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Kendle International, Inc. (NASDAQ:KNDL)

Q3 2007 Earnings Call

October 31, 2007 8:30 am ET

Executives

Patty Frank - Director of Investor Relations

Candace Kendle - Chairman and Chief Executive Officer

Chris Bergen - President and Chief Operating Officer

Buzz Brenkert - Chief Financial Officer.

Analysts

Robert Gilliam - UBS

Alex Alvarez - Goldman Sachs

Dave Windley - Jefferies & Company

Todd Van Fleet - First Analysis

Sandy Draper - Raymond James

Terri Powers - Robert W. Baird

Andrew Weinberger - Galleon

Operator

Good morning. Welcome to the Kendle Third Quarter 2007Earnings Conference Call and Webcast. As a reminder, this call is beingrecorded.

At this time I will now turn the call over to Patty Frank,Kendle's Director of Investor Relations. Please go ahead.

Patty Frank

Thank you. Good morning, everyone, and welcome to ourconference call. With us today are Dr. Candace Kendle, Kendle's Chairman andCEO, Chris Bergen, Kendle's President and Chief Operating Officer and BuzzBrenkert, Kendle's Chief Financial Officer.

By now you should have all received a copy of our earningsrelease. This release also is posted on our corporate website at kendle.com orvia PR newswire at prnewswire.com.

If you are interested in listening to a replay of this call,a telephone version is available through November 30th by dialing 706-645-9291and entering access code 5447273. Or you may access a webcast of the archivedcall at kendle.com.

All participants are currently in a listen-only mode. Aquestion-and-answer session will be conducted following management's formalremarks (Operator Instructions).

Please note webcast participants do not have the capabilityto ask questions. Before I turn the call over to Dr. Kendle, I would like toremind everyone that statements made during today's call that are nothistorical might be considered forward-looking.

Today we will be talking about our expectations regarding anumber of activities in which Kendle is engaged. Reliance should not be placedon such forward-looking statements because they involve risks and uncertaintiesthat may cause our actual results to differ materially from those which we aregoing to discuss or which we may imply.

Those risks and uncertainties are outlined in our Securitiesand Exchange Commission filings. During today's call we will be referring tocertain non-GAAP financial measures that have not been prepared in accordancewith generally accepted accounting principles.

A reconciliation of the non-GAAP financial measures to themost directly comparable GAAP measures is available within the earningsrelease.

With that, I would like to now turn the call over to Dr.Kendle.

Candace Kendle

Thank you, Patty. Good morning to everyone. Buzz, you wantto start us off?

Buzz Brenkert

Okay. Good morning, everyone. Before we get into the resultsfor the third quarter, I would like to discuss a few items related to thequarter that we will be mentioning throughout the call this morning.

First, I want to briefly discuss the convertible notes thatwe issued on July 16. These are five-year notes with a net share settlementfeature. The principal amount of $200 million has a coupon rate of 3-3/8%,which is less than half the rate that we had on the term loan used to financethe Charles River clinical services acquisition last year.

Most of the proceeds from that convertible debt were used topay down the term debt. And by the end of the quarter the term debt was paidoff entirely. In conjunction with paying off the term loan we wrote off theassociated deferred finance fees, totaling $4.2 million. That appears as anon-operating item in the income statement third quarter.

The second item relates to the Company's effective tax rateof approximately 25% for the third quarter, which reflects the reversal ofapproximately $833,000 of tax liabilities as required by financialinterpretation number 48, which is entitled accounting for uncertainty inincome taxes.

These liabilities were established at the beginning of theyear as part of the initial adoption of FIN 48. During the third quarter of2007 the time period for assessing tax on certain of these items expired,necessitating actually triggering the reversal.

Lastly, I just want to remind you that this is the firstquarter where previous years' quarter and year-to-date results include partialperiod results from the Charles River acquisition. We celebrated theacquisition anniversary on August 16th. Therefore the acquisition results wereincluded for only half of last year's third quarter. With all of that said,let's move on to discussing the third-quarter results.

Net service revenues for the quarter totaled $100.1 million.That is another quarterly record and a 33% increase over last year's thirdquarter. Operating income and $14.2 million grew 76% from the third quarter oflast year.

Although non-operating expenses including the $4.2 millionexpense related to the write-off of deferred financing fees, $3.3 million ofinterest expense and foreign exchange losses of approximately $2.1 million. Allof those non-operating expenses dropped pretax income slightly below last year.

For the quarter the Company's reporting earnings per shareof $0.25, diluted earnings per share in Q3 of last year was $0.27. Eliminatingthe intangible amortization expense of over $0.04 a share and the write-off ofthe deferred financing fees of almost $0.18 a share, results in pro forma EPSof $0.48 for the current quarter versus $0.30 for the same quarter last year.

Focusing on revenue, as I mentioned earlier $100 million ofrevenue for this quarter represents 33% growth over last year. That is also 2%growth over the second quarter of this year.

Fluctuations in foreign exchange rates accounted for about6% of the year-over-year growth and about 1% of the growth over Q2. Revenue inour Phase II through IV operations was strong, growing at 37% from Q3 of lastyear.

Revenue in our early stage operation, however, decreased 16%from Q2. That reflects a 22% increase in revenue in our bioequivalence unit inWest Virginia offset by a 30% decline in our unit in the Netherlands.

The revenue decline in the Netherlands primarily resultedfrom a program delay and subsequent cancellation that comprised over fivestudies. Revenue is expected to continue to increase in the West Virginia unit,and the Netherlands unit has signed contracts for Q4 that exceed Q3 levels byabout 40%.

Geographic distribution of total net service revenue hasshifted slightly from the second quarter, North American based service revenuesincreased 51%, increased to 51% of the total from 50% last quarter. Europeanrevenues does just the opposite. They were 41% of total, down from 42% lastquarter. Latin American and Asia-Pacific revenues both remained steady at 5%and 3% of total, respectively.

