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Pharmaceutical Product Development, Inc. (NASDAQ:PPDI)

Q2 2011 Earnings Conference Call

July 27, 2011 9:00 am ET

Executives

Luke Heagle – Investor Relations

Fredric N. Eshelman, Pharm.D. – Executive Chairman

Daniel G. Darazsdi – Chief Financial Officer

William J. Sharbaugh – Chief Operating Officer

Analysts

John Kreger – William Blair & Company, L.L.C.

Robert Jones – Goldman Sachs

Todd Van Fleet – First Analysis Corp.

Eric Coldwell – Robert W. Baird & Co.

James Kumpel – BB&T Capital Markets

Douglas Tsao – Barclays Capital

Sandy Draper – Raymond James

Stephen Unger – Lazard Capital Markets

David Windley – Jefferies & Co.

Operator

Good morning. My name is Steve, and I will be your conference operator today. At this time, I would like to welcome everyone to the PPD's Second Quarter 2011 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions) Thank you.

At this time, I would like to turn the call over to Mr. Luke Heagle, Executive Director of Investor Relations. You may begin, Sir.

Luke Heagle

Good morning, and welcome to PPD's second quarter 2011 earnings conference call. In our comments today, we will refer to selected non-GAAP financial measures for all period discussed today unless specifically noted, net revenue, SG&A expense and margins exclude reimbursed out-of-pocket and equity compensation expense.

For a quantitative reconciliation of all non-GAAP numbers discussed in today's call to the most comparable GAAP measure, please see the reconciliation information that is posted under Presentations and Events in the Investors section of our website.

I'd like to remind everyone that except for historical information, all of the statements, expectations and assumptions discussed in today's call are forward-looking statements that involve a number of risks and uncertainties.

Actual results might differ materially from those in the forward-looking statements. Information about factors that could cause actual results to vary is disclosed in the press release announcing our results and in the SEC filings for PPD, copies of which are available free of charge from our Investor Relations department.

I will now turn the call over to our Executive Chairman, Dr. Fred Eshelman.

Fredric N. Eshelman

Thanks, Luke and good morning to you all. It is our pleasure to report second quarter 2011 results. The team will give you details in a few minutes. But first, I’d like to hit some highlights and make a few comments.

As Luke noted, I will be referring to certain non-GAAP numbers, which do not include reimbursed out-of-pockets or equity compensation expense.

Year-over-year total revenue grew 10.2% and operating margin improved 368 basis points. RFP flow for the first half of 2011 was up more than 40% versus the first half of 2010 and the competitive hit rate improved over 500 basis points.

The sales cycle did appear to lengthen somewhat. We had a very solid sales quarter of $753 million, and despite higher than normal cancellations we had a book to bill of 1.29. Backlog grew 14.2% year-over-year to a $3.685 billion. DSO remained in the mid 20s at 26.

Looking at the segments for clinical development sciences we significantly reduced SG&A as a percent of revenue year-over-year. Gross margin held up above our 50% target and operating margin improved 462 basis points year-over-year. Clinical revenue grew at 14.1% versus Q2 of 2010. On the lab side, revenue grew 8.1% year-over-year, but importantly grew 10.6% versus Q1 of 2011.

Gross margin deteriorated due to lower than expected performance in the Vaccine Lab and BioDuro. G&A was reduced as a percent of revenue year-over-year, but due to the gross margin fall, overall operating margin continued below that of 2010. However versus Q1 of 2011, operating margin improved 226 basis points. So the business is performing well with exception of vaccines in BioDuro and Dr. Babiss is available to share our plans and efforts there.

As to the CEO search, we have identified good candidates and the process of interviewing and selecting continues to move forward. As I have noted previously, we are focused on finding the right candidate unless so on the speed of the process.

You all saw the recent press release regarding our ongoing strategic and capital structure review. Our board including our new directors requested this review. We’ve hired a financial advisor to assist with the review including advising us on potential ways to unlock value for shareholders. As noted in our release, this review does not envision a combination with another CRO. The review continues and of course we will update you if and as appropriate.

Now, we will hear from our CFO, Dan Darazsdi.

Daniel G. Darazsdi

Thank you, Fred and good morning. Net revenue increased 10% year-over-year to $376.2 million in the second quarter of 2011. We delivered year-over-year net revenue growth of 14% in our Clinical Development Services segment, and Laboratory Services segment net revenue increased 8% year-over-year and 11% sequentially. The sequential increase in Laboratory Services segment net revenue was due primarily to growth in our bioanalytical lab, Phase I clinic and global central lab.

We expect Laboratory Services segment net revenue growth to remain strong on a sequential basis throughout the year. Foreign exchange positively impacted net revenue in the second quarter converted at average second quarter 2010 rates net revenue would have been $6.6 million lower.

Backlog increased 14% year-over-year at quarter end and breaks down by client type as follows: 77% pharmaceutical, 17% biotechnology and 6% government and other. The weighted average backlog duration at the end of the second quarter was 33 months with our backlog conversion rate to revenue increasing slightly to 10.5% of beginning backlog.

