnings and per
share data as if the Company had applied the fair value recognition provisions
of SFAS No. 123 to stock-based employee compensation.
9
PDI, INC.
NOTES TO INTERIM FINANCIAL STATEMENTS - CONTINUED
(UNAUDITED)
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
--------- --------- --------- ---------
(in thousands, except per share data)
Net income, as reported $ 5,467 $ 4,182 $ 16,485 $ 7,772
Add: Stock-based employee compensation
expense included in reported net income, net
of related tax effects 172 82 667 294
Deduct: Total stock-based employee
compensation expense determined under fair
value based methods for all awards, net of
related tax effects (988) (1,666) (3,053) (4,800)
--------- --------- --------- ---------
Pro forma net income $ 4,651 $ 2,598 $ 14,099 $ 3,266
========= ========= ========= =========
Net income per share
Basic--as reported $ 0.37 $ 0.29 $ 1.13 $ 0.55
========= ========= ========= =========
Basic--pro forma $ 0.32 $ 0.18 $ 0.97 $ 0.23
========= ========= ========= =========
Diluted--as reported $ 0.37 $ 0.29 $ 1.11 $ 0.54
========= ========= ========= =========
Diluted--pro forma $ 0.31 $ 0.18 $ 0.95 $ 0.23
========= ========= ========= =========
Compensation cost for the determination of pro forma net income - as
adjusted and related per share amounts were estimated using the Black Scholes
option pricing model, with the following assumptions: (i) risk free interest
rate of 3.40% and 2.85% at September 30, 2004 and 2003, respectively; (ii)
expected life of five years for the three and nine month periods ended September
30, 2004 and 2003; (iii) expected dividends - $0 for the three and nine month
periods ended September 30, 2004 and 2003; and (iv) volatility of 100% for the
three and nine months periods ended September 30, 2004 and 2003. The weighted
average fair value of options granted during the three and nine month periods
ended September 30, 2004 was $20.99 and $19.27, respectively and for the three
and nine month periods ended September 30, 2003 were $12.94 and $11.23,
respectively.
In March 2003, the Company initiated an option exchange program pursuant
to which eligible employees, which excluded certain members of senior
management, were offered an opportunity to exchange an aggregate of 357,885
outstanding stock options with exercise prices of $30.00 and above for either
cash or shares of restricted stock, depending upon the number of options held by
an eligible employee. The offer exchange period expired on May 12, 2003.
Approximately 310,403 shares of common stock underlying eligible options were
tendered by eligible employees and accepted by the Company. This number
represented approximately 87% of the total shares of common stock underlying
eligible options. A total of approximately 120 eligible participants elected to
exchange an aggregate of approximately 59,870 shares of common stock under
eligible options and received cash in the aggregate amount of approximately
$67,000 (which amount includes applicable withholding taxes). A total of
approximately 145 eligible participants elected to exchange an aggregate of
approximately 250,533 shares of common stock underlying eligible options in
exchange for an aggregate of approximately 49,850 shares of restricted stock.
All tendered options were canceled and became eligible for re-issuance under the
Company's option plans. The restricted stock is subject to three-year cliff
vesting and is subject to forfeiture upon termination of employment other than
in the event of the recipient's death or disability.
10
PDI, INC.
NOTES TO INTERIM FINANCIAL STATEMENTS - CONTINUED
(UNAUDITED)
Approximately 47,483 options, which were offered to, but did not
participate in, the option exchange program, are subject to variable accounting.
As such, the Company may record compensation expense if the market price of the
Company's common stock exceeds the exercise price of the non-tendered options
until these options are terminated, exercised or forfeited. To date, this has
not occurred. The non-tendered options have exercise prices ranging from $59.50
to $80.00 and a remaining life of 6.0 to 6.3 years.
5. CEFTIN CONTRACT TERMINATION
In October 2000, the Company entered into an agreement (the Ceftin
Agreement) with GlaxoSmithKline (GSK) for the exclusive U.S. sales, marketing
and distribution rights for Ceftin(R) Tablets and Ceftin(R) for Oral Suspension,
two dosage forms of a cephalosporin antibiotic, which agreement was terminated
in February 2002 by mutual agreement of the parties. The Ceftin Agreement had a
five-year term but was cancelable by either party without cause on 120 days'
notice. From October 2000 through February 2002, the Company marketed Ceftin to
physicians and sold the products primarily to wholesale drug distributors,
retail chains and managed care providers.
On August 21, 2001, the U.S. Court of Appeals overturned a preliminary
injunction granted by the New Jersey District Court to GSK, which subsequently
allowed for the entry of a generic competitor to Ceftin immediately upon
approval by the FDA. The affected Ceftin patent had previously been scheduled to
run through July 2003. The generic version of Ceftin was approved by the FDA in
February 2002 and it began to be manufactured in late March 2002. As a result of
this U.S. Court of Appeals decision and its impact on future sales, in the third
quarter of 2001 the Company recorded a charge to cost of goods sold and a
related reserve of $24.0 million representing the anticipated future loss to be
incurred by the Company under the Ceftin Agreement as of September 30, 2001. The
recorded loss was calculated as the excess of estimated costs that the Company
was contractually obligated to incur to complete its obligations under the
Ceftin Agreement, over the remaining estimated gross profits to be earned under
the Ceftin Agreement from selling the inventory. These costs primarily consisted
of amounts paid to GSK to reduce purchase commitments, estimated committed sales
force expenses, selling and marketing costs through the effective date of the
termination, distribution costs, and fees to terminate existing arrangements.
The Ceftin Agreement was terminated by the Company and GSK under a mutual
termination agreement entered into in December 2001. GSK resumed exclusive
rights to Ceftin after the effective date of the termination of the Ceftin
Agreement, and the Company believes that GSK currently sells Ceftin under its
own label code.
Pursuant to the termination agreement, the Company agreed to perform
marketing and distribution services through February 28, 2002. As is common in
the pharmaceutical industry, customers who purchased the Company's Ceftin
product are permitted to return unused product, after approval from the Company,
up to six months before and one year after the expiration date for the product,
but no later than December 31, 2004. The products sold by the Company prior to
the Ceftin Agreement termination date of February 28, 2002 have expiration dates
through June 2004. The Company also maintains responsibility for processing and
payment of certain sales rebates through December 31, 2004. The Company's Ceftin
sales aggregated approximately $628 million during the term of the Ceftin
Agreement.
As of December 31, 2002, the Company had accrued reserves of
approximately $16.5 million related to Ceftin sales. Of this accrual, $11.0
million related to return reserves and $5.5 million related to sales rebates
accruals. On an ongoing basis, the Company assesses its reserve for product
returns by: analyzing historical sales and return patterns; monitoring
prescription data for branded Ceftin; monitoring inventory withdrawals by the
wholesalers and retailers for branded Ceftin; inquiring about inventory levels
and potential product returns with the wholesaler companies; and estimating
demand for the product. During the third quarter of 2003, the Company made a
$5.5 million payment to settle its estimated remaining sales
11
PDI, INC.
NOTES TO INTERIM FINANCIAL STATEMENTS - CONTINUED
(UNAUDITED)
rebate liabilities, and concluded based on its returns reserve review process,
which included a review of prescription and withdrawal data for branded Ceftin
as well as information communicated to the Company by the wholesalers, that the
remaining $11.0 million reserve for returns was adequate as of September 30,
2003.
In the fourth quarter of 2003, the Company determined, based primarily
upon new information obtained from its wholesalers as part of its ongoing
reserve review process, that significant amounts of inventory, incremental to
that previously reported by the wholesalers, were being held by them in
inventory. The Company believed that this resulted, in part, from the sale by
the wholesalers of Ceftin product not supplied by the Company and acquired by
the wholesalers subsequent to the mutual termination of the Ceftin agreement.
Based upon that information, the Company increased its returns reserve $12.0
million to a total reserve of $22.8 million in the fourth quarter of 2003.
On March 31, 2004, the Company signed an agreement and waiver with a large
wholesaler by which the Company agreed to pay that wholesaler $10.0 million, and
purchase $2.5 million worth of services from that wholesaler by March 31, 2006,
in exchange for that wholesaler waiving, to the fullest extent permitted by law,
all rights with respect to any additional returns of Ceftin to the Company. The
Company made the payment on April 5, 2004. In the second quarter of 2004 the
Company increased its return reserve by approximately $1.2 million based
primarily upon new information obtained from the wholesalers as part of the
Company's ongoing reserve review process.
The Company's reserve of $4.6 million at September 30, 2004 reflects the
Company's estimated liability for all identified product that could potentially
be returned by all the remaining wholesalers, and an estimate of the Company's
liability with respect to remaining, but not yet identified, product sold by the
Company that is still being held in the trade. The reserve has been calculated
based on, with respect to certain wholesalers, reimbursing the wholesalers at
the amount that they purchased the product from the Company. The reserve as
recorded by the Company is its best estimate based on its understanding of its
obligations. The reserve also includes a liability of $2.5 million for services
to be purchased by the Company from a large wholesaler which the Company was
able to negotiate in lieu of cash payments as described above. The Company will
continue to assess the adequacy of its reserves until the Company's obligations
for processing any returned products ceases on December 31, 2004.
6. OTHER PERFORMANCE BASED CONTRACTS
In May 2001, the Company entered into a copromotion agreement with
Novartis Pharmaceuticals Corporation (Novartis) for the U.S. sales, marketing
and promotion rights for Lotensin(R), Lotensin HCT(R) and Lotrel(R). That
agreement was scheduled to run through December 31, 2003. On May 20, 2002, this
agreement was replaced by two separate agreements, one for Lotensin and one for
Lotrel-Diovan through the addition of Diovan(R) and Diovan HCT(R). Both of these
agreements were scheduled to end December 31, 2003; however, the Lotrel-Diovan
agreement was renewed on December 24, 2003 for an additional one year period. In
February 2004, the Company was notified by Novartis of its intent to terminate
the Lotrel-Diovan agreement, without cause, effective March 16, 2004 and, as a
result, $28.9 million of anticipated revenue associated with the Lotrel-Diovan
agreement in 2004 will not be realized. The Company was compensated under the
terms of the agreement through the effective termination date. Even though the
Lotensin agreement ended December 31, 2003, the Company is still entitled to
receive royalty payments on the sales of Lotensin through December 31, 2004. The
royalties earned under this arrangement for the three and nine month periods
ended September 30, 2004 were approximately $441,000 and $3.4 million,
respectively; the royalties earned during the remainder of 2004 are expected to
diminish because the product lost its patent protection in February 2004.
In October 2002, the Company entered into an agreement with Xylos
Corporation (Xylos) for the
12
PDI, INC.
NOTES TO INTERIM FINANCIAL STATEMENTS - CONTINUED
(UNAUDITED)
exclusive U.S. commercialization rights to the Xylos XCell(TM) Cellulose Wound
Dressing (XCell) wound care products. The Company began selling the Xylos
products in January 2003; however, sales were significantly slower than
anticipated and actual 2003 sales did not meet the Company's forecasts. The
Company did have the right to terminate the agreement with 135 days' notice to
Xylos, beginning January 1, 2004. Based on these sales results, the Company
concluded that sales of XCell were not sufficient enough to sustain the
Company's continued role as commercialization partner for the product and
therefore, on January 2, 2004, the Company exercised its contractual right to
terminate the agreement on 135 days' notice to Xylos. The Company accepted
orders for XCell products through May 16, 2004 when the agreement terminated;
however, the Company's promotional activities in support of the brand concluded
in January 2004. The Company recorded a reserve for potential excess inventory
during 2003 of approximately $835,000. As discussed in Note 7, the Company
continues to have an investment in Xylos. In addition, in February 2004, the
Company entered into a term loan agreement with Xylos, pursuant to which it made
loans to Xylos in an aggregate amount of $500,000; $375,000 was disbursed in the
quarter ended March 31, 2004 and the remaining $125,000 was disbursed in April
2004. Pursuant to the terms of the agreement, the loans are due to be repaid on
June 30, 2005.