Customer concentration continues to lessen year-over-year.This quarter our top five customers in terms of revenue accounted for 24% ofrevenue as compared to 30% in the third quarter last year and our ten largestcustomers accounted for 39% of revenue versus 44% last year.

No customer accounted for 10% or more of revenue. Incomefrom operations for the quarter was $14.2 million. That is a 76% increase overQ3 of last year and also represents a very strong operating margin of 14.2%, upfrom 10.8% in Q3 of last year and up from 11.1% in the prior quarter.

Excluding $1 million of intangible amortization associatedwith the Charles River acquisition, pro forma operating income for the quarterwas $15.3 million, representing a pro forma operating margin of 15.3%, whichagain represents a strong increase over last year's Q3 margin of 11.7% and theprior quarter's pro forma margin of 12.2%.

Pretax income for the quarter totaled $5 million, down from$6 million last year, primarily due to the $4.2 million write-off of deferredfinancing fees, foreign exchange losses, which are mostly non-cash, totalingover $2 million and net interest expense of $3 million, which compares to netinterest expense of $1.8 million last year.

Interest expense for the remainder of the year will continueto decrease due to the convertible notes replacing the term loan that was paidoff during the third quarter. Net income of $3.8 million is down slightly from$4 million in Q3 of the prior year and as I mentioned earlier, the dilutedearnings per share of $0.25 is down from Q3 last year of $0.27.

Excluding the intangible amortization expense associatedwith the Charles River acquisition, and the write-off of the deferred financingfees, pro forma EPS was $0.48 versus $0.30 last year. Looking at our nine-monthoperating results, net service revenues totaled $293 million, an increase of49% versus last year. Foreign exchange rate differences between years accountfor approximately 7% of that growth.

Full-year revenue contribution by region shifted from NorthAmerica, or shifted between North America and Europe from last year. NorthAmerica has contributed 50% of year-to-date net service revenues compared to56% last year, and Europe has contributed 42%. That is up from 37% last year.Latin America has increased to 5% from 4%, and Asia-Pacific has remained steadyat 3% of net service revenues.

For the full-year our top five customers accounted for about25% of net revenues. That is down from almost 27% last year, and again, nocustomer accounted for 10% or more of revenue. Operating income year-to-date of$37.6 million represents a margin of 12.8% and compares favorably to the 2006operating income of $21.8 million.

The operating margin last year was 11%. Excluding $3.1million of intangible amortization associated with the Charles Riveracquisition, pro forma operating income for the year-to-date was $40.7 millionor 13.9% of net service revenue, up from a year-to-date pro forma operatingmargin of 11.4% last year.

Pretax income year-to-date totaled $18.2 million. That isdown from $20.3 million last year, primarily due to net interest expense ofalmost $11 million versus net interest expense of about $800,000 last year.

The $4.2 million write-off of deferred financing fees andnet other expenses primarily foreign exchange losses of $4.4 million, whichcompares to only $650,000 last year. On a GAAP basis net income for theyear-to-date totaled $12.3 million or $0.83 per diluted share, compares to$13.2 million last year, $0.89 per share last year.

After adjusting for the items discussed previously, proforma EPS totaled $1.14 for the first nine months of this year versus $0.92 forthe first nine months of 2006. Cash flow from operations for the year-to-datetotaled $38.1 million and capital expenditures were $10.8 million.

Turning to the balance sheet, we ended the quarter with cashand marketable securities totaling over $29 million. That’s up from $25 millionat the start of the quarter. Accounts Receivable at the end of the quartertotaled over $146 million, including about $74 million of unbilled receivablesand $72 million of billed receivables.

Advance billings totaled about $83 million, resulting in netreceivables of over $63 million and DSL of 40 days, down from 42 days at thestart of the quarter.

On the liability side, borrowings of $200 millionoutstanding at the end of the quarter represent the convertible notes; as wementioned earlier the term loan was paid off completely during the thirdquarter. With that, I will turn it back to you, Candace.

Candace Kendle

Thank you, Buzz. I will begin by speaking about the salesfor the quarter followed by comments on labor and revenue. Gross sales for thequarter were $175 million, which compares to gross sales of $148 million forthe same quarter last year, an 18% increase and compared to last quarter of$165 million or a 6% increase.

Cancellations for the quarter were $7 million, whichcompares to cancellations in last quarter of 13; cancellations were approximately4% of gross sales. The backlog was once again at an all-time high of $831million for this quarter compared to $590 million for the same quarter lastyear, representing a 41% increase and sequentially backlog increased by 10%from the end of last quarter, which at that point totaled $758 million. Ourgross book-to-bill was 1.8 to 1 while the net book-to-bill was 1.7 to 1.

Just a few comments on our RSP volumes, again in the thirdquarter the average dollar per proposal rose, and we can continue to make gainson our 12-month rolling hit rate. With regard to the customer concentration insales for this quarter, the top five customers as a percent of total gross andnet sales were 62% and 65%, respectively.

I’d like to make a few comments with regard to labor. Ourtotal headcount at the end of the third quarter was 3,260, which does notinclude the use of contractors around the world. An important point here forlater comments is that our utilization for billable staff is at this point onbudget.

We do see some pockets particularly in the U.S. where thereis higher need, but nothing extraordinary. Good progress is being made in therecruitment area; retention while the industry average is still a company widearea of focus, as well as enhanced efforts to build employee engagement.

We are currently effectively matching the business need withthe employee base in most regions of the world. This represents significantimprovement over the last three quarters. Our success in this area is in partdue to the improved recruiting and retention efforts and also as a result ofthe slowdown in the revenue rollout, which is a result of a significantlyaltered business mix with regard to mega trials, and I am going to talk aboutthat in a minute.

