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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 2007 Earnings Conference Call and Webcast. As a reminder, this call is being recorded.

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 our conference call. With us today are Dr. Candace Kendle, Kendle's Chairman and CEO, Chris Bergen, Kendle's President and Chief Operating Officer and Buzz Brenkert, Kendle's Chief Financial Officer.

By now you should have all received a copy of our earnings release. This release also is posted on our corporate website at kendle.com or via 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 706-645-9291 and entering access code 5447273. Or you may access a webcast of the archived call at kendle.com.

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

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

Today we will be talking about our expectations regarding a number of activities in which Kendle is engaged. Reliance should not be placed on such forward-looking statements because they involve risks and uncertainties that may cause our actual results to differ materially from those which we are going to discuss or which we may imply.

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

A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is available within the earnings release.

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 want to start us off?

Buzz Brenkert

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

First, I want to briefly discuss the convertible notes that we issued on July 16. These are five-year notes with a net share settlement feature. 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 finance the Charles River clinical services acquisition last year.

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

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

These liabilities were established at the beginning of the year as part of the initial adoption of FIN 48. During the third quarter of 2007 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 first quarter where previous years' quarter and year-to-date results include partial period results from the Charles River acquisition. We celebrated the acquisition anniversary on August 16th. Therefore the acquisition results were included 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 third quarter. Operating income and $14.2 million grew 76% from the third quarter of last year.

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

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

Focusing on revenue, as I mentioned earlier $100 million of revenue 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 about 6% of the year-over-year growth and about 1% of the growth over Q2. Revenue in our Phase II through IV operations was strong, growing at 37% from Q3 of last year.

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

The revenue decline in the Netherlands primarily resulted from a program delay and subsequent cancellation that comprised over five studies. 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 by about 40%.

Geographic distribution of total net service revenue has shifted slightly from the second quarter, North American based service revenues increased 51%, increased to 51% of the total from 50% last quarter. European revenues does just the opposite. They were 41% of total, down from 42% last quarter. 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% of revenue as compared to 30% in the third quarter last year and our ten largest customers accounted for 39% of revenue versus 44% last year.

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

Excluding $1 million of intangible amortization associated with the Charles River acquisition, pro forma operating income for the quarter was $15.3 million, representing a pro forma operating margin of 15.3%, which again represents a strong increase over last year's Q3 margin of 11.7% and the prior 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 deferred financing fees, foreign exchange losses, which are mostly non-cash, totaling over $2 million and net interest expense of $3 million, which compares to net interest expense of $1.8 million last year.

Interest expense for the remainder of the year will continue to decrease due to the convertible notes replacing the term loan that was paid off 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 diluted earnings per share of $0.25 is down from Q3 last year of $0.27.

Excluding the intangible amortization expense associated with the Charles River acquisition, and the write-off of the deferred financing fees, pro forma EPS was $0.48 versus $0.30 last year. Looking at our nine-month operating results, net service revenues totaled $293 million, an increase of 49% versus last year. Foreign exchange rate differences between years account for approximately 7% of that growth.

Full-year revenue contribution by region shifted from North America, or shifted between North America and Europe from last year. North America has contributed 50% of year-to-date net service revenues compared to 56% 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 steady at 3% of net service revenues.

For the full-year our top five customers accounted for about 25% of net revenues. That is down from almost 27% last year, and again, no customer 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 2006 operating income of $21.8 million.

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

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

The $4.2 million write-off of deferred financing fees and net other expenses primarily foreign exchange losses of $4.4 million, which compares to only $650,000 last year. On a GAAP basis net income for the year-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, pro forma EPS totaled $1.14 for the first nine months of this year versus $0.92 for the first nine months of 2006. Cash flow from operations for the year-to-date totaled $38.1 million and capital expenditures were $10.8 million.

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

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

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

Candace Kendle

Thank you, Buzz. I will begin by speaking about the sales for the quarter followed by comments on labor and revenue. Gross sales for the quarter were $175 million, which compares to gross sales of $148 million for the 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, which compares to cancellations in last quarter of 13; cancellations were approximately 4% of gross sales. The backlog was once again at an all-time high of $831 million for this quarter compared to $590 million for the same quarter last year, representing a 41% increase and sequentially backlog increased by 10% from the end of last quarter, which at that point totaled $758 million. Our gross 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 third quarter the average dollar per proposal rose, and we can continue to make gains on our 12-month rolling hit rate. With regard to the customer concentration in sales for this quarter, the top five customers as a percent of total gross and net sales were 62% and 65%, respectively.

I’d like to make a few comments with regard to labor. Our total headcount at the end of the third quarter was 3,260, which does not include the use of contractors around the world. An important point here for later comments is that our utilization for billable staff is at this point on budget.