On December 31, 2002, the Company entered into a licensing agreement with
Cellegy Pharmaceuticals, Inc. (Cellegy) for the exclusive North American rights
for Fortigel(TM), a testosterone gel product. The agreement is in effect for the
commercial life of the product. Cellegy submitted a New Drug Application (NDA)
for the hypogonadism indication to the U.S. Food and Drug Administration (FDA)
in June 2002. In July 2003, Cellegy received a letter from the FDA rejecting its
NDA for Fortigel. Cellegy has told the Company that it is in discussions with
the FDA to determine the appropriate course of action needed to meet
deficiencies cited by the FDA in its determination. Under the terms of the
agreement, the Company paid Cellegy a $15.0 million initial licensing fee on
December 31, 2002. Under the terms of the licensing agreement, if it should be
enforced (see discussion of the lawsuit below), this nonrefundable payment was
made prior to FDA approval and, since there is no alternative future use of the
licensed rights, the $15.0 million payment was expensed by the Company in
December 2002, when incurred. This amount was recorded in other selling,
general, and administrative expenses in the December 31, 2002 consolidated
statements of operations. Pursuant to the terms of the licensing agreement, if
it should be enforced (see discussion of lawsuit below), the Company will be
required to pay Cellegy a $10.0 million incremental license fee milestone
payment upon Fortigel's receipt of all approvals required by the FDA (if such
approvals are obtained) to promote, sell and distribute the product in the U.S.
This incremental milestone license fee, if incurred, will be recorded as an
intangible asset and amortized over its estimated useful life, as then
determined, which is not expected to exceed the life of the patent. The Company
believes that it will not be required to pay Cellegy the $10.0 million
incremental license fee milestone payment in 2004, and it is unclear at this
point when or if Cellegy will get Fortigel approved by the FDA which would
trigger the Company's obligation to pay $10.0 million to Cellegy. Royalty
payments to Cellegy over the term of the commercial life of the product would
range from 20% to 30% of net sales. As discussed in Note 13, the Company filed a
complaint against Cellegy in December 2003, that alleges, among other things,
that Cellegy fraudulently induced the Company to enter into the licensing
agreement, and seeks the return of the $15.0 million initial licensing fee, plus
additional damages caused by Cellegy's conduct. Since the Company filed the
lawsuit, Cellegy is no longer in regular contact with the Company regarding
Fortigel. Thus, for example, the Company has been informed that Cellegy is in
continuing contact with the FDA but the Company is unaware of the precise FDA
status regarding Fortigel (as of June 30, 2004, it had not been approved).
Accordingly, the Company may not possess the most current and reliable
information concerning the current status of, or future prospects relating to
Fortigel. The issuance of the non-approvable letter by the FDA concerning
Fortigel, however, casts significant doubt upon Fortigel's prospects and whether
it will ever be approved. The Company cannot predict with any certainty whether
the FDA will ultimately approve Fortigel for sale in the U.S.
As discussed in Note 13, in May 2003, the Company settled a lawsuit with
Auxilium
13
PDI, INC.
NOTES TO INTERIM FINANCIAL STATEMENTS - CONTINUED
(UNAUDITED)
Pharmaceuticals, Inc. which sought to enjoin its performance under the Cellegy
agreement.
7. OTHER INVESTMENTS
In October 2002, the Company acquired $1.0 million of preferred stock of
Xylos. The Company recorded its investment in Xylos under the cost method and
its ownership interest in Xylos is less than five percent. As discussed in Note
6, the Company served in 2003 as the exclusive distributor of the Xylos XCell
product line, but on January 2, 2004, the Company terminated that arrangement
effective May 16, 2004. In addition, in February 2004, the Company entered into
a term loan agreement with Xylos, pursuant to which it has made loans to Xylos
in an aggregate amount of $500,000; $375,000 was disbursed in the quarter ended
March 31, 2004 and the remaining $125,000 was disbursed in April 2004. Pursuant
to the terms of the agreement, the loans are due to be repaid on June 30, 2005.
Although Xylos recognized operating losses in 2003 and through the first nine
months of 2004, the Company continues to believe that, based on current
prospects and activities at Xylos, its investment in Xylos is not impaired and
the amounts loaned are recoverable as of September 30, 2004. However, if Xylos
continues to experience losses and is not able to generate sufficient cash flows
through financing, the Company may not recover its loans and its investment may
become impaired.
In May 2004, the Company entered into a loan agreement with TMX
Interactive, Inc. (TMX), a provider of sales force effectiveness technology.
Pursuant to the loan agreement, the Company provided TMX with a term loan
facility of $500,000 and a convertible loan facility of $500,000, each of which
are due to be repaid on November 26, 2005. In connection with the convertible
loan facility, the Company has the right to convert all, or, in multiples of
$100,000, any part of the convertible note into common stock of TMX.
8. INVENTORY
At September 30, 2004 the Company no longer has any finished goods
inventory relating to the XCell wound care products. At December 31, 2003, the
Company had approximately $43,000 in finished goods inventory, net of reserves.
In the third quarter of 2003, as a result of the continued lower than
anticipated Xylos product sales, management recorded a reserve of $835,000 to
reduce the value of the XCell inventory to its estimated net realizable value.
As discussed in Note 6, on January 2, 2004 the Company gave notice of
termination of its agreement with Xylos, effective May 16, 2004. As of September
30, 2004 all remaining inventory had been destroyed.
9. NEW ACCOUNTING PRONOUNCEMENTS
In January 2003, the FASB issued Interpretation No. 46, "CONSOLIDATION OF
VARIABLE INTEREST ENTITIES" (FIN 46). FIN 46 requires a variable interest entity
(VIE) to be consolidated by a company, if that company is subject to a majority
of the risk of loss from the VIE's activities or entitled to receive a majority
of the entity's residual returns or both. In December 2003, the FASB issued a
revision to the FIN 46 (FIN46R) which partially delayed the effective date of
the interpretation to March 31, 2004 and added additional scope exceptions. The
adoption of FIN46 and FIN46R did not have a material impact on the Company's
business, financial condition and results of operations.
In December 2003, the Staff of the Securities and Exchange Commission
issued Staff Accounting Bulletin No. 104 (SAB 104), "REVENUE RECOGNITION," which
supercedes SAB 101, "REVENUE RECOGNITION
14
PDI, INC.
NOTES TO INTERIM FINANCIAL STATEMENTS - CONTINUED
(UNAUDITED)
IN FINANCIAL STATEMENTS." SAB 104's primary purpose is to rescind accounting
guidance contained in SAB 101 related to multiple element revenue arrangements,
superceded as a result of the issuance of EITF 00-21, "ACCOUNTING FOR REVENUE
ARRANGEMENTS WITH MULTIPLE DELIVERABLES." Additionally, SAB 104 rescinds the
SEC's "REVENUE RECOGNITION IN FINANCIAL STATEMENTS FREQUENTLY ASKED QUESTIONS
AND ANSWERS" (the FAQ) issued with SAB 101 that had been codified in SEC Topic
13, "REVENUE RECOGNITION." The revenue recognition principles provided for in
both SAB 101 and EITF 00-21 remain largely unchanged. As a result, the adoption
of SAB 104 did not have a material impact on the Company's business, financial
condition and results of operations.
On March 31, 2004, the FASB issued an Exposure Draft, "Share-Based Payment
- - An Amendment of FASB Statements No. 123 and 95" (proposed FAS 123R), which
currently is expected to be effective for public companies in periods beginning
after June 15, 2005. We would be required to implement the proposed standard no
later than the quarter that begins July 1, 2005. The cumulative effect of
adoption, if any, applied on a modified prospective basis, would be measured and
recognized on July 1, 2005. The proposed FAS 123R addresses the accounting for
transactions in which an enterprise receives employee services in exchange for
(a) equity instruments of the enterprise or (b) liabilities that are based on
the fair value of the enterprise's equity instruments or that may be settled by
the issuance of such equity instruments. The proposed FAS 123R would eliminate
the ability to account for share-based compensation transactions using APB 25,
and generally would require instead that such transactions be accounted for
using a fair-value based method. As proposed, companies would be required to
recognize an expense for compensation cost related to share-based payment
arrangements including stock options and employee stock purchase plans. The FASB
expects to issue a final standard by December 31, 2004. We are currently
evaluating option valuation methodologies and assumptions in light of the
proposed FAS 123R related to employee stock options. Current estimates of option
values using the Black-Scholes method (as shown above) may not be indicative of
results from valuation methodologies ultimately adopted in the final rules.
10. HISTORICAL AND PRO FORMA BASIC AND DILUTED NET INCOME PER SHARE
Historical and pro forma basic and diluted net income per share is
calculated based on the requirements of SFAS No. 128, "EARNINGS PER SHARE." A
reconciliation of the number of shares used in the calculation of basic and
diluted earnings per share for the periods ended September 30, 2004 and 2003 is
as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
------------------ -----------------
2004 2003 2004 2003
------ ------ ------ ------
(in thousands)
Basic weighted average number
of common shares outstanding ...... 14,621 14,252 14,538 14,202
Dilutive effect of stock options and
restricted stock .................. 312 291 335 147
------ ------ ------ ------
Diluted weighted average number
of common shares outstanding ...... 14,933 14,543 14,873 14,349
====== ====== ====== ======
Outstanding options at September 30, 2004 to purchase 412,268 shares of
common stock with exercise prices ranging from $27.00 to $93.75 were not
included in the computation of historical and pro forma diluted net income per
share because to do so would have been antidilutive. Outstanding options at
September 30, 2003 to purchase 447,174 shares of common stock with exercise
prices ranging from
15
PDI, INC.
NOTES TO INTERIM FINANCIAL STATEMENTS - CONTINUED
(UNAUDITED)
$21.10 to $93.75 were not included in the computation of historical and pro
forma diluted net income per share because to do so would have been
antidilutive.
11. SHORT-TERM INVESTMENTS
At September 30, 2004, short-term investments were $29.0 million,
including approximately $1.5 million of investments classified as available for
sale securities. At September 30, 2003, short-term investments were $1.7
million, including approximately $1.2 million of investments classified as
available for sale securities. The unrealized after-tax gain/(loss) on the
available for sale securities is included as a separate component of
stockholders' equity as accumulated other comprehensive income. All other
short-term investments are stated at cost, which approximates fair value.
12. OTHER COMPREHENSIVE INCOME
A reconciliation of net income as reported in the Consolidated Statements
of Operations to Other comprehensive income, net of taxes is presented in the
table below.
Three Months Ended Nine Months Ended
September 30, September 30,
------------------ -----------------
2004 2003 2004 2003
------ ------ ------ ------
(thousands)
Net income $ 5,467 $ 4,182 $16,485 $ 7,772
Other comprehensive income, net of tax:
Unrealized holding gain on
available-for-sale securities
arising during the period (10) 16 1 106
Reclassification adjustment for
losses included in net income -- 3 21 37
------- ------- ------- -------
Other comprehensive income $ 5,457 $ 4,201 $16,507 $ 7,915
======= ======= ======= =======
13. COMMITMENTS AND CONTINGENCIES
Due to the nature of the business in which the Company is engaged, such as
product detailing and distribution of products, it could be exposed to certain
risks. Such risks include, among others, risk of liability for personal injury
or death to persons using products the Company promotes or distributes. There
can be no assurance that substantial claims or liabilities will not arise in the
future because of the nature of the Company's business activities and recent
increases in litigation related to healthcare products, including
pharmaceuticals, increases this risk. The Company seeks to reduce its potential
liability under its service agreements through measures such as contractual
indemnification provisions with clients (the scope of which may vary from client
to client, and the performances of which are not secured) and insurance. The
Company could, however, also be held liable for errors and omissions of its
employees in connection with the services it performs that are outside the scope
of any indemnity or insurance policy. The Company could be materially adversely
affected if it was required to pay damages or incur defense costs in connection
with a claim that is outside the scope of an indemnification agreement; if the
indemnity, although applicable, is not performed in accordance with its terms;
or if the Company's liability exceeds the amount of applicable insurance or
indemnity.
16
PDI, INC.
NOTES TO INTERIM FINANCIAL STATEMENTS - CONTINUED
(UNAUDITED)
SECURITIES LITIGATION
In January and February 2002, the Company, its chief executive officer and
its chief financial officer were served with three complaints that were filed in
the United States District Court for the District of New Jersey alleging
violations of the Securities Exchange Act of 1934 (the "Exchange Act"). These
complaints were brought as purported shareholder class actions under Sections
10(b) and 20(a) of the Exchange Act and Rule 10b-5 established thereunder. On
May 23, 2002, the Court consolidated all three lawsuits into a single action
entitled In re PDI Securities Litigation, Master File No. 02-CV-0211, and
appointed lead plaintiffs (Lead Plaintiffs) and Lead Plaintiffs' counsel. On or
about December 13, 2002, Lead Plaintiffs filed a second consolidated and amended
complaint (Second Consolidated and Amended Complaint), which superseded their
earlier complaints.
