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Filed pursuant to Rule 424(b)(3)
Registration Statement No. 333-05535
Prospectus Supplement No. 9, dated April 9, 1998
(To Prospectus dated April 1, 1997, as supplemented
on April 29, 1997, May 15, 1997, August 20, 1997,
November 12, 1997, November 17, 1997, February 4,
1998, March 3, 1998 and March 31, 1998)
[AAI LOGO]
Applied Analytical Industries, Inc.
Common Stock
(par value $0.001 per share)
On April 9, 1998, the Company filed Amendment No. 1 on Form 10-K/A to
its Annual Report on Form 10-K for the year ended December 31, 1998 with the
Securities and Exchange Commission. Such amendment was filed solely to include
earnings per share data for the years in which the Company was a subchapter S
corporation (1995, 1994 and 1993) which had been omitted from the Annual Report
on Form 10-K. A copy of such amendment on the Form 10-K/A is attached.
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K/A
(Amendment No. 1)
[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1997
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number 0-21185
APPLIED ANALYTICAL INDUSTRIES, INC.
(Exact name of Registrant as specified in its charter)
DELAWARE 04-2687849
(State or other jurisdiction of (I.R.S. employer
incorporation or organization) identification no.)
5051 NEW CENTRE DRIVE, WILMINGTON, NC
28403 (Address of principal
executive office) (Zip code)
Registrant's telephone number, including area code: (910) 392-1606
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.001 par value per share
(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES X NO
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K of any
amendment to this Form 10-K. [ ]
The number of shares outstanding of the Registrant's common stock, as of
March 20, 1998 was 16,302,208 shares. The aggregate market value for the
voting stock held by non-affiliates of the Registrant on March 20, 1998 was
approximately $110,411,000.
Documents Incorporated by Reference
Portions of the Registrant's 1997 Annual Report to Shareholders are incorporated
by reference in Parts I, II, and IV hereof. Portions of the Registrant's 1997
Proxy Statement dated approximately April 10, 1998 are incorporated by reference
in Part III hereof.
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EXPLANATORY NOTE
This Form 10-K/A of Applied Analytical Industries, Inc. (the "Company") is being
filed to amend portions of Exhibit 13 to the Company's Form 10-K for the year
ended December 31, 1997, as filed with the Commission on March 31, 1998. Certain
data related to historical earnings per share for the years the Company was a
subchapter S corporation (1995, 1994, and 1993) was omitted in the original
filing.
Although only Exhibit 13 is being amended, the Company has included the main
body of the previously filed Form 10-K with this filing as a convenience to
potential EDGAR users.
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PART I
Item 1. Business.
The terms "Company", "Registrant" or "AAI" in this Form 10-K include
Applied Analytical Industries, Inc., its corporate predecessors and its
subsidiaries, except where the context may indicate otherwise. The Company was
incorporated in 1986, although its corporate predecessor was founded in 1979.
AAI operates in two business segments which include a fee-for-service business
and a product development business. Financial information by business segment is
included on page 26 of the 1997 Annual Report to Shareholders (the "Annual
Report") and is incorporated herein by reference.
In the fee-for-service business, AAI is a leading integrated contract
research and development resource to the worldwide pharmaceutical and
biotechnology industries, offering an efficient, variable cost alternative to
its clients' internal drug development, compliance and quality control programs.
The Company provides a broad array of value-added services, including chemical
analysis, synthesis and other laboratory services; drug formulation development;
clinical trial and bioanalytical services; clinical supply and niche
manufacturing; and regulatory and compliance consulting. AAI has contributed to
the submission, approval or continued marketing of client products worldwide,
encompassing a wide range of therapeutic categories and technologies. The
Company believes that its ability to offer an extensive portfolio of high
quality drug development and support services enables it to effectively compete
as pharmaceutical and biotechnology companies look for integrated drug
development solutions that offer cost-effective results on an accelerated basis.
In addition to the fee-for-service business, AAI leverages its expertise
by allocating a significant proportion of its technical resources and operating
capacity to internal drug and drug technology development. The Company generally
funds the expense of development and then participates in the benefits of any
potential commercial success through licensing and royalty arrangements.