Cancellations and adjustments for the second quarter were considerably higher than recent quarters, due in part to a $43 million cancellation for a global clinical trial. This cancellation was due to the sale of a compound by a mid-sized pharma company prior to start of the trial.

Our gross margin for the second quarter was approximately 50% driven by continued strong gross margin above our 50% objective within our Clinical Development Services segment.

Second quarter SG&A expense as a percent of revenue was soft on a sequential basis, including $1.5 million related to the elimination of excess space in our Latin America clinical development services business and consolidating our EMEA and Asia-Pacific information technology call center services and our existing call center in Sofia, Bulgaria.

Our entire management team continues to focus on all SG&A spending to drive productivity gains as we deliver revenue more efficiently.

Operating margin increase to 16.5% in the second quarter, Clinical Development Services segment operating margin of 18.2% remain strong for the quarter. And Laboratory Services segment operating margin increased over 200 basis point sequentially to 10.8%. Increased investment to support the future growth of our drug discovery services business, BioDuro and soft net revenue in our vaccine and biologic center of excellence continue to pressure Laboratory Services segment operating margin in the second quarter. We expect the Laboratory Services segment operating margin to continue to increase throughout the year driven by strong sequential net revenue growth and operating efficiency.

Foreign exchange negatively impacted operating income in the second quarter, converted at average second quarter 2010 rates operating income would have been $3.8 million higher and operating margin would have been over 100 basis points higher.

Our second quarter equity compensation expense was $5.0 million. Other income for the quarter was $0.3 million tend to remain relatively low, mostly due to nominal yields on our investments.

Our investment in Celtic Therapeutics generated income of $10.6 million during the quarter due primarily to an increase in the fair market value of the funds investment. We expect the impact from this investment to be positive in both the third and fourth quarters of this year.

The effective tax rates for the second quarter was 32%, but should be within our guidance range for the balance of the year. Diluted earnings per share for the second quarter of 2011 were $0.41, which included a $1.3 million loss on investments.

Cash flows from operations for the quarter was $18 million and was impacted by significant income tax payments in the quarter and an increase in DSOs to 26 days outstanding.

Capital expenditures were $26.0 million including investments in our new bioanalytical laboratory in Richmond, Virginia for dedicated client demand of $10.5 million, our vaccines and biologic centre of excellence of $3.5 million, BioDuro of $2.4 million and our cGMP Labs of $2.1 million along with the investments in technology and our facilities.

We finished the second quarter with a strong balance sheet including $440 million in cash and short and long-term investments and no debt.

This concludes my remarks. I will now turn it over to our Chief Operating Officer, Bill Sharbaugh.

William J. Sharbaugh

Thank you, Dan. We made solid progress executing on our operational initiatives during the second quarter, and our Q2 performance is a direct result of our focus on top line growth and productivity improvement. We continue to generate solid net revenue growth year-over-year in both business segments while controlling SG&A costs and expanding our Laboratory Services segment operating margin.

we are maintaining financial discipline. our pricing philosophy remains unchanged and we are selling on value and quality to maintain strong margin delivery in the years ahead.

Our continued client focus and operating flexibility resulted in strong growth authorizations for the quarter, and we are seeing signs of improving market conditions. We experienced very strong RFP activity in Phase II through IV during the quarter and our hit rates improved.

RFPs received were at a record high in terms of the absolute number and the dollar value. Two observations are worth noting: first, our strategic partners made significant contribution to growth authorizations for the quarter. Secondly, we saw sizeable awards from biotech companies, which signaled at funding is showing signs of recovery.

We continue to see a shift in revenue from North America to emerging markets and our global revenue profile for the second quarter with a 55% North America versus 45% rest of world.

Second quarter net revenue breaks down by therapeutic area with oncology as our largest, followed by cardiovascular, endocrine and infectious disease. Our top client represented less than 10% of year-to-date revenue, our top five clients accounted for 36% of year-to-date revenue, and the top 25 clients accounted for 74% of year-to-date revenue. Headcount increased slightly to a 11,253 at quarter end.

I will now review the second quarter performance of our Clinical Development Services and Laboratory Services business segments. Clinical Development Services segment net revenue grew 14% year-over-year and the operating margin remained strong at 18.2%. We delivered solid year-over-year net revenue growth in all regions with the strongest growth in Latin America and Asia Pacific.

Asia Pacific remains a key growth area for us and I’m pleased to welcome Edward Ian to PPD as Vice President of Clinical Development Services for Asia Pacific. He will provide strategic and operational leadership for our clinical business in this important region.

During the quarter, we renewed our focus on quality and continuous improvement fostering our culture of operational excellence is vital to our future success and this is reflected in our number one ranking amongst CROs in CenterWatch’s 2011 Global Site Survey. We were also pleased to receive the 2011 Microsoft Life Sciences Innovation Award for PPD 3D, which is a virtual collaboration technology designed to improve the cost effectiveness, speed and quality of clinical trial training.

Turning to our Laboratory Services segment, net revenue for this segment increased 8% year-over-year and 11% sequentially. Operating margin improved 226 basis points sequentially and we expect continued operating margin expansion through out the rest of the year.