The complaint names the Company, its chief executive officer and its chief
financial officer as defendants; purports to state claims against the Company on
behalf of all persons who purchased the Company's Common Stock between May 22,
2001 and August 12, 2002; and seeks money damages in unspecified amounts and
litigation expenses including attorneys' and experts' fees. The essence of the
allegations in the Second Consolidated and Amended Complaint is that the Company
intentionally or recklessly made false or misleading public statements and
omissions concerning its financial condition and prospects with respect to its
marketing of Ceftin in connection with the October 2000 distribution agreement
with GSK, its marketing of Lotensin in connection with the May 2001 distribution
agreement with Novartis, as well as its marketing of Evista(R) in connection
with the October 2001 distribution agreement with Eli Lilly and Company.
In February 2003, the Company filed a motion to dismiss the Second
Consolidated and Amended Complaint under the Private Securities Litigation
Reform Act of 1995 and Rules 9(b) and 12(b)(6) of the Federal Rules of Civil
Procedure. That motion is fully submitted to the court for its decision. The
Company believes that the allegations in this purported securities class action
are without merit and intends to defend the action vigorously.
BAYER-BAYCOL LITIGATION
The Company has been named as a defendant in numerous lawsuits, including
two class action matters, alleging claims arising from the use of Baycol(R), a
prescription cholesterol-lowering medication. Baycol was distributed, promoted
and sold by Bayer Corporation (Bayer) in the United States through early August
2001, at which time Bayer voluntarily withdrew Baycol from the United States
market. Bayer retained certain companies, such as the Company, to provide
detailing services on its behalf pursuant to contract sales force agreements.
The Company may be named in additional similar lawsuits. To date, the Company
has defended these actions vigorously and has asserted a contractual right of
indemnification against Bayer for all costs and expenses the Company incurs
relating to these proceedings. In February 2003, the Company entered into a
joint defense and indemnification agreement with Bayer, pursuant to which Bayer
has agreed to assume substantially all of the Company's defense costs in pending
and prospective proceedings and to indemnify the Company in these lawsuits,
subject to certain limited exceptions. Further, Bayer agreed to reimburse the
Company for all reasonable costs and expenses incurred to date in defending
these proceedings. To date, Bayer has reimbursed the Company for approximately
$1.6 million in legal expenses, of which approximately $700,000 was received in
the nine months ended September 30, 2003 and was reflected as a credit within
selling, general and administrative expense. No amounts have been recorded in
2004.
17
PDI, INC.
NOTES TO INTERIM FINANCIAL STATEMENTS - CONTINUED
(UNAUDITED)
AUXILIUM PHARMACEUTICALS LITIGATION
On January 6, 2003, the Company was named as a defendant in a lawsuit
filed by Auxilium Pharmaceuticals, Inc. (Auxilium), in the Pennsylvania Court of
Common Pleas, Montgomery County. Auxilium was seeking monetary damages and
injunctive relief, including preliminary injunctive relief, based on several
claims related to the Company's alleged breaches of a contract sales force
agreement entered into by the parties on November 20, 2002, and claims that the
Company was misappropriating trade secrets in connection with its exclusive
license agreement with Cellegy.
On May 8, 2003, the Company entered into a settlement and mutual release
agreement with Auxilium (Settlement Agreement), by which the lawsuit and all
related counter claims were dropped without any admission of wrongdoing by
either party. The settlement terms included a cash payment which was paid upon
execution of the Settlement Agreement as well as certain other additional
expenses. The Company recorded a $2.1 million charge in the first quarter of
2003 related to this settlement. Pursuant to the Settlement Agreement, the
Company also agreed that it would (a) not sell, ship, distribute or transfer any
Fortigel product to any wholesalers, chain drug stores, pharmacies or hospitals
prior to November 1, 2003, and (b) pay Auxilium an additional amount per
prescription to be determined based upon a specified formula, in the event any
prescriptions were filled for Fortigel prior to January 26, 2004. As discussed
in Note 6, in July 2003, Cellegy received a letter from the FDA rejecting its
NDA for Fortigel. The Company did not pay any additional amount to Auxilium as
set forth in clause (b) above since Fortigel was not approved by the FDA prior
to January 26, 2004. The Company does not believe that the terms of the
Settlement Agreement will have any impact on the success of its
commercialization of the product if, or when, the FDA approves it.
CELLEGY PHARMACEUTICALS LITIGATION
On December 12, 2003, the Company filed a complaint against Cellegy in the
U.S. District Court for the Southern District of New York. The complaint alleges
that Cellegy fraudulently induced the Company to enter into a December 2002
license agreement with Cellegy regarding Fortigel ("License Agreement"). The
complaint also alleges claims for misrepresentation and breach of contract
related to the License Agreement. In the complaint, the Company seeks, among
other things, rescission of the License Agreement and return of the $15.0
million initial licensing fee it paid Cellegy. After the Company filed this
lawsuit, also on December 12, 2003, Cellegy filed a complaint against the
Company in the U.S. District Court for the Northern District of California.
Cellegy's complaint seeks a declaration that Cellegy did not fraudulently induce
the Company to enter the License Agreement and that Cellegy has not breached its
obligations under the License Agreement. The Company filed an answer to
Cellegy's complaint on June 18, 2004, in which it makes the same allegations and
claims for relief as it does in its New York action, and it also alleges Cellegy
violated California unfair competition law. By order dated April 23, 2004, the
Company's lawsuit was transferred to the Northern District of California where
it may be consolidated with Cellegy's action. The Company is unable to predict
the ultimate outcome of these lawsuits.
OTHER LEGAL PROCEEDINGS
The Company is currently a party to other legal proceedings incidental to
its business. While the Company currently believes that the ultimate outcome of
these proceedings individually, and in the aggregate, will not have a material
adverse effect on its consolidated financial statements, litigation is subject
to inherent uncertainties. Were the Company to settle a proceeding for a
material amount or were an unfavorable ruling to occur, there exists the
possibility of a material adverse effect on the Company's business, financial
condition and results of operations.
18
PDI, INC.
NOTES TO INTERIM FINANCIAL STATEMENTS - CONTINUED
(UNAUDITED)
No material amounts have been accrued for losses under any of the above
mentioned matters, as no amounts are considered probable or reasonably estimable
at this time.
Other than the foregoing, the Company is not currently a defendant in any
material pending litigation and it is not aware of any material threatened
litigation.
14. RESTRUCTURING AND OTHER RELATED EXPENSES
During the third quarter of 2002, the Company adopted a restructuring
plan, the objective of which was to consolidate operations in order to enhance
operating efficiencies (the 2002 Restructuring Plan). This plan was primarily in
response to the general decrease in demand within the Company's markets for the
sales and marketing services segment, and the recognition that the
infrastructure that supported these business units was larger than required. The
Company originally estimated that the restructuring would result in annualized
SG&A savings of approximately $14.0 million, based on the level of SG&A spending
at the time it initiated the restructuring. However, these savings have been
partially offset by incremental SG&A expenses the Company incurred in subsequent
periods as the Company has been successful in expanding its business platforms.
Substantially all of the restructuring activities were completed as of December
31, 2003.
During the quarter ended March 31, 2003, the Company recognized a $270,000
reduction in the restructuring accrual due to negotiating higher sublease
proceeds than originally estimated for the leased facility in Cincinnati, Ohio.
During the quarter ended June 30, 2003 the Company incurred approximately
$133,000 of additional restructuring expense due to higher than expected
contractual termination costs. This additional expense was recorded in program
expenses consistent with the original recording of the restructuring charges.
Also during the quarter ended June 30, 2003 the Company recognized a
$473,000 reduction in the restructuring accrual due to lower than expected sales
force severance costs. Greater success in the reassignment of sales
representatives to other programs and the voluntary departure of other sales
representatives combined to reduce the requirement for severance costs. This
adjustment was recorded in program expenses consistent with the original
recording of the restructuring charges.
The accrual for restructuring and exit costs totaled approximately
$321,000 at September 30, 2004, and is recorded in current liabilities on the
accompanying balance sheet.
A roll forward of the activity for the 2002 Restructuring Plan is as follows:
BALANCE AT BALANCE AT
DECEMBER 31, SEPTEMBER 30,
(IN THOUSANDS) 2003 ADJUSTMENTS PAYMENTS 2004
----------- ----------- -------- ------------
Administrative severance $285 $ -- $(199) $ 86
Exit costs 459 -- (224) 235
---- ----- ----- ----
744 -- (423) 321
---- ----- ----- ----
Sales force severance -- -- -- --
---- ----- ----- ----
TOTAL $744 $ -- $(423) $321
==== ===== ===== ====
15. SEGMENT INFORMATION
Effective in the first quarter of 2004, the Company reorganized its
internal operating units from three reporting segments into two reporting
segments: sales and marketing services group (SMSG) and PDI
19
PDI, INC.
NOTES TO INTERIM FINANCIAL STATEMENTS - CONTINUED
(UNAUDITED)
products group (PPG). These reorganized segments reflect the termination of the
Xylos agreement and the decision to manage the other medical device and
diagnostic (MD&D) units under the Company's existing contract sales structure.
Additionally, the reorganized segments reflect the greater emphasis the Company
intends to place on its services business and away from licensing and acquiring
pharmaceutical and medical device products. As a result of this reorganization,
the MD&D segment was disaggregated and assimilated into the two remaining
segments. The MD&D segment was comprised of the clinical sales unit, MD&D
contract sales unit, and product licensing. The SMSG segment now includes the
Company's clinical sales and MD&D contract sales units; the Company's dedicated
and shared contract sales units; and the Company's marketing research and
medical education and communication services. The businesses within SMSG
recognize revenue predominantly through fee for service contracts. The PPG
contracts are characterized by either significant management effort required
from the Company's product marketing group, or reliance on the attainment of
performance incentives in order to fully cover the Company's costs, or both. The
PPG segment now includes MD&D product offerings in addition to the rest of the
Company's copromotion services. PPG derives revenue through a variety of
agreement types including directly from product sales or based on a formula with
product sales as its basis. The segment information from prior periods has been
restated to conform to the current period's presentation.
Corporate charges are allocated to each of the operating segments on the
basis of total salary costs. Corporate charges include corporate headquarter
costs and certain depreciation expense. Capital expenditures have not been
allocated to the operating segments since it is impracticable to do so.
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------ -------------------------
2004 2003 2004 2003
-------- -------- -------- --------
(in thousands)
Revenue (2003 amounts restated)
Sales and marketing services group $ 92,008 $ 81,322 $274,131 $209,631
PDI products group 514 13,229 2,501 35,677
-------- -------- -------- --------
Total $ 92,522 $ 94,551 $276,632 $245,308
======== ======== ======== ========
Income (loss) from operations, before
corporate allocations
Sales and marketing services group $ 16,825 $ 12,087 $ 50,483 $ 32,999
PDI products group 200 (1,609) (321) (8,870)
Corporate charges (7,990) (3,937) (23,082) (11,983)
-------- -------- -------- --------
Total $ 9,035 $ 6,541 $ 27,080 $ 12,146
======== ======== ======== ========
Corporate allocations
Sales and marketing services group $ (7,964) $ (3,438) $(22,895) $(10,113)
PDI products group (26) (499) (187) (1,870)
Corporate charges 7,990 3,937 23,082 11,983
-------- -------- -------- --------
Total $ -- $ -- $ -- $ --
======== ======== ======== ========
20
PDI, INC.
NOTES TO INTERIM FINANCIAL STATEMENTS - CONTINUED
(UNAUDITED)
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------ -------------------------
2004 2003 2004 2003
-------- -------- -------- --------
(in thousands)
Income (loss) from operations, less
corporate allocations
Sales and marketing services group $ 8,861 $ 8,649 $ 27,588 $ 22,886
Pharmaceutical products group 174 (2,108) (508) (10,740)
Corporate charges -- -- -- --
-------- -------- -------- --------
Total $ 9,035 $ 6,541 $ 27,080 $ 12,146
======== ======== ======== ========
Reconciliation of income from operations to
income before provision for income taxes
Total EBIT for operating groups $ 9,035 $ 6,541 $ 27,080 $ 12,146
Other income, net 230 246 861 741
-------- -------- -------- --------
Income before provision for income taxes $ 9,265 $ 6,787 $ 27,941 $ 12,887
======== ======== ======== ========
Capital expenditures
Sales and marketing services group $ 2,772 $ 1,055 $ 7,774 $ 1,482
PDI products group -- -- -- --
-------- -------- -------- --------
Total $ 2,772 $ 1,055 $ 7,774 $ 1,482
======== ======== ======== ========
Depreciation expense
Sales and marketing services group $ 1,095 $ 965 $ 3,674 $ 2,864
PDI products group 3 649 28 1,103
-------- -------- -------- --------
Total $ 1,098 $ 1,614 $ 3,702 $ 3,967
======== ======== ======== ========
15. GOODWILL AND INTANGIBLE ASSETS
Effective January 1, 2002, the Company adopted SFAS No. 142, "GOODWILL AND
OTHER INTANGIBLE ASSETS." Under SFAS No. 142, goodwill is no longer amortized
but is evaluated for impairment on at least an annual basis. The Company has
established reporting units for purposes of testing goodwill for impairment.