Internal drug development is focused on generic products, line extensions and
patented technologies. Certain of these products have been licensed or sold. The
Company's proprietary technology includes patents and pending patent
applications on formulations, methods and drug delivery vehicles. Since 1993,
the Company has allocated a growing proportion of its technical resources and
operating capacity to its internal drug and drug technology development program.
The Company has only recently begun to recognize significant license and royalty
revenues from its internal development efforts because of the significant time
required for development and regulatory approval of pharmaceutical products.
In 1994, as part of its internal development program, the Company
organized Endeavor Pharmaceuticals Inc. ("Endeavor") to develop certain hormone
pharmaceutical products, focusing initially on several such products then under
development by AAI. The Company owns approximately 40% of the fully diluted
common equity of Endeavor.
On December 31, 1996, the Company acquired L.A.B. Gesellschaft fur
pharmakologische Untersuchungen mbH & Co. ("L.A.B."). L.A.B. is a European
contract research and development organization headquartered in Neu-Ulm, Germany
with principal operating units in Neu-Ulm and Munich, Germany; and in Paris,
France, as well as smaller operational units in London, England and Arnheim,
Netherlands. L.A.B. focuses on both clinical and non-clinical pharmaceutical
product development and provides services that include drug formulation
development; chemical analysis; Phase I clinical trial studies; bioanalytical
testing; and European regulatory consulting. L.A.B. also provides Phase II-IV
multi-center clinical trial studies focused in niche therapeutic areas including
hepatic disease, chemotherapeutics, and hormone replacement therapy.
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Fee-for-Services Business
The Company provides a broad array of drug development services,
including chemical analysis, synthesis and other laboratory services;
formulation development; clinical trial and bioanalytical services; clinical
supply and niche manufacturing; and regulatory and compliance consulting. The
Company assigns project management teams consisting of customer service
representatives and technical employees that meet with clients at frequent
intervals to monitor and guide projects through the development process.
Continual client interaction allows the Company to efficiently manage the drug
development process.
Historically, the Company's laboratory services have accounted for
approximately one half of its fee-for-service revenue, although relative amounts
vary from year to year. Formulation development projects and clinical supply and
niche manufacturing generally have contributed the major portions of remaining
annual fee-for-service revenue. With the addition of L.A.B., the Company
anticipates that clinical trials services will contribute more significantly to
total revenues.
Laboratory Services
In support of drug development and compliance programs, the Company
offers laboratory services to characterize and measure drug components and
impurities. The Company has over 18 years experience in providing analytical
testing services dedicated exclusively to the drug industry and has developed
the scientific expertise, state-of-the-art equipment and broad range of
scientific methods to accurately and quickly analyze almost any compound or
product. The Company's laboratory services include method development and
validation; stability studies; raw materials and release testing; biotechnology,
microbiology and bioanalytical testing; product characterization and organic
synthesis.
Method Development and Validation. The Company develops and validates
methods used in a broad range of laboratory testing necessary to determine
physical or chemical characteristics of compounds. Analytical methods are
developed to demonstrate potency, purity, stability or physical attributes.
These methods are validated to ensure the data generated by these methods are
accurate, precise, reproducible and reliable and are used throughout the drug
development process and in product support testing.
Stability Studies. The Company provides stability testing and secure
storage facilities necessary to establish and confirm product purity, potency
and other shelf-life characteristics. Stability testing is required at all
phases of product development, from dosage form development through commercial
production, to confirm shelf life of each manufactured batch. The Company
maintains state-of-the-art controlled-climate facilities in the United States
and Germany to determine the range of storage conditions a product can
withstand. FDA regulations and the regulations of European regulatory
authorities require that samples of clinical and commercial products placed in
stability chambers be analyzed in a timely fashion after scheduled "pull points"
occur, based on the date of manufacture. The Company's proprietary LTS systems
track client products maintained at the Company's stability storage facilities
and automatically schedules required testing as pull points occur.