But Phase I clinic recovered nicely from unexpected cancellations in the first quarter delivering strong sequential net revenue growth. The bioanalytical lab and global central lab also delivered strong net revenue growth on a sequential basis.

This month, we opened our new purpose build laboratory in Richmond, Virginia to support vaccine testing and its state of the art facility is expected to contribute solid top line growth in the second half of 2011.

The GMP Lab also performed well during the quarter adding 15 new clients across our U.S. and Ireland locations to drive future growth.

Second quarter gross authorizations were strong for our Phase I clinic bioanalytical lab and GMP lab and exceeded internal targets. Overall lab backlog increased 8% year-over-year. The soft areas were BioDuro and the vaccine lab. BioDuro delivered a slight increase in year-over-year revenue and the vaccine lab delivered a slight decrease in year-over-year revenue. Both delivered lower than expected gross authorizations.

While performance did not meet our expectations, we anticipate both businesses to improve throughout the remainder of the year. We have strengthened our business development and scientific expertise at BioDuro, and we are late stage discussions with two large pharma companies for strategic partnerships within our vaccine’s lab. We expect Laboratory Services segment net revenue growth to remain strong on a sequential basis. It’s driving operating margin expansion in the second half of this year.

That concludes my comments and we are now ready for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes from the line of John Kreger with William Blair. Your line is now open.

John Kreger – William Blair & Company, L.L.C.

Hi, thanks very much. Could you just give us a review of how you view competitive pricing dynamics at this point across your various businesses? Are they getting better? Are they getting worse? And how do you feel, how does that influence your view about ability to drive margin improvements over the balance of the year?

Fredric N. Eshelman

Dan, you’re going to take that?

Daniel G. Darazsdi

I will take that. I would say principally when we look at pricing, we are continuing to put forward our value proposition as we always have. We don’t see a lot of change in our response from a pricing view point. We are taking our pricing forward with the focus on supporting our value proposition. I think that’s been really consistent, you’ve seen that, we’ve had a nice uplift in authorizations, and through this process we are maintaining our pricing philosophy and discipline.

John Kreger – William Blair & Company, L.L.C.

That’s great, thanks. Some of the proposal flow comments that you mentioned were very encouraging. If you look at that improvement across different client segments, where do you see the most notable improvement, is the improved business are really coming more from the larger pharma companies or from the smaller client basin? And I guess there would be a similar question around hit rate. Did you see your hit rate improve across both of those client classes or more in one versus the other?

William J. Sharbaugh

Yeah. I’ll go ahead and take that one. Obviously, we’re seeing an up-tick from our strategic partnerships, which we think is a promising sign. If you look at the quarter, a little over half of our second quarter net revenue, growth authorizations and a large chunk of our backlog are from the strategic partners. So we’re certainly seeing those partnerships and large pharma contribute. I did mention that we saw some signs of life from smaller biotech companies, which could be an indication of fundings picking up.

John Kreger – William Blair & Company, L.L.C.

Yeah. And the hit rate question, Bill, pretty consistent across both classes?

William J. Sharbaugh

Yeah. As Fred mentioned, he gave some specific numbers. Our hit rate looks really good and we saw year-on-year and sequential improvement there.

John Kreger – William Blair & Company, L.L.C.

Okay.

Fredric N. Eshelman

Yeah, John, this is Fred, just to quantify that a little bit. I think as Bill noted, as the strategic accounts really begin to pick up and contribute more both revenue and authorizations, we should expect to see some up-tick in the competitive hit rate because if we happen to be in an account where there are only two major players, then by definition, you get under most circumstances about 50% of what they have.

John Kreger – William Blair & Company, L.L.C.

Makes sense. Thanks very much.

Operator

Your next question comes from the line of Robert Jones with Goldman Sachs. Your line is now open.

Robert Jones – Goldman Sachs

Thanks for the questions. I think one of the question obviously in everyone's mind is around the idea of unlocking value and understanding it's a very fluid process at this point, but I was wondering, Fred, if maybe you could just take a step back and help us understand the motivation around the timing to have the management team evaluate the strategic plan at this point.

Fredric N. Eshelman

Well, as I indicated and as we indicated in our press release, our Board and in particular our new board members of which there are three, thought it would be a very good time to have a strategic review not only in interest of the company and shareholders, but also as somewhat of an educational exercise for the new directors. Naturally, while we were doing that and while we were putting together extensive plans and numbers and so forth and so on, it became pretty obvious that, that would be a good time to see, are there other ways that we could unlock value for shareholders given how the stock price has performed. And having said that, that’s about all the comments we can make on that, and I guess I'd have to refer you back to our press release.

Robert Jones – Goldman Sachs

No, that’s fair. I appreciate the additional color. You guys also mentioned, I believe that conversion was lengthening somewhat. I guess could you talk a little bit about what the driver there was, and how are you guys thinking about conversion of backlog going forward?

Daniel G. Darazsdi

The conversion and backlog actually is quite good. I mean, we came in with a 33 month conversion rate on backlog, that’s in line actually a little bit better than it’s operated on a historic level, and the revenue conversion was quite positive.