With regard to leadership, we are making very good progressin Asia-Pacific. I thought I would be able to announce today but we had alittle timing issue, but you will be hearing on our promise to you on thatfront very soon. And then I am going to speak to you in a minute about ourearly stage leadership, which I also promised enhanced new leadership byyear-end.

At this point I would like to talk to you about revenue. AsBuzz has previously mentioned, the early stage business in Utrecht was adisappointment this quarter, while we had anticipated a rebound in this unit wehad an unexpected cancellation in an entire program across five studies.

While this particular event is unanticipated, we do feel thevolatility across the entire early stage business is in part due to lack ofleadership. We are happy to announce today that we have secured new leadershipin our Morgantown, West Virginia unit and this individual actually started thisweek. And we are very pleased about this.

And we are also optimistic that we will meet our year-endgoals for securing global leadership for our entire early stage group. And wewill be talking to you about that leadership and business expansion in thatarea on the next call.

While there is little anyone can do about cancellations,early recognition of risk and customer management are always key to smoothingout these events. And we think this will come with new leadership in the earlysold or early stage arena. I now want to spend a few minutes talking about therevenue rollout, which is affecting all of the CROs that are moving rapidly tothe mega trial space.

We have undertaken, as promised, a retrospective review ofour business in this space and will continue to monitor the rollout of revenueas we move forward. I did today want to try to share with you a little insightinto what we are finding but a big caution here, these are limited data pointsand can shift with the award of even a single large study.

I do want to -- for many of you this will be a reinforcementof what you know -- but for some of you perhaps this is new data. There is nodoubt that the principal reason revenue has not grown in proportion to thegrowth in backlog is the significant growth in mega trials in the industry andat Kendle.

I want to remind you that at this time this is not a laborissue for Kendle. As I mentioned earlier in my labor section, our utilizationis on budget. Most areas of the world labor matches business need. Again, thereare a few pockets where this is not true, but the revenue lag is not due tolabor at this time.

While labor could at some point have an effect, again thatis not the issue for Kendle going forward. What we have found in our review isthat there are some very important trial variables that merit ongoing review.The first is a trial over $10 million.

The specific customer, the disease type, the country ofaward and the geography for execution of work. These all seem to be trialvariables that influence revenue rollout, again with a very limited data. Weare looking at data from 2004, which if you recall was early in our businessrecovery and at a time in which we had very few of the larger trials throughdata August 2007.

During this period, just to give you a little more thinkingabout the caution, not only did the trial size change, but the customer sizechanged and the international footprint at Kendle changed. So, we will be ableto give you more insight into this as we collect prospectively. But I wouldlike to share some generalizations that we are seeing with regard to the dragon revenue rollout.

With regard to all trials, regardless of size, the days tocontract signing, that is the time at which you begin recognizing revenue issignificantly longer when the work must be authorized outside the U.S. Andthere is a growing base of business with international authorization.

Again, trials over $10 million roll out more slowly in allquarters when measured over eight quarters, which is about as long as we feelwe can even look at. And we don't have -- note the smaller trials obviouslydon't run out much longer than eight quarters. The larger trials, of course,do. But we don't have good data for more than eight quarters.

But again, in each of the eight quarters the larger trialsroll out more slowly. The revenue from these larger trials roll out at aboutone-third the speed of all other trials, largely impacted by two factors,regulatory influence and again what would appear to be customer lack offamiliarity with things like site setup expectations.

Specific customers also drive longer rollouts. Somecustomers will award early in the outsourcing process. Some have longercontractual processes, longer site approvals, particularly in new areas. And weare now beginning to track individual customers to better predict our backlogperformance.

It is no surprise to many of you, revenue roll out is alsoaffected by therapeutic area. In the early review of data it would appear thatGI and oncology studies track more slowly than others as one could speculatewhy this might be. But we don't really have good data on this.

And it is really too early to begin this kind of analysis.But again, GI and oncology look to roll out more slowly. So again, it is sizeover $10 million, specific customers, disease type, country of award and the geographyfor the execution of work.

With regard to Kendle's business since 2004, our mega trialbusiness as you know has grown larger, more internationally based with moreinternationally based studies. And we have worked very hard to broaden thecustomer base. And this has had some influence on our revenue roll out.

I will just say as an aside here, just again on a verylimited number of data, this does not look to be preferred customer driven withregard to specific customers. It happens both to customers where you havepreferred buyer agreements and those where you don't.

Kendle is also increased its oncology concentration, whichwe may be an added influence. All of these areas look to be drivers of theslower roll out of our business. But again, it is premature to draw anyconclusions. We will continue to monitor data and look at industry comparatorswhere possible to drive better forecasting. And we look to be able to give youmore visibility to our backlog and revenue roll out on future calls.

At this point, I would like to move to a guidance update.Due to the shortfall in revenue from our early stage business this year and theslower than anticipated roll out of revenue from our late stage backlog, webelieve it is prudent to adjust the revenue guidance to $390 million to $400million, although we do believe that we will be in the higher end of the range.

Year-to-date our operating margin of 12.8% on a GAAP basisand 13.9% on a pro-forma basis, are almost right in the middle of our currentguidance range. So, we will continue with our operating margin guidance ofbetween 12% and 14% on a GAAP basis, and 13% to 15% on a pro-forma basis.

Our earnings per share guidance needs to be adjusted,primarily due to the unanticipated foreign exchange loss, which has cost us$4.2 million so far this year and the disappointing operating loss in our earlystage business. We now expect our GAAP EPS for the year to range between $1.25to $1.35 and our pro-forma EPS to range between $1.60 and $1.70.

Just as a caution, I have been asked to remind you that allof the EPS guidance figures assume no significant share dilution from the newconvertible debt. I hope you were able to understand me. I've got some littleseasonal issue here.

And, we would like, operator, to move at this point toQ&A.

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes fromthe line of Robert Gilliam, UBS.

Robert Gilliam - UBS

Good morning.

Buzz Brenkert

Good morning.