Goodwill has been assigned to the reporting units to which the value of the
goodwill relates. The Company performed the required annual impairment tests in
the fourth quarter of 2003 and determined that no impairment existed at December
31, 2003. These tests involved determining the fair market value of each of the
reporting units with which the goodwill was associated and comparing the
estimated fair market value of each of the reporting units with its carrying
amount. The Company's total goodwill, which is not subject to amortization,
totaled $21.8 million and $11.1 million as of September 30, 2004 and December
31, 2003, respectively.
As a result of the acquisition of Pharmakon (discussed in Note 3), there
was an additional $10.6 million added to the carrying amount of goodwill. The
carrying amounts at September 30, 2004 by operating segment are shown below:
(in thousands) SMSG PPG TOTAL
------- ------- -------
Balance as of December 31, 2003 $11,132 $ -- $11,132
Amortization -- -- --
Acquisitions 10,627 -- 10,627
------- ------- -------
Balance as of September 30, 2004 $21,759 $ -- $21,759
======= ======= =======
All identifiable intangible assets recorded as of September 30, 2004 are
being amortized on a straight-line basis over the life of the intangibles which
range from 5 to 15 years. The carrying amounts at September 30, 2004 and
December 31, 2003 are as follows:
21
PDI, INC.
NOTES TO INTERIM FINANCIAL STATEMENTS - CONTINUED
(UNAUDITED)
(in thousands) As of September 30, 2004 As of December 31, 2003
----------------------------------- ---------------------------------
Carrying Accumulated Carrying Accumulated
Amount Amortization Net Amount Amortization Net
-------- ------------ ------- -------- ------------ ------
Covenant not to compete $ 1,826 $1,035 $ 791 $1,686 $ 780 $ 906
Customer relationships 17,508 831 16,677 1,208 559 649
Corporate tradename 2,672 119 2,553 172 79 93
------- ------ ------- ------ ------ ------
Total $22,006 $1,985 $20,021 $3,066 $1,418 $1,648
======= ====== ======= ====== ====== ======
Amortization expense totaled approximately $260,000 and $567,000 for the
three and nine months ended September 30, 2004 and approximately $153,000 and
$460,000 for the three and nine months ended September 30, 2003. Estimated
amortization expense for the next five years is as follows:
(in thousands)
2004 $1,040
======
2005 1,895
======
2006 1,703
======
2007 1,281
======
2008 1,281
======
22
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
VARIOUS STATEMENTS MADE IN THIS QUARTERLY REPORT ON FORM 10-Q ARE
"FORWARD-LOOKING STATEMENTS" (WITHIN THE MEANING OF THE PRIVATE SECURITIES
LITIGATION REFORM ACT OF 1995) REGARDING THE PLANS AND OBJECTIVES OF MANAGEMENT
FOR FUTURE OPERATIONS. THESE STATEMENTS INVOLVE KNOWN AND UNKNOWN RISKS,
UNCERTAINTIES AND OTHER FACTORS THAT MAY CAUSE OUR ACTUAL RESULTS, PERFORMANCE
OR ACHIEVEMENTS TO BE MATERIALLY DIFFERENT FROM ANY FUTURE RESULTS, PERFORMANCE
OR ACHIEVEMENTS EXPRESSED OR IMPLIED BY THESE FORWARD-LOOKING STATEMENTS. THE
FORWARD-LOOKING STATEMENTS INCLUDED IN THIS REPORT ARE BASED ON CURRENT
EXPECTATIONS THAT INVOLVE NUMEROUS RISKS AND UNCERTAINTIES. OUR PLANS AND
OBJECTIVES ARE BASED, IN PART, ON ASSUMPTIONS INVOLVING JUDGEMENTS ABOUT, AMONG
OTHER THINGS, FUTURE ECONOMIC, COMPETITIVE AND MARKET CONDITIONS AND FUTURE
BUSINESS DECISIONS, ALL OF WHICH ARE DIFFICULT OR IMPOSSIBLE TO PREDICT
ACCURATELY AND MANY OF WHICH ARE BEYOND OUR CONTROL. ALTHOUGH WE BELIEVE THAT
OUR ASSUMPTIONS UNDERLYING THE FORWARD-LOOKING STATEMENTS ARE REASONABLE, ANY OF
THESE ASSUMPTIONS COULD PROVE INACCURATE AND, THEREFORE, WE CANNOT ASSURE YOU
THAT THE FORWARD-LOOKING STATEMENTS INCLUDED IN THIS REPORT WILL PROVE TO BE
ACCURATE. IN LIGHT OF THE SIGNIFICANT UNCERTAINTIES INHERENT IN THE
FORWARD-LOOKING STATEMENTS INCLUDED IN THIS REPORT, THE INCLUSION OF THESE
STATEMENTS SHOULD NOT BE INTERPRETED BY ANYONE THAT OUR OBJECTIVES AND PLANS
WILL BE ACHIEVED. FACTORS THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY
AND ADVERSELY FROM THOSE EXPRESSED OR IMPLIED BY FORWARD-LOOKING STATEMENTS
INCLUDE, BUT ARE NOT LIMITED TO, THE FACTORS, RISKS AND UNCERTAINTIES (i)
IDENTIFIED OR DISCUSSED HEREIN, (ii) SET FORTH IN "RISK FACTORS" UNDER PART I,
ITEM 1, OF THE COMPANY'S AMENDED ANNUAL REPORT ON FORM 10-K/A FOR THE YEAR ENDED
DECEMBER 31, 2003 AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION, AND
(iii) SET FORTH IN THE COMPANY'S PERIODIC REPORTS ON FORMS 10-Q/A AND 8-K AS
FILED WITH THE SECURITIES AND EXCHANGE COMMISSION SINCE JANUARY 1, 2004. WE
UNDERTAKE NO OBLIGATION TO REVISE OR UPDATE PUBLICLY ANY FORWARD-LOOKING
STATEMENTS FOR ANY REASON.
RESTATEMENT OF CONSOLIDATED FINANCIAL STATEMENTS
We have restated our previously issued consolidated financial statements
for the quarter ended September 30, 2003 (the previously issued financial
statements) to apply the provisions of EITF 01-14, "Income Statement
Characterization of Reimbursement Received for `Out-of-Pocket' Expenses
Incurred". In accordance with EITF 01-14, direct reimbursements received by us
from our clients for certain costs incurred should have been included as part of
revenue with an identical increase to cost of goods and services, rather than
being netted against cost of goods and services. Revenue and cost of goods and
services in the previously issued financial statements were increased by $8.3
million for the quarter ended September 30, 2003, and $20.2 million for the nine
months ended September 30, 2003. EITF 01-14, which was issued in late 2001, was
applicable for years beginning in 2002, and also required reclassification of
all previous periods for comparative purposes.
This restatement does not affect previously reported gross profit,
operating income, net income, cash flows from operations or earnings per share.
Additionally, there is no effect on the consolidated balance sheets,
consolidated statements of cash flows or consolidated statements of
stockholders' equity for the previously issued financial statements. A summary
of the effects of the restatement to reclassify these amounts is as follows:
23
QUARTER ENDED NINE MONTHS ENDED
30-SEP-03 30-SEP-03
------------------------ ------------------------
AS AS
PREVIOUSLY AS PREVIOUSLY AS
REPORTED RESTATED REPORTED RESTATED
---------- ---------- ---------- ----------
CONSOLIDATED STATEMENTS
OF OPERATIONS:
Service revenue $ 86,200 $ 94,470 $ 224,888 $ 245,112
Product revenue 81 81 197 197
---------- ---------- ---------- ----------
TOTAL REVENUE 86,281 94,551 225,085 245,309
---------- ---------- ---------- ----------
Program expenses 61,815 70,085 162,004 182,228
Cost of goods sold 952 952 1,097 1,097
---------- ---------- ---------- ----------
TOTAL COST OF GOODS
AND SERVICES 62,767 71,037 163,101 183,325
---------- ---------- ---------- ----------
GROSS PROFIT $ 23,514 $ 23,514 $ 61,984 $ 61,984
---------- ---------- ---------- ----------
OVERVIEW
We are a healthcare sales and marketing company serving the
biopharmaceutical and medical devices and diagnostics (MD&D) industries. We
create and execute sales and marketing campaigns intended to improve the
profitability of pharmaceutical or MD&D products. We do this by partnering with
companies who own the intellectual property rights to these products and
recognize our ability to commercialize these products and maximize their sales
performance. We have a variety of agreement types that we enter into with our
partner companies, ranging from fee for service arrangements to performance
based contracts.
REPORTING SEGMENTS
Our business is organized into two reporting segments:
o PDI sales and marketing services group (SMSG), comprised of:
o Sales Teams Business
o Dedicated contract sales teams
o Shared contract sales teams
o Medical device and diagnostic contract sales teams
o Clinical sales teams
o Hybrid teams
o Marketing research and consulting (MR&C)
o Medical education and communications (PDI EdComm and Pharmakon)
o PDI products group (PPG) is comprised of those agreements in which PDI is
directly or indirectly compensated on the basis of product sales. This
segment currently has the remaining revenue from PDI's agreement with
Novartis in support of Lotensin and the agreement with Xylos in support of
XCell wound care products. We terminated our agreement our agreement with
Xylos effective May 16, 2004. Both agreements have been terminated and the
PPG segment is reporting the residual financial activity from those
agreements.
We reorganized our segments in the first quarter of 2004 due to the
termination of the Xylos agreement and the decision to manage the other MD&D
units under our existing contract sales structure. Additionally, the reorganized
segments reflect the greater emphasis we intend to place on our services
business and away from licensing and acquiring pharmaceutical and medical device
products. The businesses within the sales and marketing services group recognize
revenue predominantly through fee
24
for service contracts. The products group derives revenue through a variety of
agreement types including directly from product sales or based on a formula with
product sales as its basis. The PPG contracts are characterized by either
significant management effort required from our product marketing group, or
reliance on the attainment of performance incentives in order to fully cover our
costs, or both.
DESCRIPTION OF BUSINESSES
SALES AND MARKETING SERVICES GROUP (SMSG)
Dedicated Contract Sales Teams
- ------------------------------
Product detailing involves a representative meeting face-to-face with
targeted physicians and other healthcare decision makers to provide a technical
review of the product being promoted. Dedicated contract sales teams work
exclusively on behalf of one client and often carry the business cards of the
client. Each sales team is customized to meet the specifications of our client
with respect to representative profile, physician targeting, product training,
incentive compensation plans, integration with clients' in-house sales forces,
call reporting platform, program duration and data integration. Without adding
permanent personnel, the client gets a high quality, industry-standard sales
team comparable to its internal sales force.
Shared Contract Sales Teams
- ---------------------------
Our shared sales teams sell multiple brands from different pharmaceutical
manufacturers. Through them, we make a face-to-face selling resource available
to those clients that want an alternative to a dedicated team. The PDI Shared
Sales teams are leading providers of these detailing programs in the U.S. Since
costs are shared among various companies, these programs may be less expensive
for the client than programs involving a dedicated sales force. With a shared
sales team, the client still gets targeted coverage of its physician audience
within the representatives' geographic territories.
Medical Device and Diagnostics Contract Sales Teams
- ---------------------------------------------------
MD&D contract sales is an outsourced solution for selling medical devices
to hospitals, clinics and other healthcare institutions. The MD&D contract sales
teams work exclusively on behalf of one client. Each sales team is customized to
meet the specifications of our client with respect to representative profile,
identified territories, product training, incentive compensation plans,
integration with clients' in-house sales forces, activity reporting platform,
program duration and data integration. Without adding permanent personnel, the
client gets a high quality, industry-standard sales team.
Medical Device and Diagnostics Clinical Sales Teams
- ---------------------------------------------------
Our clinical sales teams employ nurses, medical technologists, and other
clinicians who train and provide hands-on clinical education and after sales
support to the medical staffs of hospitals and clinics that recently purchased
our clients' equipment. Our activities maximize product utilization and customer
satisfaction for the medical practitioners, while simultaneously enabling our
clients' sales forces to continue their selling activities instead of
in-servicing the equipment.