William J. Sharbaugh

Yeah. Bob, I think what you’re referring to, Fred may mention that the sales cycle was lengthening a little bit, conversion is pretty steady.

Robert Jones – Goldman Sachs

Okay, good. Thanks for the clarification. And the last one I have is just on Celtic, you know obviously it’s something that you guys had mentioned should fluctuate quarter-to-quarter, I think the previous expectation of was that it would be neutral to slightly positive clearly a little bit more than that this quarter. Can you maybe just give us a sense of how much visibility you guys have into the earning stream from Celtic? Is it something where you can actually see ahead of a quarter, what the contribution is tracking at intra quarter or is it something you get once every three months?

Fredric N. Eshelman

This is Fred. It’s not an earning stream, it’s a revaluation of assets which they have to do, and they have a lengthy process that they go through with market research consultants who come up with numbers and then of course those numbers are vetted with a major big for accounting firm to come up with the actual numbers. So that’s how that occurs.

Robert Jones – Goldman Sachs

And I guess, is there any clarity on the expectation around that for the rest of the year?

Fredric N. Eshelman

Dan?

Daniel G. Darazsdi

You know, we think at this point, this is a place that’s going to fluctuate in full challenging the (inaudible). But we think over the next couple of quarters is like, we to be just slightly positive, and of course that can fluctuate.

Robert Jones – Goldman Sachs

Great. Thanks for the question.

Operator

Your next question comes from the line of Todd Van Fleet with First Analysis. Your line is open.

Todd Van Fleet – First Analysis Corp.

Hi, good morning, guys. I’m just curious as to what your view was with the impact of the softness in vaccine and BioDuro in the quarter in terms of kind of margin impact or EPS impact, if you could articulate that for us would be helpful.

Lee E. Babiss

Yes. I’ll take that, and good morning. This is Lee E. Babiss. Let me touch on the vaccine area first. Since the end of last year, we’ve seen growing interest amongst the major pharmaceutical companies that are doing vaccine work to outsource more of their lab work. And we believe we're poised to capture that because of not only the credibility of the technological capabilities we have in outlying facility, but also by the experience the 120 scientists have there having contributed to bringing four vaccines to the market while working at Merck.

We believe we have all of the platforms and the technical know-how in place. We primarily focus on prophylactic vaccines and there we have all assays in place in support of vaccines under markets as well as those in clinical trails today. We’re also working with government in support of epidemiological studies, and we’re investing and enhancing our PBMC and biorepository capabilities.

The Merck relationship is in year three of a five-year contract and that work is going well. We have signed on an additional large pharma client into three-year deal working at molecular efficacy by PCR as well as SBA testing. We have another large pharma client authorization that we plan to close this week and it’s up the same magnitude of the previous one that I just described. We have either completed or are doing pilot studies with all of the major pharmaceutical companies in the vaccine space as well as the midsize biotech’s as well.

All of the reports that we’re getting from those are leading to again, small term contracts as well as very positive feedback in terms of our abilities relative to the competition.

We continue to expand our capabilities in terms of platform testing, enhancing our biorepository capabilities and also poising ourselves to capture the emerging therapeutic vaccine R&D market.

From a network perspective, the network is expanding very nicely. Bill talked about our (inaudible) capabilities during vaccine work and the large contract we have there and that’s now expanding into a GMP area as well. So overall, we feel very good about the vaccine work as a growth drive that’s starting in Q3 of this year.

Todd Van Fleet – First Analysis Corp.

That sounds great. I guess I’m curious as well as to the performance because you had mentioned both the vaccine and the BioDuro business kind of hitting gross margin in the quarter. I would guess just based on the results that the short fall relative to your expectations in those two business segments was more on the expense side of the equation or the margin performance for that business rather than the revenue, although it sounds like though maybe that’s not entirely accurate and the way you’re talking about or ramp up or the expected ramp up for those businesses in the back half of the year. So the, I guess, what I’m saying as the overall margin performance for the business was below what we expected in the June quarter. You had would mention vaccines and BioDuro’s being of particular areas of softness relative to your expectations, I’m just trying to get to articulate what the shortfall was relative to your expectations?

Daniel G. Darazsdi

Yeah. Well, let me go ahead and face that. I think the point that we’re trying to make here is, our historical core laboratories are performing very well and meeting the expectations. What you have you know with BioDuro and the vaccine lab are two new businesses for the company. We’re making strategic investments in those businesses. In the bottom line, at this point in time you know we don’t have as much revenue growth to offset the investments that we’re making hence our margins are little bit lower than we want them to be. But what you here is a lot of confidence based on conversations with client and contracts that we’ve been in discussions with or closing over the course of this year and into the second half of the year to give us confidence that those two business units within our lab segment are going to improve thereby bringing up the entire segment.

Todd Van Fleet – First Analysis Corp.

Okay.

Fredric N. Eshelman

This is, Fred. I think you know folks are trying to get us to quantitate this somehow in this quarter, since we called this as being a negative impact so, do you have an estimate of what the impact might have been between vaccines and BioDuro.