Robert Gilliam - UBS

I've got a laundry list of questions here, some of which youaddressed already. I guess my first question, more of housekeeping, if youcould just give the margins as you break them out in 10-Q filings as far as theearly stage to late stage and also on the services line, revenue and marginswould be helpful?

Buzz Brenkert

Okay. For the quarter, revenue in early stage, $4,687,000.Income from operations, $281.4 million. That's an operating margin of 6.0%.Late stage, $93,380.6 million. Income from operations $24,623.4 million.Operating margin of 26.4%. Support and other, $2,002.4 million revenue. Lossfrom operations $10,659.4 million. Is that what you're looking for, Rob?

Robert Gilliam - UBS

Perfect. Thanks a lot. Just moving on to hiring andheadcount, it looks like by my calculations with the headcount number you gaveit was up about 3.1% sequentially this quarter, was up about 3.5% sequentiallybetween Q2 and 1Q.

And I think in the second quarter Candace mentioned on theconference call or it might have been you, Buzz, the internal goal was toincrease headcount by 10% in the second quarter. And if you could just kind ofhelp me reconcile the differences between what happened and what was expectedand then also what your expectations are for hiring in fourth quarter.

Candace Kendle

In terms of the hiring, again it doesn't includecontractors, for one thing. And the other thing is that again to the reduced,the drag on work has really slowed the need, if you will, in some parts of theworld. I don't have for you a specific need going forward. But again,utilization worldwide is on budget.

Robert Gilliam - UBS

Okay. And so is it just trying to determine kind of thedirection, the chicken and the egg. If you had been able to hire more people,do you think you would have been able to make your revenue numbers? Or wouldn'thave need to bring them down in the fourth quarter, or is it more you didn'thire as many people because you didn't see the revenue burn coming in asquickly as expected?

Candace Kendle

It is primarily the latter. The revenue miss is in largepart the early stage misses. Had we made the early stage programs, had theburns not been canceled we would have made our revenue projections. Again,there are a couple of pockets in the U.S. where we would like to see someincreased recruiting. But in large part utilization is right on budget.

Robert Gilliam - UBS

Okay. And as far as the tax rate in the fourth quartereverything is going to bounce back up to around 35%?

Buzz Brenkert

For the fourth quarter?

Robert Gilliam - UBS

Yes.

Buzz Brenkert

Yes, this is a one-quarter anomaly, if you will.

Robert Gilliam - UBS

Okay. And then a bigger picture question on cancellationrates. It looks like Kendle's cancellation rates have been significantly lowerthan many people or many of your other peers. I was just wondering if you knewa specific reason for that, kind of how you think it might change going forwardgiven the larger exposure to the elephant trials? And then I just have onefinal follow-up on FX?

Candace Kendle

We have always enjoyed the benefit of the FSP as apercentage of our work in terms of reducing the cancellation rate. But as theconcentration of our work moves towards the mega trial, we would expect thecancellation rates to climb to the industry average. I thought it would happena little sooner, quite frankly, but other than that we don't see any prescribedreason why it is happening.

Robert Gilliam - UBS

Okay, so essentially going forward I know you're not goingto give 2008 guidance today, but more just assume it goes to where your peersare.

Candace Kendle

Yes.

Robert Gilliam - UBS

Okay. Then finally just on FX though obviously a negativeimpact this quarter. Saw a negative impact also or a larger negative impact inthe first quarter and not so much in the second quarter; just what are yourexpectations as far as guidance for the fourth quarter? What is kind offactored into your numbers there?

Buzz Brenkert

Basically what is factored in is a little bit of a loss onFX more along the lines of the second quarter than the first or third quarter.But it is always just a guess. It could go either way; it could swing to again, although I think the dollar hit an all time low versus the euroyesterday.

So, my guess is it probably is not going to turn to a gain.It is not a very significant number in our guidance. But we've kept a ratherbroad range on the guidance just to be cushioned a little from what may happenwith FX.

Robert Gilliam - UBS

Okay. All right. Thanks a lot. I'll let somebody else take aturn.

Operator

Your next question comes form the line of Alex Alvarez, GoldmanSachs.

Alex Alvarez - Goldman Sachs

Good morning. Candace, based on the factor that you laid outin terms of what is impacting the revenue rollout, where do you think theCompany is today in terms of seeing the impact of those factors flow throughthe backlog and the P&L?

We kind of early in the process just given that you are nowfully leveraging the combined assets of both companies, are we kind of halfwaythere? I know it is probably a tough question but what is your assessment hereof where you stand today in terms of fully seeing those things work throughoutthe real business model?

Candace Kendle

I'm not sure I understand the question. With regard toeffect by Charles River, there is none.

Alex Alvarez - Goldman Sachs

What I imply by that is that you are now winning a lot ofbigger contracts. I would imagine in part because of a bigger infra, a biggerglobal network now that you have the two combined entities. And that is what ifI am correct me if I am mistaken but that is what is benefiting you in terms ofwinning some of these bigger trials which is impacting the conversion ofbacklog into revenue.

And just curious as to whether we are just starting to seethe impacts of some of those trends that you mentioned, or do you feel this hasbeen going on for a while but we are just now starting to see it? Just curiousas to kind of where we are here in terms of seeing the slowdown in revenue,which has impacted not just you but a lot of your competitors.

Candace Kendle

I see. Thank you. Absolutely the Charles River clinicalacquisition was about scale, and we certainly benefited from that scale. Webelieve we saw the impact almost immediately, certainly within a quarter webegan to see the impact. I think Kendle is enjoying recognition of being amajor player and having the kind of global breadth and depth we've been talkingabout.

But I also think there is a big industry impact that all ofthose competitors moving to that space are seeing. If you look at this earlierin my comments I didn't give any visibility to sales going forward, but I willtell you that the fourth quarter has a record number of RFPs relative toprojects, over requests for projects, over what would be $10 million.