Hybrid Teams
- ------------
Hybrid teams take elements of the different sales teams outlined above and
coordinate their activities to achieve a unique solution for a client. In order
to gain greater physician coverage across the country, a client may want to
deploy a dedicated team to the large metropolitan markets and supplement that
team with a shared team in order to reach additional markets and physicians not
reached by the dedicated team. Another example of a hybrid team may be the
combination of a sales team with a clinical team when the product requires a
sales effort along with clinical support. Hybrid teams enable us to craft custom
25
solutions for clients with unique challenges.
Marketing Research (Mr&C)
- -------------------------
Employing leading edge, and in some instances proprietary, research
methodologies, we provide qualitative and quantitative marketing research to
pharmaceutical companies with respect to healthcare providers, patients and
managed care customers in the U.S. and globally. We offer a full range of
pharmaceutical marketing research services, including studies to identify the
most impactful business strategy, profile, positioning, message, execution,
implementation and post implementation for a product. Correctly implemented, our
marketing research model improves the knowledge clients obtain about how
physicians and other healthcare professionals will likely react to products.
We utilize a systematic approach to pharmaceutical marketing research.
Recognizing that every marketing need, and therefore every marketing research
solution, is unique, we have developed our marketing model to help identify the
work that needs to be done in order to identify critical paths to marketing
goals. At each step of the marketing model we can offer proven research
techniques, proprietary methodologies and customized study designs to address
specific product needs.
In addition to conducting marketing research, we have trained several
thousand industry professionals at our public seminars. Our professional
development seminars focus on key marketing processes and issues.
Medical Education and Communications (Pdi Edcomm and Pharmakon)
- ---------------------------------------------------------------
Our PDI EdComm group provides medical education and promotional
communications to the biopharmaceutical and MD&D industries. Using an
expert-driven, customized approach, we provide our clients with integrated
advocacy development, accredited continuing medical education (CME), promotions,
publication services and interactive sales initiatives to generate incremental
value for products.
PDI EdComm creates custom designed programs focusing on optimizing the
informed use of our clients' products. Our services are executed through a
customized, integrated plan that can be leveraged across the product's entire
life cycle. We can meet a wide range of objectives, including advocacy during
pre-launch, communicating disease state awareness, supporting a product launch,
helping an under-performing brand, fending off new competition and expanding
market leadership.
Pharmakon's emphasis is on the creation, design and implementation of
interactive peer persuasion programs. Each marketing program can be offered
through a number of different venues including teleconferences, dinner meetings,
"lunch and learns", and web casts. Within each of its programs, Pharmakon offers
a number of services including strategic design, tactical execution, technology
support, moderator services and thought leader management.
PDI PRODUCTS GROUP (PPG)
There are occasions when a biopharmaceutical or medical device or
diagnostic company would want to outlicense, sell or copromote a product that
they own or to which they own the rights. They may not have the capabilities to
market a product themselves or they may have other products in their portfolio
on which they are concentrating their sales and marketing resources. In this
instance, our products group works to create a mutually beneficial partnership
arrangement, pursuant to which we utilize our sales, marketing and
commercialization capabilities to commercialize the product for our partner.
These agreements may require upfront payments, royalty payments, milestone
payments and/or other compensation strategies. These agreements generally are
riskier for us, but generally have the potential to deliver greater revenues,
margins and consistency than our services businesses.
26
Given the broad array of our service offerings, we are able to provide
complete product commercialization capabilities (Integrated Commercialization
Services) to pharmaceutical companies on a fee for service basis. The execution
of these product sales, marketing and commercialization activities would be
substantially similar to those we perform in a copromotion, licensing or product
acquisition transaction; however, our fee structure and risk profile would be
markedly different.
NATURE OF CONTRACTS BY SEGMENT
Given the customized nature of our business, we utilize a variety of
contract structures. Historically, most of our product detailing contracts have
been fee for service, I.E., the client pays a fee for a specified package of
services. These contracts typically include operational benchmarks, such as a
minimum number of sales representatives or a minimum number of calls. Also, our
contracts might have a lower base fee offset by built-in incentives we can earn
based on our performance. In these situations, we have the opportunity to earn
additional fees, as incentives, based on attaining performance benchmarks.
Our product detailing contracts generally are for terms of one to three
years and may be renewed or extended. However, the majority of these contracts
are terminable by the client for any reason on 30 to 90 days' notice. These
contracts sometimes provide for termination payments in the event they are
terminated by the client without cause. While the cancellation of a contract by
a client without cause may result in the imposition of penalties on the client,
these penalties may not act as an adequate deterrent to the termination of any
contract. In addition, we cannot assure you that these penalties will offset the
revenue we could have earned under the contract or the costs we may incur as a
result of its termination. The loss or termination of a large contract or the
loss of multiple contracts could have a material adverse effect on our business,
financial condition and results of operations. Contracts may also be terminated
for cause if we fail to meet stated performance benchmarks.
Our MR&C, PDI EdComm, and Pharmakon contracts generally are for projects
lasting from three to six months. The contracts are terminable by the client and
provide for termination payments in the event they are terminated without cause.
Termination payments include payment of all work completed to date, plus the
cost of any nonrefundable commitments made on behalf of the client. Due to the
typical size of the projects, it is unlikely the loss or termination of any
individual MR&C, EdComm, or Pharmakon contract would have a material adverse
effect on our business, financial condition and results of operations.
The contracts within the products group can be either performance based or
fee for service and may require sales, marketing and distribution of product. In
performance-based contracts, we typically provide and finance a portion, if not
all, of the commercial activities in support of a brand in return for a
percentage of product sales. An important performance parameter is normally the
level of sales or prescriptions attained by the product during the period of our
marketing or promotional responsibility, and in some cases, for periods after
our promotional activities have ended.
In May 2001, we entered into a copromotion agreement with Novartis
Pharmaceuticals Corporation (Novartis) for the U.S. sales, marketing and
promotion rights for Lotensin(R), Lotensin HCT(R) and Lotrel(R). That agreement
was scheduled to run through December 31, 2003. On May 20, 2002, that agreement
was replaced by two separate agreements: one for Lotensin and another one for
Lotrel, Diovan(R) and Diovan HCT(R). The Lotensin agreement called for us to
provide promotion, selling, marketing and brand management for Lotensin. In
exchange, we were entitled to receive a percentage of product revenue based on
certain total prescription (TRx) objectives above specified contractual
baselines. Both agreements were scheduled to run through December 31, 2003;
however, the Lotrel-Diovan agreement was renewed on December 24, 2003 for an
additional one-year period. In February 2004, we were notified by Novartis of
its intent to terminate the Lotrel-Diovan contract without cause, effective
March 16, 2004 and, as a result, $28.9 million of anticipated revenue associated
with the Lotrel-Diovan contract in 2004 will not be realized. We were
compensated under the terms of the agreement
27
through the effective termination date. Even though the Lotensin agreement ended
December 31, 2003, we are still entitled to receive royalty payments on the
sales of Lotensin through December 31, 2004. The royalties earned under this
arrangement for the three and nine month periods ended September 30, 2004 were
approximately $441,000 and $3.4 million, respectively; the royalties earned
during the remainder of 2004 are expected to diminish because the product lost
its patent protection in February 2004.
On December 31, 2002, we entered into an exclusive licensing agreement
with Cellegy Pharmaceuticals, Inc. (Cellegy) for the exclusive North American
rights for Fortigel(TM), a testosterone gel product. The agreement is in effect
for the commercial life of the product. Cellegy submitted a New Drug Application
(NDA) for the hypogonadism indication to the U.S. Food and Drug Administration
(FDA) in June 2002. In July 2003, Cellegy received a letter from the FDA
rejecting its NDA for Fortigel. Cellegy has told us that it is in discussions
with the FDA to determine the appropriate course of action needed to meet
deficiencies cited by the FDA in its determination. Under the terms of the
agreement, we paid Cellegy a $15.0 million initial licensing fee on December 31,
2002. Under the terms of the licensing agreement, if it should be enforced (see
discussion of the lawsuit below), this nonrefundable payment was made prior to
FDA approval and since there is no alternative future use of the licensed
rights, we expensed the $15.0 million payment in December 2002, when incurred.
This amount was recorded in other selling, general and administrative expenses
in the December 31, 2002 consolidated statements of operations. Pursuant to the
terms of the licensing agreement, if it should be enforced (see discussion of
lawsuit below), we will be required to pay Cellegy a $10.0 million incremental
license fee milestone payment upon Fortigel's receipt of all approvals required
by the FDA (if such approvals are obtained) to promote, sell and distribute the
product in the U.S. This incremental milestone license fee, if incurred, will be
recorded as an intangible asset and amortized over its estimated useful life, as
then determined, which is not expected to exceed the life of the patent. We
believe that we will not be required to pay Cellegy the $10.0 million
incremental license fee milestone payment in 2004, and it is unclear at this
point when or if Cellegy will get Fortigel approved by the FDA which would
trigger our obligation to pay $10.0 million to Cellegy. Royalty payments to
Cellegy over the term of the commercial life of the product would range from 20%
to 30% of net sales. As discussed in Note 13, we filed a complaint against
Cellegy in December 2003, that alleges, among other things, that Cellegy
fraudulently induced us to enter into the licensing agreement, and seeks the
return of the $15.0 million initial licensing fee, plus additional damages
caused by Cellegy's conduct. Since we filed the lawsuit, Cellegy is no longer in
regular contact with us regarding Fortigel. Thus, for example, we have been
informed that Cellegy is in continuing contact with the FDA but we are unaware
of the precise FDA status regarding Fortigel (as of September 30, 2004, it had
not been approved) and the FDA continued to express concern about the high
supraphysiologic Cmax serum testosterone levels achieved in subjects of Fortigel
testing. We are also unaware of what steps Cellegy is taking to develop
Fortigel, to obtain FDA approval for Fortigel, and/or to arrange for a party to
manufacture Fortigel. We have requested this information from Cellegy but have
not received full and complete responses from Cellegy. Accordingly, we may not
possess the most current and reliable information concerning the current status
of, or future prospects relating to Fortigel. The issuance of the non-approvable
letter by the FDA concerning Fortigel, however, casts significant doubt upon
Fortigel's prospects and whether it will ever be approved. We cannot predict
with any certainty whether the FDA will ultimately approve Fortigel for sale in
the U.S.
In October 2002, we partnered with Xylos Corporation (Xylos) for the
exclusive U.S. commercialization rights to the Xylos XCell(TM) Cellulose Wound
Dressing (XCell) wound care products, by entering into an agreement pursuant to
which we became the exclusive commercialization partner for the sales, marketing
and distribution of the product line in the U.S. On January 2, 2004, we
exercised our contractual right to terminate the agreement on 135 days' notice
to Xylos since sales of XCell were not sufficient to sustain our role as
commercialization partner for the product. We accepted orders for XCell products
through May 16, 2004 when the agreement terminated; however, our promotional
activities in support of the brand concluded in January 2004. See Notes 6 and 7
to the financial statements for more information. We currently do not anticipate
entering into similar commercialization agreements in the MD&D market.
28
REVENUE RECOGNITION AND ASSOCIATED COSTS
The paragraphs that follow describe the guidelines that we adhere to in
accordance with generally accepted accounting principles (GAAP) when recognizing
revenue and cost of goods and services in our financial statements. In
accordance with GAAP, service revenue and product revenue and their respective
direct costs have been shown separately on the income statement.
Historically, we have derived a significant portion of our service revenue
from a limited number of clients. Concentration of business in the
pharmaceutical services industry is common and the industry continues to
consolidate. As a result, we are likely to continue to experience significant
client concentration in future periods. For the three months ended September 30,
2004, and 2003 the Company's three largest clients who each individually
represented 10% or more of its service revenue, accounted for approximately, in
the aggregate, 74.4%, and 72.4%, respectively, of the Company's service revenue.
For the nine months ended September 30, 2004, and 2003 the Company's two largest
clients who each accounted for 10% or more of its service revenue totaled, in
the aggregate, 64.9%, and 67.0%, respectively, of the Company's service revenue.
SERVICE REVENUE AND PROGRAM EXPENSES
Service revenue is earned primarily by performing product detailing
programs and other marketing and promotional services under contracts. Revenue
is recognized as the services are performed and the right to receive payment for
the services is assured. Revenue is recognized net of any potential penalties
until the performance criteria relating to the penalties have been achieved.