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

We are currently effectively matching the business need with the employee base in most regions of the world. This represents significant improvement over the last three quarters. Our success in this area is in part due to the improved recruiting and retention efforts and also as a result of the slowdown in the revenue rollout, which is a result of a significantly altered business mix with regard to mega trials, and I am going to talk about that in a minute.

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

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

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

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

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

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

I do want to -- for many of you this will be a reinforcement of what you know -- but for some of you perhaps this is new data. There is no doubt that the principal reason revenue has not grown in proportion to the growth in backlog is the significant growth in mega trials in the industry and at Kendle.

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

While labor could at some point have an effect, again that is not the issue for Kendle going forward. What we have found in our review is that 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 of award and the geography for execution of work. These all seem to be trial variables that influence revenue rollout, again with a very limited data. We are looking at data from 2004, which if you recall was early in our business recovery and at a time in which we had very few of the larger trials through data August 2007.

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

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

Again, trials over $10 million roll out more slowly in all quarters when measured over eight quarters, which is about as long as we feel we can even look at. And we don't have -- note the smaller trials obviously don'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 trials roll out more slowly. The revenue from these larger trials roll out at about one-third the speed of all other trials, largely impacted by two factors, regulatory influence and again what would appear to be customer lack of familiarity with things like site setup expectations.

Specific customers also drive longer rollouts. Some customers will award early in the outsourcing process. Some have longer contractual processes, longer site approvals, particularly in new areas. And we are now beginning to track individual customers to better predict our backlog performance.

It is no surprise to many of you, revenue roll out is also affected by therapeutic area. In the early review of data it would appear that GI and oncology studies track more slowly than others as one could speculate why 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 size over $10 million, specific customers, disease type, country of award and the geography for the execution of work.

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

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

Kendle is also increased its oncology concentration, which we may be an added influence. All of these areas look to be drivers of the slower roll out of our business. But again, it is premature to draw any conclusions. We will continue to monitor data and look at industry comparators where possible to drive better forecasting. And we look to be able to give you more 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 the slower than anticipated roll out of revenue from our late stage backlog, we believe it is prudent to adjust the revenue guidance to $390 million to $400 million, 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 basis and 13.9% on a pro-forma basis, are almost right in the middle of our current guidance range. So, we will continue with our operating margin guidance of between 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 early stage business. We now expect our GAAP EPS for the year to range between $1.25 to $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 all of the EPS guidance figures assume no significant share dilution from the new convertible debt. I hope you were able to understand me. I've got some little seasonal issue here.

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

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes from the 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 you addressed already. I guess my first question, more of housekeeping, if you could just give the margins as you break them out in 10-Q filings as far as the early stage to late stage and also on the services line, revenue and margins would 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. Loss from 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 and headcount, it looks like by my calculations with the headcount number you gave it was up about 3.1% sequentially this quarter, was up about 3.5% sequentially between Q2 and 1Q.

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

Candace Kendle

In terms of the hiring, again it doesn't include contractors, 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 the world. 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 the direction, 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't have need to bring them down in the fourth quarter, or is it more you didn't hire as many people because you didn't see the revenue burn coming in as quickly as expected?

Candace Kendle

It is primarily the latter. The revenue miss is in large part the early stage misses. Had we made the early stage programs, had the burns 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 some increased recruiting. But in large part utilization is right on budget.

Robert Gilliam - UBS

Okay. And as far as the tax rate in the fourth quarter everything 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 cancellation rates. It looks like Kendle's cancellation rates have been significantly lower than many people or many of your other peers. I was just wondering if you knew a specific reason for that, kind of how you think it might change going forward given the larger exposure to the elephant trials? And then I just have one final follow-up on FX?

Candace Kendle

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

Robert Gilliam - UBS

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

Candace Kendle

Yes.

Robert Gilliam - UBS

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

Buzz Brenkert

Basically what is factored in is a little bit of a loss on FX 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 a gain, although I think the dollar hit an all time low versus the euro yesterday.

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 rather broad range on the guidance just to be cushioned a little from what may happen with FX.

Robert Gilliam - UBS

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

Operator

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

Alex Alvarez - Goldman Sachs

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

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

Candace Kendle

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

Alex Alvarez - Goldman Sachs

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

And just curious as to whether we are just starting to see the impacts of some of those trends that you mentioned, or do you feel this has been going on for a while but we are just now starting to see it? Just curious as 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 clinical acquisition was about scale, and we certainly benefited from that scale. We believe we saw the impact almost immediately, certainly within a quarter we began to see the impact. I think Kendle is enjoying recognition of being a major player and having the kind of global breadth and depth we've been talking about.