So I think what we are seeing in the industry at-large isbigger global trials in an effort to get trial completion done more readily. Soif that is what you mean, Kendle is certainly more positioned than it once was.The industry is delivering outsourcing at an increasing rate and particularlythe mega trials are in higher number.

Alex Alvarez - Goldman Sachs

And how does having a bigger mix of these mega trials impactyour hiring and your planning in terms of when you bring on headcount? Is thereany impact to how you run the HR department?

Candace Kendle

Yes, I think the addition of Karen Crone as head of HR; theadditional recruiters that we brought and placed, retention and engagementprograms that she has brought through her experience of Kendle are making a difference.It will take some time to get there, but already we are seeing onmonth-to-month basis improvements again in various pockets around the world.

Alex Alvarez - Goldman Sachs

And Buzz, maybe more specifically in terms of directexpenses for the quarter that came down sequentially from Q2. And there wassome hiring that took place. Just trying to understand here what led to thatsequential decline, which I would have expected that number to actually havecome up, given that you are hiring. Perhaps not at the rate that you wereexpecting earlier in the year, but it seems like there was some increase inbillable headcount.

Buzz Brenkert

There was an increase in billable headcount during thequarter. What really drives and I think you can see this historically, in thethird and fourth quarter, we typically see a reduction in direct expenses. Andit is really driven by paid time off.

PTO reserve is typically built up during the first twoquarters of the year and the big times for vacations, at least in the NorthernHemisphere are the third quarter, July and August are big months for vacationtime. And the holiday periods in the fourth quarter.

So that really offsets, you end up with a number of people,when they are going on vacation and then when they do that their salaries arecharged against the PTO reserve that you've been building up all year long.

Alex Alvarez - Goldman Sachs

You would expect to see a sequential increase in directexpenses in the fourth quarter then?

Buzz Brenkert

Well, the fourth quarter has the same sort of phenomenon inthat there is a lot of holidays and a lot of PTO that is taken particularlyaround those holidays. So, I would not expect, the direct expenses to go to thesame level that they were in the second quarter. Perhaps a little bit of apickup, but they won't grow to the levels of the first and second quarter.

Alex Alvarez - Goldman Sachs

How should we look at then the 51% gross margin this quarterwas much stronger than I think anything we've seen out of Kendle at least inthe last several quarters. How should we think about that from a going forwardperspective?

Buzz Brenkert

We typically tend to look at operating margin as opposed togross margin. But I would expect for the fourth quarter that you’ll see that51% gross margin drop a bit.

Alex Alvarez - Goldman Sachs

Okay. And then, just one last one. In terms of the 833,000reversal of the tax liability, I just want to make sure I understand how thatwas flowing through the P&L. Was your tax expense in the quarter reduced bythat full amount, by the full 833,000?

Buzz Brenkert

That's correct.

Alex Alvarez - Goldman Sachs

Okay. Thank you.

Operator

Our next question comes from the line of Dave Windley,Jefferies & Company.

Dave Windley - Jefferies & Company

Hi, good morning. Thanks for taking the questions. I wantedto touch on a few. The first I wanted to understand, Buzz, is on the FX. Youare seeing benefit to the revenue line from FX, but then lowering guidance inpart due to the hit that you've taken in FX.

And help me to understand is it disproportionate eitherbecause of the currency that the contracts are priced on or because of hedges,imperfect hedges that are in place or what exactly -- what about that isimbalanced to cause EPS to need to come in that much?

Buzz Brenkert

The effect on foreign exchange differences or fluctuationsin the income statement do affect both the operating results and thenon-operating expenses. From an operating standpoint with the dollar weakening,foreign denominated revenues and expenses grow, if you will, with a -- becauseexpenses grow at the same time revenue grows, the effect on operating incomeand the bottom line of those operations are diluted a bit.

What goes through non-operating income are adjustments tothe balance sheet. And it basically, assets that you may have that aredenominated in foreign currencies and get translated back run through theincome statement. So that things like receivables that are denominated in euroswhen they get translated back into dollars come in at lower dollar amounts.

So it is those losses that come through the non-operatingthat have been rather significant and difficult to really project oranticipate.

Dave Windley - Jefferies & Company

Okay. That's helpful. So the principal assets there would befunds receivable held outside the U.S., and I guess cash held in subsidiariesoutside the U.S.?

Buzz Brenkert

Correct. It is also affected by inter-company accounts,which is really a non-cash effect on results.

Dave Windley - Jefferies & Company

Presumably you would have the ability to controlinter-company.

Buzz Brenkert

We have some control over it, in that there are repatriationissues as far as tax effects and so forth that limit how much control we reallyhave or dampened control we really have on inter-company accounts.

Dave Windley - Jefferies & Company

All right. Candace, on labor and utilization, you say thatutilization is basically on budget. I want to understand are you emphasizingthat it is not over budget, or it is not under budget?

Candace Kendle

I am emphasizing that it is not over budget. In other words,we had anticipated a need for many more people with the revenue rolling outmore quickly. And we are seeing a greater drag, sort of a less steep curve, ifyou will, than we had anticipated in Q1 thinking about the big ramp up that isrequired.

We still have shortfalls in the U.S., but not any more thanwe faced in other times in our growth. So, I don't want to give you the sensethat there is some sitting back on our heels here in terms of recruiting. It isstill a lot of pressure on recruiting. But the fact that we fell short of whatwe thought we were going to need in the second quarter really isn't hamperingour business in any way.

So that is sort of the message here is that labor is, youcan't find labor. We have as I mentioned last quarter, begun partnerships withuniversities, in-house training programs and so forth and so on. But it is, weare not either disappointing our customers or unable to sell as a result ofthose talent issues.