Performance incentives, as well as termination payments, are recognized as
revenue in the period earned and when payment of the bonus, incentive or other
payment is assured. Under performance based contracts, revenue is recognized
when the performance based parameters are achieved.
Program expenses consist primarily of the costs associated with executing
product detailing programs, performance based contracts or other sales and
marketing services identified in the contract. Program expenses include
personnel costs and other costs associated with executing a product detailing or
other marketing or promotional program, as well as the initial direct costs
associated with staffing a product detailing program. Such costs include, but
are not limited to, facility rental fees, honoraria and travel expenses, sample
expenses and other promotional expenses. Personnel costs, which constitute the
largest portion of program expenses, include all labor related costs, such as
salaries, bonuses, fringe benefits and payroll taxes for the sales
representatives and sales managers and professional staff who are directly
responsible for executing a particular program. Initial direct program costs are
those costs associated with initiating a product detailing program, such as
recruiting, hiring, and training the sales representatives who staff a
particular product detailing program. All personnel costs and initial direct
program costs, other than training costs, are expensed as incurred for service
offerings. Product detailing, marketing and promotional expenses related to the
detailing of products we distribute are recorded as a selling expense and are
included in other selling, general and administrative expenses in the
consolidated statements of operations.
Reimbursable Out-of-pocket Expenses
-----------------------------------
Reimbursable out-of-pocket expenses include those relating to out-of
pocket expenses and other similar costs, for which we are reimbursed at cost
from our clients. In accordance with EITF 01-14 reimbursements received for
out-of-pocket expenses incurred are characterized as revenue and an identical
amount is included as cost of goods and services in the consolidated statements
of operations. Out-of-pocket expenses for the three and nine month periods ended
September 30, 2004 were $5.4 million and $18.0 million, respectively. Out-of-
29
pocket expenses for the three and nine month periods ended September 30, 2003
were $8.3 million and $20.3 million, respectively.
Training and Other Initial Direct Costs
---------------------------------------
Training costs include the costs of training the sales representatives and
managers on a particular product detailing program so that they are qualified to
properly perform the services specified in the related contract. For all
contracts, training costs are deferred and amortized on a straight-line basis
over the shorter of the life of the contract to which they relate or 12 months.
When we receive a specific contract payment from a client upon commencement of a
product detailing program expressly to compensate us for recruiting, hiring and
training services associated with staffing that program, such payment is
deferred and recognized as revenue in the same period that the recruiting and
hiring expenses are incurred and amortization of the deferred training is
expensed. When we do not receive a specific contract payment for training, all
revenue is deferred and recognized over the life of the contract.
As a result of the revenue recognition and program expense policies
described above, we may incur significant initial direct program costs before
recognizing revenue under a particular product detailing program. Our inability
to specifically negotiate for payments that are specifically attributable to
recruiting, hiring or training services in our product detailing contracts could
adversely impact our operating results for periods in which the costs associated
with the product detailing services are incurred.
PRODUCT REVENUE AND COST OF GOODS SOLD
Product revenue is recognized when products are shipped and title is
transferred to the customer. Product revenue was negative $3,000 and negative
$1.0 million for the three and nine months ended September 30, 2004. The
negative $1.0 million for the nine months ended September 30, 2004 was primarily
due to the $1.2 million increase in the Ceftin returns reserve as discussed more
fully in Note 5. Additionally we had product revenue of $81,000 and $197,000 for
the three and nine months ended September 30, 2003, respectively, primarily from
the sale of the Xylos wound care products.
Cost of goods sold includes all expenses for product distribution costs,
acquisition and manufacturing costs of the product sold. Inventory is valued at
the lower of cost or market value. Cost is determined using the first-in,
first-out costing method. Inventory to date has consisted of only finished
goods.
CONSOLIDATED RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, certain
consolidated statements of operations data as a percentage of revenue. The
trends illustrated in this table may not be indicative of future results.
30
Three Months Ended Nine Months Ended
September 30, September 30,
------------------- --------------------
2004 2003 2004 2003
------ ------ ------ ------
Revenue (restated) (restated)
Service ........................................... 100.0% 99.9% 100.4% 99.9%
Product, net ...................................... -- 0.1 (0.4) 0.1
------ ------ ------ ------
Total revenue .................................. 100.0% 100.0% 100.0% 100.0%
Cost of goods and services
Program expenses .................................. 73.6 74.1 73.6 74.3
Cost of goods sold ................................ -- 1.0 0.1 0.4
------ ------ ------ ------
Total cost of goods and services ............... 73.6% 75.1% 73.7% 74.7%
Gross profit ......................................... 26.4 24.9 26.3 25.3
Compensation expense ................................. 9.1 9.8 9.6 11.1
Other selling, general and administrative expenses ... 7.5 8.2 6.9 8.4
Restructuring and other related expenses, net ........ -- -- -- (0.1)
Litigation settlement ................................ -- -- -- 0.9
------ ------ ------ ------
Total operating expenses ....................... 16.6 18.0 16.5 20.3
------ ------ ------ ------
Operating income ..................................... 9.8 6.9 9.8 5.0
Other income, net .................................... 0.2 0.3 0.3 0.3
------ ------ ------ ------
Income before provision for income taxes ............. 10.0 7.2 10.1 5.3
Provision for income taxes ........................... 4.1 2.8 4.1 2.1
------ ------ ------ ------
Net income ........................................... 5.9% 4.4% 6.0% 3.2%
====== ====== ====== ======
THREE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 2003
REVENUE. Revenue for the quarter ended September 30, 2004 was $92.5
million, 2.1% less than revenue of $94.6 million for the quarter ended September
30, 2003. Revenue from the SMSG segment for the quarter ended September 30, 2004
was $92.0 million, 13.1% more than revenue of $81.3 million from that segment
for the comparable prior year period. The increase is mainly attributable to the
higher number of sales representatives contracted for by our dedicated contract
sales clients in the quarter ended September 30, 2004 than in the comparable
prior year period. PPG revenue for the quarter ended September 30, 2004 was
approximately $515,000, consisting almost entirely of revenue due to Lotensin
royalties. The Lotensin royalties earned during the remainder of 2004 are
expected to diminish because the product lost its patent protection in February
2004. PPG revenue was $13.2 million in the comparable prior year period. The
Lotensin contract, which was a major contributor in 2003, was completed December
31, 2003 and we will continue to earn Lotensin royalties until December 31,
2004.
COST OF GOODS AND SERVICES. Cost of goods and services for the quarter
ended September 30, 2004 was $68.1 million, comparable to $71.0 million for the
quarter ended September 30, 2003. As a percentage of total revenue, cost of
goods and services were 73.6% for the quarter ended September 30, 2004 slightly
less than 75.1% in the comparable prior year period. Program expenses (i.e.,
cost of services) associated with the SMSG segment for the quarter ended
September 30, 2004 were $68.1 million, 11.5% more than program expenses of $61.1
million for the comparable prior year period. The increase is mainly
attributable to the higher number of sales representatives contracted for by our
dedicated contract sales clients in the quarter ended September 30, 2004 than in
the comparable prior year period. As a percentage of sales and marketing
services segment revenue, program expenses for the quarter ended September 30,
2004 decreased to 74.0% from 75.1% in the comparable prior year period. Cost of
goods and services associated with the PPG segment were $11,000 and $9.9 million
for the quarters ended September 30, 2004 and 2003, respectively. This decrease
can be primarily attributed to the completion of the Lotensin contract which
ended December 31, 2003.
COMPENSATION EXPENSE. Compensation expense for the quarter ended September
30, 2004 was $8.4 million, 9.6% less than $9.3 million for the comparable prior
year period. The decrease in compensation expense was primarily due to the
decreased staffing in support of the product businesses, which have been
de-emphasized. As a percentage of total revenue, compensation expense decreased
to 9.1% for the quarter ended September 30, 2004 from 9.8% for the quarter ended
September 30, 2003. Compensation expense for the quarter ended September 30,
2004 attributable to the SMSG segment was $8.2 million compared to $6.2 million
for the quarter ended September 30, 2003. This increase can be attributed to a
greater amount of internal resources and management's time and effort being
expended, related to the SMSG segment in 2004. Compensation expense as a
percentage of revenue increased to 8.9% from 7.6% in the comparable prior year
period. Compensation expense for the quarter ended September 30, 2004
attributable to the PPG segment was approximately $216,000 compared to $3.1
million in the prior year period. This decrease can be attributed to the lower
level of resources required after the completion of the Lotensin contract which
ended December 31, 2003.
31
OTHER SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Total other selling,
general and administrative expenses were $6.9 million for the quarter ended
September 30, 2004, 9.6% less than other selling, general and administrative
expenses of $7.7 million for the quarter ended September 30, 2003. This decrease
is primarily a result of a reduction of sales force and marketing costs related
to Xylos, a product we marketed and distributed. During 2003, we incurred
approximately $500,000 in sales force and marketing costs whereas those costs
were not incurred for the quarter ended September 30, 2004 as we stopped selling
the products on May 16, 2004. As a percentage of total revenue, total other
selling, general and administrative expenses decreased to 7.5% for the quarter
ended September 30, 2004 from 8.2% for the quarter ended September 30, 2003 due
to continuing cost management efforts. Other selling, general and administrative
expenses attributable to the SMSG segment for the quarter ended September 30,
2004 were $6.8 million, compared to other selling, general and administrative
expenses of $5.4 million attributable to that segment for the comparable prior
year period. This increase is primarily due to a larger portion of corporate
resources being expended on behalf of the SMSG segment in the current period. As
a percentage of revenue from sales and marketing services, other selling,
general and administrative expenses were 7.4% and 6.6% for the quarters ended
September 30, 2004 and 2003, respectively. Other selling, general and
administrative expenses attributable to the PPG segment for the quarter ended
September 30, 2004 were approximately $114,000 compared to $2.3 million for the
comparable prior year period; this decrease can be attributed to the lower level
of resources required after the completion of the Lotensin contract which ended
December 31, 2003 and the termination of the Xylos agreement.
OPERATING INCOME. Operating income for the quarter ended September 30,
2004 was $9.0 million, compared to operating income of $6.5 million for the
quarter ended September 30, 2003. Operating income as a percentage of revenue
increased to 9.8% for the three months ended September 30, 2004 from 6.9% in the
comparable prior year period. Operating income for the quarter ended September
30, 2004 for the SMSG segment was $8.9 million, or 2.5% higher than the SMSG
operating income for the quarter ended September 30, 2003 of $8.6 million. As a
percentage of revenue from the sales and marketing services segment, operating
income for that segment decreased to 9.6% for the quarter ended September 30,
2004, from 10.6% for the comparable prior year period. This decrease is
primarily due to a larger portion of corporate resources being expended on
behalf of the SMSG segment in the current period. There was operating income for
the PPG segment for the quarter ended September 30, 2004 of approximately
$174,000, compared to an operating loss of $2.1 million for the prior year
period.
OTHER INCOME, NET. Other income, net, for the quarters ended September 30,
2004 and 2003 was $230,000 and $246,000, respectively, and was comprised
primarily of interest income.
PROVISION FOR INCOME TAXES. Income tax expense, which consisted of Federal
and state corporate income taxes, was $3.8 million for the quarter ended
September 30, 2004, compared to income tax expense of approximately $2.6 million
for the quarter ended September 30, 2003. The effective tax rate for the quarter
ended September 30, 2004 was 41.0% and for the quarter ended September 30, 2003
was 38.4%. The rate for the quarter ended September 30, 2003 was lower than the
Company's average annual effective rate because the return to profitable
operations in 2003 enabled the utilization of tax loss carry-forwards for
certain states.
NET INCOME. Net income for the quarter ended September 30, 2004 was
approximately $5.5 million, compared to net income of approximately $4.2 million
for the quarter ended September 30, 2003. This increase is due to the factors
discussed above.
NINE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO NINE MONTHS ENDED
SEPTEMBER 30, 2003
REVENUE. Revenue for the nine months ended September 30, 2004 was $276.6
million, 12.8% more than revenue of $245.3 million in the comparable prior year
period. Revenue from the SMSG segment
32
for the nine months ended September 30, 2004 was $274.1 million, 30.8% more than
revenue of $209.6 million for the nine months ended September 30, 2003. This
increase is mainly attributable to the addition of three significant dedicated
contract sales teams contracts in July 2003 which are still ongoing in 2004. PPG
revenue for the nine months ended September 30, 2004 was $2.5 million; that
consisted primarily of Lotensin royalties, partially offset by the $1.2 million
of negative revenue that was recognized due to the increase in the Ceftin
returns reserve (as discussed more fully in Note 5 to the financial statements).