Raw Materials and Product Release Testing. The Company offers testing
required by the FDA to confirm that raw materials used in production and
resulting finished products are consistent with established specifications. Due
to the incorporation of "just in time" inventory control systems and variations
in client production schedules, release testing for both raw materials and the
finished product often cannot be scheduled by clients in advance, yet must be
performed immediately. The Company believes that its internal scheduling
systems, analytical
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laboratory expertise and systems for prompt testing provide it with a
competitive advantage in providing both raw material and batch release testing.
The Company believes that this service enhances its client's confidence in
adopting cost-saving "just in time" inventory control systems.
Biotechnology Analysis and Synthesis. Although the types of analytical
investigations of biotechnology products are similar to those required for more
traditional pharmaceutical products, the complex molecular structure of many
biotechnology products requires different technology and expertise. The Company
provides a broad array of biotechnology services, including both analytical and
biological testing and method development and validation. AAI's breadth of
services allows the Company to rapidly deduce and characterize the complex
structure of the biotechnology product and measure the molecule or its
metabolites in human blood plasma to support clinical trial evaluation. The
Company has expertise in a broad spectrum of biochemical and immunochemical
methods for characterization and analysis of biotechnology drugs. These methods
include amino acid sequencing, amino acid analysis, peptide mapping,
carbohydrate and lipid analysis and electrophoresis. The Company also has
expertise in developing chromatographic methods that precisely evaluate the
purity and stability of biotechnology products. This service breadth and
diversity of analytical skills and technologies enable the Company to assist its
clients from early product development through the investigational new drug
application and product license application stages and commercial production.
Microbiological Testing. Microbiological testing is an essential
indicator to ensure that a drug product, whether raw material or finished
product, does not contain harmful micro-organisms. The Company has significant
experience conducting various microbial tests to identify and quantify
micro-organisms that may be present, including limulus amebocyte lysate (LAL)
testing, which measures toxic byproducts of micro-organisms, and particulate
matter testing to determine the presence of foreign matter in injectable drug
products. The Company also performs sterility testing to identify the genus and
species of any micro-organisms that are present. In addition, the Company
performs tests to determine the effectiveness of antibiotics against
micro-organisms and the minimum levels of preservatives necessary in product
formulations.
The Company also assists clients with environmental monitoring, including
water and air systems testing, using an automated biochemical system to identify
micro-organisms present and determine whether such systems are within applicable
microbial limits. The Company assists clients in validating their environmental
control systems to ensure compliance with GMP regulations.
Bioanalytical Testing. The Company offers bioanalytical testing services
to support clinical trials, analyzing plasma samples to characterize the
metabolized forms of the drug and determine the rate of absorption.
Bioanalytical studies of new drugs often present challenging and complex issues,
with products being metabolized into multiple active and inactive forms, each of
which must be measured. The Company works with its clients to develop and
validate analytical methods to permit detection and measurement of the various
components to trace levels. The acquisition of L.A.B. significantly enhanced the
Company's bioanalytical capabilities.
Product Characterization. The Company has the expertise and instruments
required to identify and characterize a broad range of chemical entities.
Characterization analysis identifies the chemical composition, structure and
physical properties of a compound, and characterization data forms a significant
portion of a regulatory application. The Company uses numerous techniques to
characterize the compound, including spectroscopy, chromatographic analysis and
other physical chemistry techniques. Additionally, the Company uses such
information for control testing to be performed throughout development and
marketing to confirm consistent
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drug composition. Once appropriate test methods are developed and validated, and
appropriate reference standards (highly pure samples) are characterized and
certified, the Company can assist clients by routinely testing compounds for
clinical and commercial use.
Organic Synthesis. The Company develops synthesis methods for producing
experimental quantities of new compounds needed for analytical characterization,
toxicological studies, formulation development and clinical trials. Through
organic synthesis techniques, the Company can produce reference standards of the
active compound, specific impurities, degradation by-products, bioassay
reference standards or molecular analogs to permit sufficient quantities of such
compounds to be separately characterized and studied.