Dave Windley - Jefferies & Company

Okay. As, it relates to contractors, has your use ofcontractors I will say proportionally increased? And as we look forwardrelative to your ability to hire full-time people, it sounds like maybe thepressure on that has eased ever so slightly but still pressure, for sure basedon what you just said. But are you relying more on contractors to make surethat your full-time people aren't overworked and burned out and leaving?

And how does that affect your view toward being able to holdthese higher EBIT margins and even see them go toward your longer-term goal?

Candace Kendle

We are using more contractors than we would like becauseobviously they are more expensive. But it comes from a couple different places.

First of all, if historically you had to go to contractors,if a customer is happy with that individual on their program, you really haveto judge the risk of moving that person off a program in order to save somemoney versus the long-term relationship with the customer. That is number one.

Number two, in areas where you are short of talent, either atherapeutic area or a geographic coverage, we still would go to a contractor.And then, the third area a little bit newer in thinking is the geography in theascending market, where the contractor base may in fact be the most experiencedand may be a trainer.

So, that we are moving away from our contractors but if themethod is that we end up using more contractors in absolute numbers as we getbigger; I mean it just, contractors are a way of life in this business. But wealways try to reduce the amount of contractors that we are using.

Dave Windley - Jefferies & Company

Right, so the essence of the question is, is the contractornumber growing faster than the permanent number?

Candace Kendle

No, no, no. The contractor number is not growing faster thanthe regular number. We find that we shift the kind of contractor need that wehave.

Dave Windley - Jefferies & Company

Okay. On this revenue burn rate I guess the -- you had --the essence of the question here is what can you -- why is visibility so low,and what can you do? You've walked through how you're doing some analysis onwhat factors are driving the burn rate of these contracts.

But I guess I look at this and I think, over a year ago whenyou bought Charles River CS, and your explicit goal was to move into theselonger contracts. And in view of your peers it is well-known to everybodywatching this industry that burn rates are slowing, and that these largercontracts roll out more slowly.

Why is it just becoming known to Kendle's management team inthe third quarter of 2007?

Buzz Brenkert

Dave, all of what you say we were aware of last year. Whatwe weren't aware of was what is the extent? How big an effect will this have onwhat our roll out is like? And what we are finding is frankly, we have beenmore successful, I think, in getting the large contracts then what weanticipated.

And they are having, therefore, a bigger effect on what ourtotal backlog is like. And they are rolling out one third the way, the speedthat our historical contracts had rolled out, which is slower than what we hadanticipated.

So, I think the anticipation or the big takeaway from whatresearch we've done this quarter is that while we anticipated in effect, it ismuch larger than what we had expected it would be.

Dave Windley - Jefferies & Company

Right. And…

Candace Kendle

Can I say -- here's another question for you, because this-- I recognize that the industry accepts that they roll out more slowly. But hereis the thing. At what point does it unnormalize? If you say that the slowdown-- and this gets to the variable analysis -- if you say that the slowdown ispredominantly regulatory.

Let's take a diabetes trial that has India and Mexico as thenormal big places one would go for that kind of trial, in both cases it is aten-month regulatory hurdle. If your business is concentrated with those kindsof geographic areas over a period of time you should see some normalization ofthat ten-month cycle.

You should get hit with it the first time, the second time;but you should see some normalization. But what we are seeing is that there isnot much normalization and so what is it that is happening?

Is it Kendle's change in customer mix? Is it that the shiftin the disease -- is there really that big a difference in the disease type? Imean I am…

Dave Windley - Jefferies & Company

I've got some answers for that. The answer is if thoseforeign countries are slower to enroll or slower to approve regulatorily andthey are speeding up their own process, as your business continues to shiftoutside the U.S., it is going to continue to slow on a mix basis alone.

Candace Kendle

Yes, but…

Dave Windley - Jefferies & Company

I guess I would go back to when you moved into EasternEurope some 10 years ago when that was the equivalent of what Asia is now, wasthere not that effect?

Candace Kendle

No. That is the whole point, Dave. There was no effect.There absolutely was no effect. And I hear what you are saying accept that,let's say you hold the concentration of business constant in those areas that Imentioned.

Let's say 25% of your business is international, in thoseslow regulatory events.

Dave Windley - Jefferies & Company

Okay. But that is not realistic because that is a movingtarget. You are intentionally trying to increase that proportion of yourbusiness.

Candace Kendle

Right, but then you ought to be able to forecast by theamount of increase in business the amount of slowing. So if I increase mybusiness 5% in those areas, once the business is normalized you would expectthe slowdown to be constant.

And it isn't. We don't have enough data to say that itisn't, but it would appear not to be. It would appear that there are -- theseother four variables driving the business slow down.

So, not just the regulatory environment in Latin America andAsia Pacific, but or not just disease states, but a combination of factors andno one wants to get to the answer more than we do.

But please don't just lump it into gee it is the growingbusiness in the emerging markets. It has to be more than that.

Dave Windley - Jefferies & Company

Well, right, or it is more factors within those areas.

Candace Kendle

Right, yes, we are on the same page.

Dave Windley - Jefferies & Company

I guess the question for management here is going as youmade acquisitions and expanded the platform of the business and moved intoareas that were unknown territory, why not err on the conservative side of whatmight occur given that there are obviously this many things that you did notknow?

Why not err on the conservative side so that perhaps you arenot either missing or lowering expectations in four out of the last five quarters?

Candace Kendle

In retrospect we should have lowered. We thought we werebeing conservative. In retrospect we should have been more conservative.

Dave Windley - Jefferies & Company

I mean, you’ll remember, I'll get off here in a second, butyou'll remember that earlier this year after the, I believe it was the fourthquarter miss and you gave guidance and we were assured that these numbers wereheavily scrubbed and they were absolutely conservative.

Candace Kendle

That is what we believed.

Dave Windley - Jefferies & Company

And then you raised guidance after you did this convert. Imean the forecasting, the financial acumen around the forecasting for thiscompany has to improve. It has to improve, because you've got to earn backcredibility. And I'll leave it at that. And I'll let somebody else askquestions.