Daniel G. Darazsdi

So, we haven’t really both forward direct impact on the margins from those specific businesses. I think the, one thing that we have really tried to highlight is that on a go forward basis in the third quarter and fourth quarter we’re expecting revenue growth to be strong from both of them in addition to some other parts of the prior business we’re expecting [bio way] to before be positive and our central lab to deliver strong. I would say just in general, with out the drag from those two businesses we would be approaching our 20% operating margin target for the segment.

Todd Van Fleet – First Analysis Corp.

Okay. If I could just ask one follow on then related to that. So thinking about the incremental margin for the new revenue that you expect to start moving through those businesses. I think it’s probably fair to say that it’s substantially above the corporate average overall, would it be fair to say that the incremental margin attached to the incremental revenue flowing to those businesses is north of say 40% or so.

Fredric N. Eshelman

Are you talking about on the gross basis or operating…

Todd Van Fleet – First Analysis Corp.

Operating…

William J. Sharbaugh

I’m not sure you can draw that conclusion. I think the, probably what you are looking to is you know our labs in general have stronger variable contribution when you start to get revenue growth, because of the overhead that’s already absorbed. So, yes as you get revenue growth it definitely gross margins in those lab businesses and lab businesses in general to try to break it up specific to the labs going to do that, but I think the insight of what I gave relative to what the quarter, that the quarter would have approached our targeted 20% with out that drug should provide pretty good insight.

Todd Van Fleet – First Analysis Corp.

Okay. Dan just quickly, what’s your share count you’re assuming for the year, full year?

Daniel G. Darazsdi

Share count for the year is 117 for the full year average for the diluted shares.

Todd Van Fleet – First Analysis Corp.

Okay. Thanks.

Operator

Your next question comes from the line of Eric Coldwell with R.W. Baird. Your line is open.

Eric Coldwell – Robert W. Baird & Co.

Thanks. Most of mine have been covered. Just a quick one recently one of the privately held bioanalytical competitors received some fairly serous FDA warnings and it’s in a process of working with the clients over the last five years to retest or those clients will need to retest all bioanalytical studies. I’m curious if things like this can be a positive short term drag for you in terms of your bioanalytical sales activity and how you respond to situations like this when a tremendous amount of rework needs to be done in this market place in a short period of time. Thanks.

William W. Richardson

Eric this is, Bill. It’s the opposite effect here at PPD, it’s not a drag our quality record in our bioanalytical lab is stellar. We have the FDA in there. I think last quarter and certainly had them in there last year. So, I think one of the value propositions for PPD is our quality record. So, we don’t see that as a drag or a potential problem

Eric Coldwell – Robert W. Baird & Co.

Actually maybe I didn’t state the question well. I actually was asking the client, the pharma are going to have to rework all of these bioanalytical studies that were done at that Houston facility for your competitor since 2005, and my question is whether that could actually drive a (inaudible) unexpected one time work and how you would attack that if it is an opportunity?

William J. Sharbaugh

Well, I don’t know the specifics of that particular client and what they need to reset. I can tell you that our doors are open if they want to bring our way.

Fredric N. Eshelman

Well, I think that if it’s a very quick push through, obviously it depends on whether or not those particular assay is validated or whether or not we have to start from scratch. But we had a similar situation some years ago that did in fact result in an up tick in our business.

Eric Coldwell – Robert W. Baird & Co.

Thanks, Fred. I was thinking the DNDS situation might be a good analogy at present for what could happen here, but I’ll take it offline. Thanks very much.

Operator

Your next question comes from the line of James Kumpel with BB&T Capital Markets. Your line is now open.

James Kumpel – BB&T Capital Markets

Good morning. I want to first start out with cash flows and see if you’re comfortable that second half operating cash flows and free cash flows will be need for improvements over the first half.

Daniel G. Darazsdi

Hey, James its, Dan. Let me just provide some additional details around cash. Cash from operations was $18 million lower than you know previously historically kind of delivered, and we had a significant tax payment in the quarter and just to kind of calibrate that a little bit for you, US and foreign tax was paid for around $30.6 million in Q2 and to give you some past sides around that first quarter was around $2.4 million and second quarter was tense to be a higher cash tax payment quarter was about $16.1 million. So that you know really it needs to be taken into consideration plus you know we have a bit of an up tick in DSOs, but I think as you hopefully appreciate you know we are really running a best-in-class and I think DSO delivery we’ve had significant improvement in that, its going to move around from time-to-time, but I think our DSOs are operating you know sub 30s and with the 26 DSO on the second quarter year-to-date basis. I think that is still pretty good number, but it did stress the cash flow for the current quarter a little bit expecting to get back on track nicely in 3Q and 4Q.

James Kumpel – BB&T Capital Markets

And can you give us sort of some parameters for what you’re looking at on free cash flow this year?

Daniel G. Darazsdi

Well, we’re not just in the guidance that was previously issued.

James Kumpel – BB&T Capital Markets

And I guess with regard to guidance you know originally was you guys looking kind of break-even for Celtic so what it make sense to adjust the quarterly going forward basis for the expected contributions or are you going to kind of stick (inaudible) that just want various moving parts.