The Lotensin royalties earned during the remaining quarter of 2004 are expected
to diminish because the product lost its patent protection in February 2004. PPG
revenue was $35.7 million in the comparable prior year period. The Lotensin
contract, which was a major contributor in 2003, was completed December 31, 2003
and we will continue to earn Lotensin royalties until December 31, 2004.
COST OF GOODS AND SERVICES. Cost of goods and services for the nine months
ended September 30, 2004 was $203.9 million, 11.2% more than cost of goods and
services of $183.3 million for the nine months ended September 30, 2003. As a
percentage of total revenue, cost of goods and services decreased to 73.7% for
the nine months ended September 30, 2004 from 74.7% in the comparable prior year
period. Program expenses (i.e., cost of services) associated with the SMSG
segment for the quarter ended September 30, 2004 were $203.7 million, 32.0% more
than program expenses of $154.3 million for the prior year period. This increase
is mainly attributable to the addition of three significant dedicated contract
sales teams contracts in July 2003. As a percentage of sales and marketing
services segment revenue, program expenses for the nine months ended September
30, 2004 and 2003 were 74.3% and 73.6%, respectively. The reduction in gross
profit percentage of 0.7% is primarily attributable to greater incentive
payments earned in 2003, and severance and reassignment costs incurred in 2004
associated with programs that terminated early. Cost of goods and services
associated with the PPG segment were $254,000 and $29.0 million for the nine
months ended September 30, 2004 and 2003, respectively. This decrease can be
primarily attributed to the completion of the Lotensin contract that ended
December 31, 2003. Also, during the nine months ended September 30, 2003, we
recognized a $340,000 net reduction in the restructuring accrual associated with
the 2002 Restructuring Plan (see Note 14 and "RESTRUCTURING AND OTHER RELATED
EXPENSES" disclosure below for further explanations.)
COMPENSATION EXPENSE. Compensation expense for the nine months ended
September 30, 2004 was $26.5 million, 2.7% less than $27.3 million for the
comparable prior year period. As a percentage of total revenue, compensation
expense decreased to 9.6% for the nine months ended September 30, 2004 from
11.1% for the nine months ended September 30, 2003 due to continuing cost
management efforts. Compensation expense for the nine months ended September 30,
2004 attributable to the SMSG segment was $24.6 million compared to $18.6
million for the nine month period ended September 30, 2003; this increase can be
attributed to a greater amount of management's time and effort being expended on
behalf of the SMSG segment in 2004. As a percentage of revenue, compensation
expense increased to 9.0% from 8.9% in the comparable prior year period.
Compensation expense for the nine months ended September 30, 2004 attributable
to the PPG segment was $1.9 million or 75.2% of PPG revenue, compared to $8.7
million or 24.4% in the prior year period. A large portion of compensation
expense through the nine months ended September 30, 2004 attributable to the PPG
segment was for severance related activities which occurred in the first quarter
of 2004. The decrease from the comparable prior year period can be attributed to
the lower level of resources required after the completion of the Lotensin
contract which ended December 31, 2003.
OTHER SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Total other selling,
general and administrative expenses were $19.1 million for the nine months ended
September 30, 2004, 7.8% less than other selling, general and administrative
expenses of $20.7 million for the nine months ended September 30, 2003.
Excluding approximately $700,000 in legal fee reimbursements from Bayer for the
nine months ended September 30, 2003, total other selling, general and
administrative expenses are approximately $2.3 million less for the comparable
period in 2004. As a percentage of total revenue, total other selling, general
and administrative expenses decreased to 6.9% for the nine months ended
September 30, 2004 from 8.4% for the nine months ended September 30, 2003. Other
selling, general and administrative expenses attributable to the SMSG segment
for the nine months ended September 30, 2004 were $18.2 million, compared to
other selling, general and administrative
33
expenses of $12.8 million attributable to that segment for the comparable prior
year period. This increase is primarily due to a larger portion of resources and
corporate overhead costs being expended on behalf of the SMSG segment in the
current period. As a percentage of revenue from sales and marketing services,
other selling, general and administrative expenses were 6.6% and 6.1% for the
nine months ended September 30, 2004 and 2003, respectively. Other selling,
general and administrative expenses attributable to the PPG segment for the nine
months ended September 30, 2004 were approximately $873,000 compared to $7.9
million for the comparable prior year period; this decrease can be attributed to
the lower level of resources required after the completion of the Lotensin
contract which ended December 31, 2003 and the termination of the Xylos
agreement.
RESTRUCTURING AND OTHER RELATED EXPENSES (CREDITS). For the nine months
ended September 30, 2004 we did not recognize any adjustments to the
restructuring accrual. During the quarter ended March 31, 2003, we recognized a
$270,000 reduction in the restructuring accrual due to negotiating higher
sublease proceeds than originally estimated for the leased facility in
Cincinnati, Ohio. During the quarter ended June 30, 2003, we also incurred
approximately $133,000 of additional restructuring expense due to higher than
expected contractual termination costs. This additional expense was recorded in
program expenses consistent with the original recording of the restructuring
charges. Also during the quarter ended June 30, 2003 we recognized a $473,000
reduction in the restructuring accrual due to greater success in the
reassignment of sales representatives to other programs and the voluntary
departure of other sales representatives which combined to reduce the
requirement for severance costs. This adjustment was recorded in program
expenses consistent with the original recording of the restructuring charges.
See the "RESTRUCTURING AND OTHER RELATED EXPENSES" disclosure below for further
explanations of the Restructuring Plan and related activity.
LITIGATION SETTLEMENT. On May 8, 2003, we entered into a settlement and
mutual release agreement with Auxillium (Settlement Agreement). The settlement
terms included a cash payment paid upon execution of the Settlement Agreement
and other additional expenses that totaled $2.1 million. This expense was
recorded in the quarter ended March 31, 2003.
OPERATING INCOME. Operating income for the nine months ended September 30,
2004 was $27.1 million, an increase of 122.9%, compared to operating income of
$12.1 million for the nine months ended September 30, 2003. Operating income as
a percentage of revenue increased to 9.8% for the nine months ended September
30, 2004 from 5.0% in the comparable prior year period. This relates to higher
revenue and gross margin from the impact of three dedicated sales contracts
entered into in July 2003 as well as the impact of management's cost containment
efforts. Operating income for the nine months ended September 30, 2004 for the
SMSG segment was $27.6 million, or 20.5% higher than the SMSG operating income
for the nine months ended September 30, 2003 of $22.9 million. As a percentage
of revenue from the sales and marketing services segment, operating income for
that segment decreased to 10.1% for the nine months ended September 30, 2004,
from 10.9% for the comparable prior year period. There was an operating loss for
the PPG segment for the nine months ended September 30, 2004 of approximately
$508,000, substantially due to the $1.2 million increase in the Ceftin returns
reserve, compared to an operating loss of $10.7 million for the prior year
period.
OTHER INCOME, NET. Other income, net, for the nine months ended September
30, 2004 and 2003 was $860,000 and $741,000, respectively, and was comprised
primarily of interest income.
PROVISION FOR INCOME TAXES. Income tax expense was $11.5 million for the
nine months ended September 30, 2004, compared to income tax expense of
approximately $5.1 million for the nine months ended September 30, 2003, which
consisted of Federal and state corporate income taxes. The effective tax rate
for the nine month period ended September 30, 2004 was 41.0%, comparable to an
effective tax rate of 39.7 % for the nine months ended September 30, 2003. The
rate for the nine months ended September 30, 2003 was lower than the Company's
average annual effective rate because the return to profitable
34
operations in 2003 enabled the utilization of tax loss carry-forwards for
certain states. The rate for the quarter ended September 30, 2004 was in line
with the expected rate for the year.
NET INCOME. Net income for the nine months ended September 30, 2004 was
approximately $16.5 million, compared to net income of approximately $7.8
million for the nine months ended September 30, 2003. This increase is due to
the factors discussed above.
LIQUIDITY AND CAPITAL RESOURCES
As of September 30, 2004, we had cash and cash equivalents and short-term
investments of approximately $106.3 million and working capital of approximately
$88.0 million, compared to cash and cash equivalents and short-term investments
of approximately $114.6 million and working capital of approximately $100.0
million at December 31, 2003.
For the nine months ended September 30, 2004, net cash provided by
operating activities was $24.7 million, compared to $28.6 million net cash
provided by operating activities for the nine months ended September 30, 2003.
The main components of cash provided by operating activities during the nine
months ended September 30, 2004 were:
o net income of approximately $16.5 million; and
o decrease in the net deferred tax asset of approximately $7.7 million;
and
o depreciation and other non-cash expenses of approximately $5.7 million
which included bad debt expense of approximately $54,000, stock
compensation expense of approximately $1.1 million and amortization of
intangible assets of approximately $567,000, each of which was charged
to SG&A; and loss on disposal of assets of approximately $264,000,
partially offset by
o a net cash decrease in "other changes in assets and liabilities" of
$5.2 million.
As of September 30, 2004, we had $2.4 million of unbilled costs and
accrued profits on contracts in progress. When services are performed in advance
of billing, the value of such services is recorded as unbilled costs and accrued
profits on contracts in progress. Normally, all unbilled costs and accrued
profits are earned and billed within 12 months from the end of the respective
period. Also, as of September 30, 2004, we had $9.8 million of unearned contract
revenue. When we bill clients for services before they have been completed,
billed amounts are recorded as unearned contract revenue, and are recorded as
revenue when earned.
The net changes in the "Other changes in assets and liabilities" section
of the consolidated statement of cash flows may fluctuate depending on a number
of factors, including the number and size of programs, contract terms and other
timing issues; these variations may change in size and direction with each
reporting period. A major net cash outflow in 2004 has been net payments of
$18.2 million to reimburse customers for returns of Ceftin product.
For the nine months ended September 30, 2004, net cash used in investing
activities was $63.8 million. The main components consisted of the following:
o Approximately $27.6 million used in the purchase of a laddered
portfolio of short-term investments in very high grade debt instruments
with a focus on preserving capital, maintaining liquidity, and
maximizing returns in accordance with our investment criteria.
35
o Capital expenditures during the nine-month period ended September 30,
2004 were $7.8 million, almost entirely composed of purchases related
to the move to our new corporate headquarters which occurred in July of
2004. The lease at our new location, which replaces our expiring
leases, is for approximately 83,000 square feet and has a duration of
approximately 12 years at market rates. There was approximately $1.5
million in capital expenditures for the nine months ended September 30,
2003. For both periods, all capital expenditures were funded out of
available cash.
On August 31, 2004, the Company acquired substantially all of the assets
of Pharmakon, L.L.C. ("Pharmakon") in a transaction treated as an asset
acquisition for tax purposes. The acquisition has been accounted for as a
purchase, subject to the provisions of Statement of Financial Accounting
Standards (SFAS) 141. The Company made payments to the members of
Pharmakon at closing of $27.4 million, and assumed approximately $2.6
million in net liabilities. Additional payments of approximately $1.0
million were made as a result of closing costs. Additionally, the members
of Pharmakon can still earn up to an additional $10 million in cash based
upon achievement of certain annual profit targets through December 2006.
In connection with this transaction, the Company recorded $10.6 million in
goodwill and $18.9 million in other identifiable intangible assets.
For the nine months ended September 30, 2004, net cash provided by
financing activities of approximately $3.1 million was due to the net proceeds
received from the exercise of stock options and the employee stock purchase
plan.
Our revenue and profitability depend to a great extent on our
relationships with a limited number of large pharmaceutical companies. For the
nine months ended September 30, 2004, we had two major clients that accounted
for, in the aggregate, approximately 43.8% and 21.1%, respectively, or a total
of 64.9% of our service revenue. We are likely to continue to experience a high
degree of client concentration, particularly if there is further consolidation
within the pharmaceutical industry. The loss or a significant reduction of
business from any of our major clients, or a decrease in demand for our
services, could have a material adverse effect on our business, financial
condition and results of operations.