Operator

Your next question comes from the line of Todd Van Fleet,First Analysis.

Todd Van Fleet - First Analysis

I want to give you a chance to talk about what you seehappening for Kendle on the early stage side. You talked about changing outsome leadership there. I’m wondering, is the new leadership coming in kind ofgiven a blank slate to roll the business as they see fit, or is there a definedstrategy on the part of more senior management within Kendle to growth thatbusiness?

And the folks that you're bringing on board are supposed toexecute on that vision?

Candace Kendle

It is a little bit of both. I mean why bring in an expertand then tie their hands, but obviously, the conversations around what makes awholesome early stage business have been helped by management in order to beable to give someone the proper commitment.

We are currently looking at expanding the Phase I, proof ofconcept, bio-equivalence business to include more bio-analytical capability,something that we've talked about now for some time.

And so any leadership in that area would not only have ageographic understanding of what customer needs are with regard to Phase I andQA, but also with regard to bio-analytical services.

Again, I am hopeful -- I am very pleased with the leadershipwe were able to gain in Morgantown, which not only has bio-equivalenceexpertise but a much broader base of expertise to contribute to a more seniorteam in early stage.

Todd Van Fleet - First Analysis

Cancellations were only about $7 million in the quarter.Where the cancellations in early stage about $1 million of that $7? I'm tryingto think about the magnitude of the impact on the cancellations in early stageand then what kind of recovery in terms of time frame you think we shouldexpect moving ahead in that business.

Candace Kendle

We me calculate the are going to get you the specific numberhere. We are being very cautious about the fourth quarter. We are told that wewill have some rebound in the fourth quarter in Utrecht, but we had been toldthat the beginning, and we believed that to be true at the beginning of last --this past third quarter. Buzz, do you have the number? Thank you.

Buzz Brenkert

Yes, the cancellations in Utrecht totaled were close to $6million of that $7 million.

Todd Van Fleet - First Analysis

$6 million of the $7 million and that presumably $6 millionwould have been realized over the course of the following what, 6 months, 3, 6,9 months?

Buzz Brenkert

It would have gone into the first quarter of next year. Thecancellations -- first it was delayed and then it was canceled rather late inthe quarter. So, it included work in the third quarter, the fourth quarter andthe first quarter of next year.

Todd Van Fleet - First Analysis

Okay, if I could I want to touch back on the subject of theForEx the currency translation. I just want to understand the moving parts andpieces, Buzz, as you see it. So from an operating standpoint if you are paid bya customer in the U.S. in U.S. dollars the P&L, the operating portion ofP&L is at risk to the extent that work is being conducted in overseas marketswhere the currency, U.S. currency is in a state of decline relative to thatcurrency?

Buzz Brenkert

Correct.

Todd Van Fleet - First Analysis

Okay, the second type of scenario is where you are paid inforeign currency and presumably more or less I guess if you want to assume theU.S. dollar is declining against most currencies all else being equal.

The operating portion of the P&L should be somewhatneutral. So you get the benefit on the top line but you also take the expensehit as well.

Buzz Brenkert

Correct.

Todd Van Fleet - First Analysis

Okay.

Buzz Brenkert

And I don't want to leave the impression that it is all thedollar. There are fluctuations between the pound and the euro, and there are anumber of currency fluctuations that come into these calculations.

Todd Van Fleet - First Analysis

Of course. So just to understand where your head at withrespect to foreign currency translation and hedging strategies and so forth, isit -- are there any hedging strategies of any kind from an operating standpointfor Kendle? And then I want to talk about the non-operating currency exposurein a second.

Buzz Brenkert

From an operating standpoint we try to match the revenue andthe payment in the currency in which we are going to experience the expenseside, if you will. So, that if it is a contract that will all be done inEurope, our expenses are, our costs will be in euros and we negotiate forrevenue to be in euros as well.

Todd Van Fleet - First Analysis

Sorry when you forecast and plan and budget out, you don'tbudget out to that level of granularity in terms of where the money is comingfrom and who is going to be paid so that you can't put together comprehensivehedging strategy surrounding the operations of Kendle?

Buzz Brenkert

We do budget out that way. We budget in the -- we budget bydepartment and in the currency of that country. But again, it is not aguarantee. And there are a number of cases where you have large global studieswhere you are going to bill in only one currency you are going to experienceexpenses in multiple currencies.

Todd Van Fleet - First Analysis

Okay, so as a level of -- there is a level of complexitythere to the hedging strategy. On the non-operating side, however, if -- and Iam assuming that $2 million charge substantially all of that was related toForEx in the quarter.

Buzz Brenkert

Yes.

Todd Van Fleet - First Analysis

Okay.

Buzz Brenkert

But most of it unrealized.

Todd Van Fleet - First Analysis

Right, right. So, assuming it was 400,000 like it was in Q2,that is a $0.10 to $0.12 swing on pro-forma EPS depending on the tax rate thatyou want to use. So it is a pretty substantial impact to EPS.

And it seems like it would warrant at least some degree ofattention concerning trying to minimize that level of uncertainty on the bottomline. So from a non-operating standpoint, as you look at the receivables and soforth, it would seem to me that is kind of maybe the easiest place to startwhen in terms of trying to establish.

Buzz Brenkert

And we are looking at several alternatives to determine howwe can minimize the effect on the income statement. The real issue becomes oneof -- there certainly is a base group, if you will, of assets and liabilitiesthat you are going to have as part of your business.

There will be translation effects from one quarter to thenext, all of which are unrealized. Do you want to have a hedging strategy thatis going to have a realized effect actually turning to cash that makes theincome statement look better but actually costs you money?

And that doesn't make a whole lot of sense to me. So thereis a happy medium. There is a happy medium that we have not yet found; I guessis the best way to put it.