Daniel G. Darazsdi

Well, you know clearly in the second quarter we had a benefit from Celtic, but on a go forward basis 3Q and 4Q we’re expecting it to just being normally positive and you know that can fluctuate as evidenced in the second quarter, but we’re not expecting that at this time.

James Kumpel – BB&T Capital Markets

Okay. With regard to the strategic which are clearly helping in terms of new authorizations, can you help us understand whether are not you know some of the potential clients are asking you for upfront investments in new capabilities and staff that some of your competitors can ask to do for particular strategic deal?

William J. Sharbaugh

Yeah, I’ll go ahead and take that one. You know the bottom line here for PPD is you know we’re very diligent in terms of making decisions about augmenting staff. It needs to be done in contract with the work, and when we sign a strategic partnership that doesn’t unlock (inaudible) of hiring what unlocks a (inaudible) of hiring is a concrete authorization from that strategic partnership, so we are doing it in concert with our new business.

James Kumpel – BB&T Capital Markets

Okay. And just finally Fred, if you can comment a little bit as to whether or not you’re seeing out in the marketplace any type of virtual outsourcing deals maybe aligned earlier this year that foresee a significant uptick in outsourcing levels?

Fredric N. Eshelman

Are you referring to FSP type deals or…?

James Kumpel – BB&T Capital Markets

No, I am thinking more like with regard to Align or maybe the level of outsourcing as a percentage of R&D is going to pick up meaningfully somewhere they should historically been.

Fredric N. Eshelman

I think it varies client by client as you well know some clients are making big cuts primarily around mergers. Other clients are up ticking just a little bit. So on balance I think we generally model some very little overall increase in R&D for Pharma higher for biotech.

I think we are seeing more enquiries around innovated ways to outsource both including taking over functions or gradually win-win down capability within and picking it up without. There is some FSP activity. So it’s all over the board but there is a lot of noise in the good sense as I think you know from the huge up-tick in RFPs.

James Kumpel – BB&T Capital Markets

Okay. Thank you very much.

Operator

Your next question comes from the line of Douglas Tsao with Barclays Capital. Your line is open.

Douglas Tsao – Barclays Capital

Hi, good morning. Just Dan, you highlighted the target operating margin for the last segment is around 20%. I was just curious when you think about where you are today given the business flows that you’ve seen and some of the investments you have to make. What’s your sort of internal planning in terms to get back to that level?

Daniel G. Darazsdi

Well Doug, you know I think you’d really have to look lab by lab but I think you know when I step back and look at the lab performance it’s going to come from number of areas Lee touched on some but look, I think we’re going to have strong revenue growth and Bill has articulated I think very clearly the great opportunity we have with the Bioway lab and the fact that that new capacity is coming on line, on schedule, DCL lab is working to have some nice growth.

Our core labs are looking to improve from a revenue delivery viewpoint and of course, that brings with it some scale advantage as revenue comes online. and I think we do a pretty good job of driving productivity. So we’re looking to get some revenue ramp in the labs, and that’s going to come with increased operational efficiency and operating margin delivery and then I think we talked very clearly expectations for vaccine and biologics center of excellence and BioDuro come up. So I think that’s how the whole model works.

Douglas Tsao – Barclays Capital

And then when you look at the margin in the clinical services business, to what extent, has the company been forced to carry some additional headcount in order to meet the requirement of some of the strategic partnerships?

Daniel G. Darazsdi

Well, to my former comment, let me back it up with some evidence. If you look at our headcount at the end of Q2, 2010 was 10,902, I just told you that at the end of this quarter, a year later it’s 11,253, that is 3% year-over-year headcount growth. So as I said, we’re going to hire in concert with the actual authorizations that we win and what we’re looking to do is obviously to grow our headcount appropriately to service those clients, but if we can keep our SG&A to support that growth below our growth rate, then we’re in good position. So we’re doing it prudently, carefully, but appropriately.

Douglas Tsao – Barclays Capital

And when I look at that headcount, those headcount numbers look very good relative to the top line growth, the margins in the Clinical Service segments are down from where you were at the end of last year. So I’m just sort of curious as to what you see as the key drivers for getting back to where you are?

William J. Sharbaugh

Well, our goal is to take that 18.2% we mentioned for clinical development services and get it up to our historical target of 20%. We’re going to do that, the old fashion way, we’re going to watch our cost structure and we’re going to deliver for clients with excellence, we’re going to keep our pricing philosophy here in tact and we think that with a lot of focus on productivity and operational improvements, we can bring those labs or those margins backup to 20% and that’s what we’re aiming to do.

Daniel G. Darazsdi

Correct. And I mean to Bill’s point look on the clinical development side, I think that business has been performing well, we’re expecting to get revenue growth over the next couple of quarters and that will come up with some SG&A efficiency, I think we’ve demonstrated a good ability to generate and support the revenue growth with really strong SG&A management and you know just as you take a look at the second quarter, recall that we did have a couple of expenses that head into the second quarter of $1.5 million I talked to which we’re going to generate a positive benefit on a go forward basis. But in the quarter that did push SG&A up a little bit. (Inaudible).

Douglas Tsao – Barclays Capital

Okay great. Thank you very much, Dan.