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

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

Alex Alvarez - Goldman Sachs

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

Candace Kendle

Yes, I think the addition of Karen Crone as head of HR; the additional recruiters that we brought and placed, retention and engagement programs 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 on month-to-month basis improvements again in various pockets around the world.

Alex Alvarez - Goldman Sachs

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

Buzz Brenkert

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

PTO reserve is typically built up during the first two quarters of the year and the big times for vacations, at least in the Northern Hemisphere are the third quarter, July and August are big months for vacation time. 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 are charged 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 direct expenses in the fourth quarter then?

Buzz Brenkert

Well, the fourth quarter has the same sort of phenomenon in that there is a lot of holidays and a lot of PTO that is taken particularly around those holidays. So, I would not expect, the direct expenses to go to the same level that they were in the second quarter. Perhaps a little bit of a pickup, 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 quarter was much stronger than I think anything we've seen out of Kendle at least in the last several quarters. How should we think about that from a going forward perspective?

Buzz Brenkert

We typically tend to look at operating margin as opposed to gross margin. But I would expect for the fourth quarter that you’ll see that 51% gross margin drop a bit.

Alex Alvarez - Goldman Sachs

Okay. And then, just one last one. In terms of the 833,000 reversal of the tax liability, I just want to make sure I understand how that was flowing through the P&L. Was your tax expense in the quarter reduced by that 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 wanted to touch on a few. The first I wanted to understand, Buzz, is on the FX. You are seeing benefit to the revenue line from FX, but then lowering guidance in part due to the hit that you've taken in FX.

And help me to understand is it disproportionate either because 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 is imbalanced to cause EPS to need to come in that much?

Buzz Brenkert

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

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

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

Dave Windley - Jefferies & Company

Okay. That's helpful. So the principal assets there would be funds receivable held outside the U.S., and I guess cash held in subsidiaries outside 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 control inter-company.

Buzz Brenkert

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

Dave Windley - Jefferies & Company

All right. Candace, on labor and utilization, you say that utilization is basically on budget. I want to understand are you emphasizing that 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 out more quickly. And we are seeing a greater drag, sort of a less steep curve, if you will, than we had anticipated in Q1 thinking about the big ramp up that is required.

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

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

Dave Windley - Jefferies & Company

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

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

Candace Kendle

We are using more contractors than we would like because obviously 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 have to judge the risk of moving that person off a program in order to save some money versus the long-term relationship with the customer. That is number one.

Number two, in areas where you are short of talent, either a therapeutic 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 the ascending market, where the contractor base may in fact be the most experienced and may be a trainer.

So, that we are moving away from our contractors but if the method is that we end up using more contractors in absolute numbers as we get bigger; I mean it just, contractors are a way of life in this business. But we always 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 contractor number growing faster than the permanent number?

Candace Kendle

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

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 on what factors are driving the burn rate of these contracts.

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

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

Buzz Brenkert

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

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

So, I think the anticipation or the big takeaway from what research we've done this quarter is that while we anticipated in effect, it is much 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 here is 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 is predominantly regulatory.

Let's take a diabetes trial that has India and Mexico as the normal big places one would go for that kind of trial, in both cases it is a ten-month regulatory hurdle. If your business is concentrated with those kinds of geographic areas over a period of time you should see some normalization of that 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 is not much normalization and so what is it that is happening?

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

Dave Windley - Jefferies & Company

I've got some answers for that. The answer is if those foreign countries are slower to enroll or slower to approve regulatorily and they are speeding up their own process, as your business continues to shift outside 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 Eastern Europe some 10 years ago when that was the equivalent of what Asia is now, was there 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 I mentioned.

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

Dave Windley - Jefferies & Company

Okay. But that is not realistic because that is a moving target. You are intentionally trying to increase that proportion of your business.

Candace Kendle

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

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

So, not just the regulatory environment in Latin America and Asia Pacific, but or not just disease states, but a combination of factors and no one wants to get to the answer more than we do.

But please don't just lump it into gee it is the growing business 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 you made acquisitions and expanded the platform of the business and moved into areas that were unknown territory, why not err on the conservative side of what might occur given that there are obviously this many things that you did not know?

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

Candace Kendle

In retrospect we should have lowered. We thought we were being 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, but you'll remember that earlier this year after the, I believe it was the fourth quarter miss and you gave guidance and we were assured that these numbers were heavily 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. I mean the forecasting, the financial acumen around the forecasting for this company has to improve. It has to improve, because you've got to earn back credibility. And I'll leave it at that. And I'll let somebody else ask questions.

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 see happening for Kendle on the early stage side. You talked about changing out some leadership there. I’m wondering, is the new leadership coming in kind of given a blank slate to roll the business as they see fit, or is there a defined strategy on the part of more senior management within Kendle to growth that business?