Todd Van Fleet - First Analysis

Okay, I'll leave it at that. And just one more, if I could.With respect to SG&A, it looks like overall on the balance this yearSG&A is probably going to run about flat as a percent of revenue relativeto last year.

The expectation for 2008, again not without giving guidancejust how you think about managing the business, it would seem that there wouldbe some leveraging of SG&A working ahead as you roll the business is thatfair to say?

Buzz Brenkert

Long-term our goal certainly is to increase operating marginso that to the extent that we sort of share that increase between direct costsand SG&A, I think it’s safe to say that long-term our goal is to bringSG&A down as a percent of revenue.

Todd Van Fleet - First Analysis

Long-term goal being three to five years, and notnecessarily over the next…

Buzz Brenkert

And perhaps the best way to put it is the continuing goal,if you will, is to continue to leverage our costs and increase our operatingmargin. Once again, direct costs versus SG&A because there are allocationsbetween those two categories. We tend to look at the cost in total as opposedto buy those two financial statement or income statement categorizations.

Todd Van Fleet - First Analysis

Okay. Thanks.

Operator

Your next question will comes from the line of Sandy Draper,Raymond James.

Sandy Draper - Raymond James

Thank you. Most of my questions have actually been asked andanswered. Just two quick things. One, Buzz, on the interest expense can youjust remind me in terms of the pricing of the convert did we have the fullimpact this quarter of the lower interest, or do we get a little bit more fullimpact in the fourth quarter?

Buzz Brenkert

No, We will get the full impact in the fourth quarter. Wedid not close on the convert until midway through July. And we had really athree-day overlap before we had any pay-off of the term loan with the cash thatwe got from the convert.

We also didn't completely pay off the term loan in July. Wecarried forward about $10 million or $11 million of the loan into August, sothat there was some interest expense on the term loan in the first two monthsof the quarter.

Sandy Draper - Raymond James

Okay, great.

Buzz Brenkert

I would expect we will save an additional $400,00 to$500,000 on interest expense in the fourth quarter.

Sandy Draper - Raymond James

Okay, great. And then I know I could go back to the analystday and look at the slides, but just remind me, what are the actual triggersfor the convert? At what stock price do we actually start to have to thinkabout that coming into play?

Buzz Brenkert

I think it will not affect earnings per share until 47.70 Ithink is the premium or the strike price.

Sandy Draper - Raymond James

Okay, great. Thanks.

Operator

Your next question comes from the line of Terri Powers,Robert Baird.

Terri Powers - Robert W. Baird

Hi guys Good morning. My question relates to the thirdquarter tax rate and the FIN 48 liability reversal. Looking at the non-GAAPearnings stream so excluding the deferred financing cost write-off in theintangibles amortization.

If we were to also exclude the liability reversal would theeffective tax rate in the quarter have been roughly 36.5% and that wouldsuggest a non-GAAP EPS of $0.44 on that basis? Is that a correct way to thinkabout that?

Buzz Brenkert

I haven't done that math, Terri, so I will trust your mathon it.

Terri Powers - Robert W. Baird

Okay, if we could follow-up off-line. And then my otherquestion was are the initial reserves related to FIN 48, was that taken in thefirst quarter of '07, and do you recall what that dollar amount of that reservewas and hopefully the EPS impact?

Buzz Brenkert

There was no EPS impact when we, when everyone adopted FIN48, the adjustment went to equity.

Terri Powers - Robert W. Baird

Okay. That's what I thought. Thanks very much.

Operator

(Operator Instructions) Your next question comes from theline of Andrew Weinberger, Galleon.

Andrew Weinberger - Galleon

Yes, hi, just quick questions, really like the bookingsnumber what I don't understand is how you are blaming a revenue miss oncancellations when they seem very modest in the quarter, $7 million. And then Iguess if you move to sort of the industry cancellation rate of 4% to 5% ofbeginning quarter backlog, how can you really model your business I guess in2008 and 2009?

How should -- can you give us sort of some -- I know theStreet is looking for pretty aggressive expectations for 2008. But I guess Iwant to understand how you guys get a handle on your business when you had whatI think is an incredible cancellation rate and it’s hard to predict thebusiness even with almost no cancellations. How are you going to do that if youget up to if your cancellation in absolute dollars increases by like five toseven times?

Buzz Brenkert

Andy, I wanted to take your questions in order but I haveforgot what your first question was.

Andrew Weinberger - Galleon

I mean, it’s really -- can you give us some growth estimatein 2008 on revenues or EPS and just so we can understand how the largercancellation rates are going to impact your business because you had aminiscule cancellation rate this quarter?

Buzz Brenkert

And it’s not just this quarter, Andy. We've had cancellationrate that’s pretty well below the industry average for the last several years.

Andrew Weinberger - Galleon

I absolutely agree, and I’m trying to understand yourvisibility on your business going forward, if you expect those cancellationrates to move up to the industry average.

Candace Kendle

Andy, one of the things that you need to think about is thetiming of the hit relative to the cancellation. We took a big third quarter hitin cancellations even though the absolute number was small. The Phase I, whenyou get canceled in Phase I there is no chance to recover, and it hitsimmediately, and you are sitting there with staff sitting empty.

So proportionately a big hit in Phase I is many times largerthan a Phase II, III hit. A cancellation in Phase II, III of a very large trialcould run out 36 months, I mean you get the story here itself.

So I think it’s a fair question that you are asking, butthey are not apples-and-apples. So the size of Phase I hit that we took thisquarter would be a much, would carry a much bigger impact. It would take a muchbigger trial to reap the same immediate impact had it been in Phase II, III.

Andrew Weinberger - Galleon

Okay. Thank you.

Operator

(Operator Instructions) At this time we are showing nofurther questions.

Candace Kendle

Thank you all for participating, and we look forward to nextquarter.

Operator

This concludes today's teleconference. You may disconnect atthis time.

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Source: Kendle International Q3 2007 Earnings Call Transcript

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