Operator

Your next question comes from the line of Sandy Draper with Raymond James. Your line is now open.

Sandy Draper – Raymond James

Thanks very much. This question relates to some of the earlier ones around the Celtic and I know you guys don’t tend to change guidance a lot or tweak a lot. I’m just curious how you thought about it, I think at the beginning of the year you weren’t really factoring in any material contributions from Celtic you obviously got it about, looks like about $0.06 this quarter. Is that just sort of a number you are willing to absorb, is that number sort of offset the weaker performance of BioDuro and Vaccines sort of how did you think about that in terms of the full year numbers. And then the second question would be I know you’re not anywhere close to talking about 2012, but when we think about the lower margins in the first half of this year to get your guidance you’ve got to have significantly better margins in the second half of the year. Is there anything in the first half of the year that would need to repeat itself and that sort of the year-over-year comps you need to factor that in or will as you improve the business in the second half of the year should that sort to be opened to be equal a new water mark for speaking about where you’re entering in 2012. Thanks.

Daniel G. Darazsdi

Hi, Sandy it’s, Dan. While doing that question we’ll share have a couple of points. I think the first part around Celtic and how we think about that and if you go back and look and we don’t talk the guidance unless we’re changing, we haven’t changed it. So, I would say in the Celtic assumption we said our earlier expectations would be pretty nominal and then maybe generate some benefit in the fourth quarter. As we look at it now, we did obviously generate some additional benefits in the second quarter, but we’re expecting it to be pretty nominal in 3Q and 4Q. So and fair it would isolate that in the second quarter I’d say we had positive contribution from Celtic and we had some challenges that weren’t not expected in the labs specifically in Vaccine and BioDuro, and we always puts and takes and that’s a little bit of what happened in the second quarter. So going forward we’re expecting to improve relative to the labs delivery, we’re not expecting to have that kind of a repeat from Celtic on a go forward basis. And at this time, we’re not talking about 2012 in terms of guidance or outlook. So probably not comment on that.

Operator

Your next question comes from the line of Steve Unger with Lazard Capital Markets. Your line is now open.

Stephen Unger – Lazard Capital Markets

Hi, good morning. Just a follow-up question on headcount. You did mentioned that the headcount is up over 3% year-over-year, your backlog is up 14% year-over-year and the duration I believe you mentioned is shortening a little bit. Is there a metric that is it is a capacity utilization or some sort of hiring, sort of bullish that we should be expecting in the future I am curious as to why the headcount growth lag so much to backlog growth?

Daniel G. Darazsdi

Well I think it’s good management on our part look we mentioned it before but Dan I sit down for every single SG&A add or replacement in the company and you know that’s run by Fred. We are being very careful there. We are certainly not turning off the stick it in terms of operational revenue generating hiring. So we are doing that in concert with the business as appropriate remember there is a lag between an authorization and ultimately the – towards the peak run rate of that contract. So this is a case of modulating your hiring to being concert with when you need it. I think that we are doing a good job and we are in the sweet spot right now doing what we do well here at PPD.

William J. Sharbaugh

Yeah, let me just add to that as well obviously on the clinical side especially as it relates to margins its all about hiring just in time and training just in time we overshoot we got a problem with G&A undershoot you can’t perform. Generally speaking cancellations are bad news however if you do have a higher the normal cancellation remember that we didn’t have capability that pulls half of those projects and is available for other projects which can also make the numbers look a little bit funny for you know a short period of time and as to your question about is there a metric, we look at certainly, we look at illustration across every single part of our business and we know where it needs to be within the particular segments. So that absolutely is a metric that we follow closely.

Stephen Unger – Lazard Capital Markets

Is that utilization at the moment optimized I mean are you feeling that you are getting the maximum utilization that you would prefer at the moment.

William J. Sharbaugh

Well no because I generally like to set that number to 120%.

Stephen Unger – Lazard Capital Markets

Okay. Got you. Just a follow up on that question, as far as direct costs are concerned your direct cost went up $10 million sequentially in the quarter, whereas the headcount was up roughly about 100, is there something else that’s going in the direct cost that we should be thinking about that outside of headcount that is ramping in the business?

Daniel G. Darazsdi

It is Dan. I will take that Steve, I think the – for your question most help me better understand exactly what you’re trying to get out with your question.

Stephen Unger – Lazard Capital Markets

Sequentially your direct cost went up $10 million but headcount was only up 100 people I’m assuming you’re not paying those people during the quarter?

Daniel G. Darazsdi

Yeah. So, those – there is two things one is utilization which is effective but the other one is recall that April 1 is annual merit cycle increase. So, those – that merit cycle hits April 1 and so you have a full quarter of solid increase. I think that helps kind of bridge that for you and thus far I want to clarify the question.

Stephen Unger – Lazard Capital Markets

Great. Okay and then is the bulk of the incremental investment in BioDuro is that behind us, is – are you going to continue to ramp investment going forward to the reminder of this year in BioDuro?