Under our licensing agreement with Cellegy, we will be required to pay
Cellegy a $10.0 million incremental license fee milestone payment upon
Fortigel's receipt of all approvals required by the FDA to promote, sell and
distribute the product in the U.S. Upon payment, this incremental milestone
license fee will be recorded as an intangible asset and amortized over the
estimated commercial life of the product, as then determined. This payment will
be funded, when due, out of cash flows provided by operations and existing cash
balances. In addition, under the licensing agreement, we would be required to
pay Cellegy royalty payments ranging from 20% to 30% of net sales, including
minimum royalty payments, if and when complete FDA approval is received. The
initial 10-month Prescription Drug User Fee Act (PDUFA) date for the product was
April 5, 2003. In March 2003, Cellegy was notified by the FDA that the PDUFA
date had been revised to July 3, 2003. On July 3, 2003, Cellegy was notified by
the FDA that Fortigel was not approved. Cellegy is in discussions with the FDA
to determine the appropriate course of action needed to meet deficiencies cited
by the FDA in its determination. We cannot predict with any certainty that the
FDA will ultimately approve Fortigel for sale in the U.S. Management believes
that it will not be required to pay Cellegy the $10.0 million incremental
license fee milestone payment in 2004, and it is unclear at this point when or
if Cellegy will get Fortigel approved by the FDA which would trigger our
obligation to pay $10.0 million to Cellegy.
On December 12, 2003, we filed a complaint against Cellegy in the U.S.
District Court for the
36
Southern District of New York. The complaint alleges that Cellegy fraudulently
induced us to enter into a license agreement with Cellegy regarding Fortigel on
December 31, 2002. The complaint also alleges claims for misrepresentation and
breach of contract related to the license agreement. In the complaint, we seek,
among other things, rescission of the license agreement and return of the $15.0
million we paid Cellegy. After we filed this lawsuit, also on December 12, 2003,
Cellegy filed a complaint against us in the U.S. District Court for the Northern
District of California. Cellegy's complaint seeks a declaration that Cellegy did
not fraudulently induce us to enter the license agreement and that Cellegy has
not breached its obligations under the license agreement. We filed an answer to
Cellegy's complaint on June 18, 2004, in which we make the same allegations and
claims for relief as we do in our New York action, and we also allege Cellegy
violated California unfair competition law. By order dated April 23, 2004 our
lawsuit was transferred to the Northern District of California where it may be
consolidated with Cellegy's action. We are unable to predict the ultimate
outcome of these lawsuits.
We believe that our existing cash balances and expected cash flows
generated from operations will be sufficient to meet our operating and capital
requirements for the next 12 months. We continue to evaluate and review
financing opportunities and acquisition candidates in the ordinary course of
business.
RESTRUCTURING AND OTHER RELATED EXPENSES
During the third quarter of 2002, we adopted a restructuring plan, the
objective of which was to consolidate operations in order to enhance operating
efficiencies (the 2002 Restructuring Plan). This plan was primarily in response
to the general decrease in demand within our markets for the sales and marketing
services segment, and the recognition that the infrastructure that supported
these business units was larger than required. We originally estimated that the
restructuring would result in annualized SG&A savings of approximately $14.0
million, based on the level of SG&A spending at the time we initiated the
restructuring. However, these savings have been partially offset by incremental
SG&A expenses we incurred in subsequent periods, as we have been successful in
expanding our business platforms. Substantially all of the restructuring
activities were completed as of December 31, 2003.
During the quarter ended March 31, 2003, we recognized a $270,000
reduction in the restructuring accrual due to negotiating higher sublease
proceeds than originally estimated for the leased facility in Cincinnati, Ohio.
During the quarter ended June 30, 2003 we incurred approximately $133,000
of additional restructuring expense due to higher than expected contractual
termination costs. This additional expense was recorded in program expenses
consistent with the original recording of the restructuring charges.
Also during the quarter ended June 30, 2003 we recognized a $473,000
reduction in the restructuring accrual due to lower than expected sales force
severance costs. Greater success in the reassignment of sales representatives to
other programs and the voluntary departure of other sales representatives
combined to reduce the requirement for severance costs. This adjustment was
recorded in program expenses consistent with the original recording of the
restructuring charges.
The accrual for restructuring and exit costs totaled approximately
$321,000 at September 30, 2004, and is recorded in current liabilities on the
accompanying balance sheet.
A roll forward of the activity for the 2002 Restructuring Plan is as
follows:
BALANCE AT BALANCE AT
DECEMBER 31, SEPTEMBER 30,
(IN THOUSANDS) 2003 ADJUSTMENTS PAYMENTS 2004
----------- ----------- -------- ------------
Administrative severance $285 $ -- $(199) $ 86
Exit costs 459 -- (224) 235
---- ----- ----- ----
744 -- (423) 321
---- ----- ----- ----
Sales force severance -- -- -- --
---- ----- ----- ----
TOTAL $744 $ -- $(423) $321
==== ===== ===== ====
37
ITEM 4. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
The Company became aware of the applicability of the accounting
pronouncement, EITF 01-14, to the Company's financial statements in September
2004. EITF 01-14 should have been applied to the Company's financial statements
beginning with first quarter of 2002. Due to the non-application of EITF 01-14
since 2002, the Company discovered certain errors in the classification of
reimbursable out-of-pocket expenses in its consolidated statements of operations
since 2002, which are described in Note 1B to the consolidated financial
statements in the Form 10-K/A for 2003 and the Form 10-Q/A's for the periods
ended March 31, 2004 and June 30, 2004, each of which were filed on November 3,
2004. As a result, the Company determined that a material weakness existed in
its disclosure controls regarding the selection and application of generally
accepted accounting principles (GAAP), and preparation of the consolidated
financial statements through June 30, 2004.
Beginning in September 2004, the Company has taken a series of steps
designed to improve the control processes regarding the selection and
application of GAAP and preparation and review of the consolidated financial
statements. Specifically, key personnel involved in the Company's financial
reporting processes have enhanced the process through which authoritative
guidance will be monitored on a regular basis. Review of both authoritative
guidance and industry practices will be conducted in order to ensure that all
new guidance is being complied with in the preparation of the financial
statements, related disclosures and periodic filings with the SEC. Additionally,
when the Company became aware of the non-application of EITF 01-14, all prior
consolidated financial statements which were filed with the SEC since 2002 were
reviewed internally and by an outside consultant for compliance with all
authoritative guidance and the application of GAAP and such filings were
determined to be in compliance.
The Company will be testing these controls in connection with management's
December 31, 2004 evaluation and opinion on the effectiveness of the Company's
internal controls.
Based on the Company's evaluation as of September 30, 2004, the Company's
management, with the participation of its chief executive officer and chief
financial officer, has evaluated the effectiveness of the Company's financial
reporting and disclosure controls and procedures (as such terms are defined in
Rules 13a-15(e), 13a-15(f), 15d-15(e) and 15d-15(f) under the Securities
Exchange Act of 1934, as amended (the "Exchange Act")) as of September 30, 2004.
Based on that evaluation, including the improvement in controls and procedures
described above, the Company's chief executive officer and chief financial
officer have concluded that, as of September 30, 2004, the Company's financial
reporting and disclosure controls and procedures are effective.
CHANGES IN INTERNAL CONTROLS
Except as described above in "Evaluation of Disclosure Controls and
Procedures", there has been no change in the Company's internal control over
financial reporting and disclosure controls (as such terms are defined in Rules
Rules 13a-15(e), 13a-15(f), 15d-15(e) and 15d-15(f) under the Exchange Act) that
was identified in connection with management's evaluation, as described above,
that has materially affected, or is reasonably likely to materially affect, the
Company's internal control over financial reporting.
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PART II - OTHER INFORMATION
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ITEM 1 - LEGAL PROCEEDINGS
SECURITIES LITIGATION
In January and February 2002, we, our chief executive officer and our
chief financial officer were served with three complaints that were filed in the
United States District Court for the District of New Jersey alleging violations
of the Securities Exchange Act of 1934 (the "Exchange Act"). These complaints
were brought as purported shareholder class actions under Sections 10(b) and
20(a) of the Exchange Act and Rule 10b-5 established thereunder. On May 23,
2002, the Court consolidated all three lawsuits into a single action entitled In
re PDI Securities Litigation, Master File No. 02-CV-0211, and appointed lead
plaintiffs ("Lead Plaintiffs") and Lead Plaintiffs' counsel. On or about
December 13, 2002, Lead Plaintiffs filed a second consolidated and amended
complaint ("Second Consolidated and Amended Complaint"), which superseded their
earlier complaints.
The complaint names us, our chief executive officer and our chief
financial officer as defendants; purports to state claims against us on behalf
of all persons who purchased our common stock between May 22, 2001 and August
12, 2002; and seeks money damages in unspecified amounts and litigation expenses
including attorneys' and experts' fees. The essence of the allegations in the
Second Consolidated and Amended Complaint is that we intentionally or recklessly
made false or misleading public statements and omissions concerning our
financial condition and prospects with respect to our marketing of Ceftin in
connection with the October 2000 distribution agreement with GlaxoSmithKline,
our marketing of Lotensin in connection with the May 2001 distribution agreement
with Novartis Pharmaceuticals Corporation, as well as our marketing of Evista(R)
in connection with the October 2001 distribution agreement with Eli Lilly and
Company.
In February 2003, we filed a motion to dismiss the Second Consolidated and
Amended Complaint under the Private Securities Litigation Reform Act of 1995 and
Rules 9(b) and 12(b)(6) of the Federal Rules of Civil Procedure. That motion is
fully submitted to the court for its decision. We believe that the allegations
in this purported securities class action are without merit and we intend to
defend the action vigorously.
BAYER-BAYCOL LITIGATION
We have been named as a defendant in numerous lawsuits, including two
class action matters, alleging claims arising from the use of Baycol, a
prescription cholesterol-lowering medication. Baycol was distributed, promoted
and sold by Bayer in the U.S. through early August 2001, at which time Bayer
voluntarily withdrew Baycol from the U.S. market. Bayer retained certain
companies, such as us, to provide detailing services on its behalf pursuant to
contract sales force agreements. We may be named in additional similar lawsuits.
To date, we have defended these actions vigorously and have asserted a
contractual right of defense and indemnification against Bayer for all costs and
expenses we incur relating to these proceedings. In February 2003, we entered
into a joint defense and indemnification agreement with Bayer, pursuant to which
Bayer has agreed to assume substantially all of our defense costs in pending and
prospective proceedings and to indemnify us in these lawsuits, subject to
certain limited exceptions. Further, Bayer agreed to reimburse us for all
reasonable costs and expenses incurred to date in defending these proceedings.
To date, Bayer has reimbursed us for approximately $1.6 million in legal
expenses.
39
CELLEGY PHARMACEUTICALS LITIGATION
On December 12, 2003, we filed a complaint against Cellegy in the U.S.
District Court for the Southern District of New York. The complaint alleges that
Cellegy fraudulently induced us to enter into a license agreement with Cellegy
regarding Fortigel on December 31, 2002. The complaint also alleges claims for
misrepresentation and breach of contract related to the license agreement. In
the complaint, we seek, among other things, rescission of the license agreement
and return of the $15.0 million we paid Cellegy. After we filed this lawsuit,
also on December 12, 2003, Cellegy filed a complaint against us in the U.S.
District Court for the Northern District of California. Cellegy's complaint
seeks a declaration that Cellegy did not fraudulently induce us to enter the
license agreement and that Cellegy has not breached its obligations under the
license agreement. We filed an answer to Cellegy's complaint on June 18, 2004,
in which we make the same allegations and claims for relief as we do in our New
York action, and we also allege Cellegy violated California unfair competition
law. By order dated April 23, 2004 our lawsuit was transferred to the Northern
District of California where it may be consolidated with Cellegy's action. We
are unable to predict the ultimate outcome of these lawsuits.
OTHER LEGAL PROCEEDINGS
We are currently a party to other legal proceedings incidental to our
business. While management currently believes that the ultimate outcome of these
proceedings, individually and in the aggregate, will not have a material adverse
effect on our consolidated financial statements, litigation is subject to
inherent uncertainties. Were we to settle a proceeding for a material amount or
were an unfavorable ruling to occur, there exists the possibility of a material
adverse effect on our business, financial condition and results of operations.
No material amounts have been accrued for losses under any of the above
mentioned matters, as no amounts are considered probable or reasonably estimable
at this time.
ITEM 6 - EXHIBITS
Exhibit
No.
- -------
31.1 Certification of Chief Executive Officer Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002
31.2 Certification of Chief Financial Officer Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002
32.1 Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section
1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002
32.2 Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section
1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002
40
SIGNATURES
In accordance with the requirements of the Securities and Exchange Act of
1934, the registrant has caused this report to be signed on its behalf by the
undersigned, thereto duly authorized.
November 3, 2004 PDI, INC.
(Registrant)
By: /s/ Charles T. Saldarini
--------------------------------------
Charles T. Saldarini
Chief Executive Officer
By: /s/ Bernard C. Boyle
--------------------------------------
Bernard C. Boyle
Chief Financial and Accounting Officer
41