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

Candace Kendle

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

We are currently looking at expanding the Phase I, proof of concept, 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 a geographic understanding of what customer needs are with regard to Phase I and QA, but also with regard to bio-analytical services.

Again, I am hopeful -- I am very pleased with the leadership we were able to gain in Morgantown, which not only has bio-equivalence expertise but a much broader base of expertise to contribute to a more senior team 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 trying to think about the magnitude of the impact on the cancellations in early stage and then what kind of recovery in terms of time frame you think we should expect moving ahead in that business.

Candace Kendle

We me calculate the are going to get you the specific number here. We are being very cautious about the fourth quarter. We are told that we will have some rebound in the fourth quarter in Utrecht, but we had been told that 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 $6 million of that $7 million.

Todd Van Fleet - First Analysis

$6 million of the $7 million and that presumably $6 million would 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. The cancellations -- first it was delayed and then it was canceled rather late in the quarter. So, it included work in the third quarter, the fourth quarter and the first quarter of next year.

Todd Van Fleet - First Analysis

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

Buzz Brenkert

Correct.

Todd Van Fleet - First Analysis

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

The operating portion of the P&L should be somewhat neutral. So you get the benefit on the top line but you also take the expense hit 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 the dollar. There are fluctuations between the pound and the euro, and there are a number of currency fluctuations that come into these calculations.

Todd Van Fleet - First Analysis

Of course. So just to understand where your head at with respect to foreign currency translation and hedging strategies and so forth, is it -- are there any hedging strategies of any kind from an operating standpoint for Kendle? And then I want to talk about the non-operating currency exposure in a second.

Buzz Brenkert

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

Todd Van Fleet - First Analysis

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

Buzz Brenkert

We do budget out that way. We budget in the -- we budget by department and in the currency of that country. But again, it is not a guarantee. And there are a number of cases where you have large global studies where you are going to bill in only one currency you are going to experience expenses in multiple currencies.

Todd Van Fleet - First Analysis

Okay, so as a level of -- there is a level of complexity there to the hedging strategy. On the non-operating side, however, if -- and I am assuming that $2 million charge substantially all of that was related to ForEx 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 that you want to use. So it is a pretty substantial impact to EPS.

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

Buzz Brenkert

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

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

And that doesn't make a whole lot of sense to me. So there is a happy medium. There is a happy medium that we have not yet found; I guess is 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 year SG&A is probably going to run about flat as a percent of revenue relative to last year.

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

Buzz Brenkert

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

Todd Van Fleet - First Analysis

Long-term goal being three to five years, and not necessarily 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 operating margin. Once again, direct costs versus SG&A because there are allocations between those two categories. We tend to look at the cost in total as opposed to 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 and answered. Just two quick things. One, Buzz, on the interest expense can you just remind me in terms of the pricing of the convert did we have the full impact this quarter of the lower interest, or do we get a little bit more full impact in the fourth quarter?

Buzz Brenkert

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

We also didn't completely pay off the term loan in July. We carried forward about $10 million or $11 million of the loan into August, so that there was some interest expense on the term loan in the first two months of 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 analyst day and look at the slides, but just remind me, what are the actual triggers for the convert? At what stock price do we actually start to have to think about that coming into play?

Buzz Brenkert

I think it will not affect earnings per share until 47.70 I think 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 third quarter tax rate and the FIN 48 liability reversal. Looking at the non-GAAP earnings stream so excluding the deferred financing cost write-off in the intangibles amortization.

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

Buzz Brenkert

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

Terri Powers - Robert W. Baird

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

Buzz Brenkert

There was no EPS impact when we, when everyone adopted FIN 48, 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 the line of Andrew Weinberger, Galleon.

Andrew Weinberger - Galleon

Yes, hi, just quick questions, really like the bookings number what I don't understand is how you are blaming a revenue miss on cancellations when they seem very modest in the quarter, $7 million. And then I guess if you move to sort of the industry cancellation rate of 4% to 5% of beginning quarter backlog, how can you really model your business I guess in 2008 and 2009?

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

Buzz Brenkert

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

Andrew Weinberger - Galleon

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

Buzz Brenkert

And it’s not just this quarter, Andy. We've had cancellation rate 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 your visibility on your business going forward, if you expect those cancellation rates to move up to the industry average.

Candace Kendle

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

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

So I think it’s a fair question that you are asking, but they are not apples-and-apples. So the size of Phase I hit that we took this quarter would be a much, would carry a much bigger impact. It would take a much bigger 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 no further questions.

Candace Kendle

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

Operator

This concludes today's teleconference. You may disconnect at this time.

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Source: Kendle International Q3 2007 Earnings Call Transcript
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