Daniel G. Darazsdi

Yeah, second take that, no I think the bulk of the investment in BioDuro has been completed and as you know the primary investments went into enhancing some of their technological capabilities as well as two big investments that we’ve made in the regeneration space one with TBL a small biotech company was whom we formed a joint-venture to provide clients with best in class monoclonal antibody therapeutics and that’s preceding well. And then the other is a – an investment we’ve made in a company called [XCAM] which has also regeneration platform for small molecules based on DNA based chemistry. So, both of those investments are in place and now we’re trying to realize the reap the benefit from those investments.

Stephen Unger – Lazard Capital Markets

Got you. And then finally Dan and as far as the – the tax rate is concerned for the back half of the year could you remind us what the guidance is?

Daniel G. Darazsdi

We’re expecting the – the tax rate to get back to within our guidance range and the full year tax rate for the 2011 initial guidance was 29% to 31%.

Stephen Unger – Lazard Capital Markets

29 to 31, great.

Daniel G. Darazsdi

Yeah. and we expect to operate during the back half of the year.

Stephen Unger – Lazard Capital Markets

Great job guys. Thanks.

Daniel G. Darazsdi

Yes.

Operator

Your last question comes from the line of David Windley with Jefferies & Co. Your line is now open.

David Windley – Jefferies & Co.

Hi, thanks for taking the questions. On strategic partnerships, I’m looking at your comments about, I think you said more than 50% of your revenue coming from the strategic partnerships, but your client concentration is relatively stable sequentially. I was hoping you could just expand a little bit on perhaps the number of those the diversity of the types of deal they are, i.e., project driven versus FSP driven and how you are I guess able to see more stability in your backlog conversion in light of the contribution in these strategic partnerships?

Daniel G. Darazsdi

Yeah. Dave, what I mentioned was second quarter net revenue in growth authorizations that a little over half way from our strategic partners. Remember, we obviously segment our customer base, so when we talk about strategic partners, we have sort of some different tiers there. But the bottom line is I think what we suggest it would play out is playing now. We’re seeing good volume from these partnerships as they mature, as they reach their run rates, and you know as Fred said, that’s helping our hit rates obviously a little bit. And if you even look at our labs, we’re seeing some spill over into the labs as well. So when you look at top clients in the labs and compare them to clinical development, you see a lot of the same companies, which we think is a good thing.

Our view is that, over time we hope that those partnerships are going to mature to where we hope they can go, and when you’re just one of a couple of providers with these big pharma companies, there’s a lot of potential.

David Windley – Jefferies & Co.

Thank you for that. Corollary, I suppose in the lab business, I think because of some strategic partnerships maybe not fully from those, you seem to have pretty solid line of sight to some specific revenue sources that were going to contribute to your back half ramp. And it sounds like one has begun in July. I wondered if the others of those are also holding pretty firm to your expected start dates on things like central lab, the Richmond biolab et cetera?

Daniel G. Darazsdi

Yeah. I think we talked to it, that we’re having all the right discussion with all the right players. There is a couple of contracts that are in the later phases stages of negotiation and hopefully award. So we feel really good about the second half of the year. And as we said, we’re going to obviously grow revenue and improve the margins on our last segment.

David Windley – Jefferies & Co.

If I could just end, couple for Fred. Fred, I’m wondering if you can comment to the value enhancing option review, do you expect that that review will result in an action without saying what that action would be, will there be an action or could it be no action?

Fredric N. Eshelman

I can’t really comment beyond what was in the press release and what I said earlier today at this time.

David Windley – Jefferies & Co.

Okay. And then also at the Board level, can you comment on what the key qualities you are looking for in the CEO search, it sounds like you’ve nailed it down, you’re moving forward with some candidates. I’m hearing some things about those candidates that they are kind of financially oriented people. And so I’m curious about what qualities you would define is the most important?

Fredric N. Eshelman

Well, when we started out, we had pretty much agreed with the Board and the search committee that they were somewhere around ten attributes that we would like to see and obviously you have to sort of use and no one is going to score a 100% in every category. and so you give and take a little bit, but financial acumen, I rate very high on my list, because in my view whoever is running the place has got to understand the numbers, be ahead of the numbers and be able to immerse themselves in those at all times.

I think it’s clear whoever comes in needs to know healthcare whether it’s this specific business or not is another matter, but certainly know something about healthcare pharma biotech and so forth, we need somebody who is generally speaking a Type A plus personality who is after at everyday, because this business will get away from you if you’re not careful and on and on and on. So we’ve got these attributes lined up, we know what they are and that’s how we are screening folks.

David Windley – Jefferies & Co.

That’s fantastic. Thank you, Fred.

Operator

This concludes the Q&A portion of today’s call. I’ll turn it back for closing remarks.

Fredric N. Eshelman

Okay. This is Fred. Thank you all very much for being on the call. Our view is that the business is doing very well, it’s coming along as planned. The laboratory weaknesses we have outlined specifically the rest of the historical labs are performing well in terms of margin and so forth. So we know the job ahead of us, we know what we have to do, and as usual at PPDs and execution story. So again, thank you very much and we look forward to talking with you soon. Good bye.

Operator

Ladies and gentlemen, this concludes today’s conference call. You may now disconnect.

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