Formulation Development Services
The Company provides integrated formulation development services,
enabling the Company to take a client's compound and develop a safe and stable
product with desired characteristics. The Company believes its formulation
expertise and extensive analytical capabilities enable it to provide an
efficient, seamless development program, with a dedicated project team tracking
the product through all stages of formulation development. The Company provides
formulation development services to its clients during each phase of the drug
development process, from new compounds and modifications of existing products
to generic versions of branded products. The Company's formulation development
projects may support a small segment of critical development activities or may
last for several years going from early formulation development to optimized and
validated production-scale, packaged product.
The Company's formulation development expertise spans a broad spectrum of
therapeutic areas. The Company works with clients to develop products with
desired characteristics, including dosage form, strength, release rate,
absorption properties, stability and appearance. The Company has developed
significant product and process capabilities that enable it to more efficiently
solve the complex problems that arise in developing formulations with targeted
characteristics and has developed a range of proprietary product technologies
that allow it to better achieve desired results in product design and
development.
In providing formulation services, the Company works closely with clients
to design and conduct feasibility studies to chart the potential of formulating
a drug using a combination of active drug ingredients and inert materials called
excipients. Using experimental designs, initial prototype formulations are
prepared to identify potential problems in stability, bioavailability and
manufacturing. Generally, formulation development is an iterative process, with
numerous initial formulations being modified as problems are encountered. The
Company believes its experience and expertise in formulation development, as
well as certain proprietary technologies, permit it to design efficient
protocols for identifying and optimizing prototypes with the greatest potential.
Upon selection of the final product prototypes, the Company develops
protocols to scale the product batch size from development stage (hundreds to
thousands of units) to clinical scale (thousands to millions of units). During
the clinical phase the Company refines the formulation in response to clinical,
bioanalytical and stability data. The manufacturing scale-up process involves
identifying and resolving manufacturing problems to facilitate an efficient
transfer to the full-scale production equipment of the Company's clients.
Throughout the development process, the Company develops and validates the
analytical methods necessary to test the product to establish and confirm
product specifications.
In addition to new drug development, the Company offers product
modification and line extension services to clients, generally for marketed
products facing patent expiration. Modifications of existing products offer the
Company's clients an opportunity to improve product characteristics, increasing
product market viability. Improved product characteristics
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include enhancement of stability, absorption profiles (e.g., quick or sustained
release), taste and appearance. Product line extensions may include new dosage
forms such as solids, liquids and chewables, as well as new dosage strengths.
Product modifications and line extensions offer clients the opportunity to
target new patient subpopulations and improve patient compliance. The Company
also offers formulation services to clients seeking to develop generic products.
Clinical Supply and Niche Manufacturing
The Company provides clinical trials materials for Phase I through IV
clinical trials. The Company has expertise in manufacturing tablets, capsules,
sachets, liquids and suspensions, creams, gels, lotions and ointments. The
Company believes that outsourcing of clinical supply manufacturing is
particularly attractive to pharmaceutical companies that maintain large,
commercial-quantity, batch facilities, where clinical supply manufacturing would
divert resources from revenue-producing manufacturing. Similarly, pharmaceutical
companies often seek to outsource commercial manufacturing of small quantity
products. In addition, the Company provides its clients assistance in scaling up
production of clinical supply quantities to commercial quantity manufacturing,
and manufactures inventory on behalf of clients for commercial sale while client
production facilities are being built and validated.
The Company's manufacturing facilities and equipment are qualified and
validated to operate under GMP (good manufacturing practices) regulations.
Regulatory and Compliance Consulting
The Company assists in the preparation of regulatory submissions, audits
a client's vendors and client operations, conducts seminars, provides training
courses, and advises clients on applicable regulatory requirements. The Company
also assists clients in designing development programs for new or existing drugs
intended to be marketed in the United States and Europe. At the client's
request, the Company will either review client prepared submissions or draft
sections and assemble regulatory packages and attend FDA meetings with clients.
The Company assists clients in preparation for FDA inspections and assists them
in correcting any deficiencies noted in FDA inspections. In preparation for an
FDA inspection, the Company's regulatory affairs specialists conduct mock
inspections to anticipate FDA observations and advise clients of appropriate
remedial actions. The Company also audits manufacturers of active and excipient
ingredients used in the drug product, as well as packaging components, on behalf
of clients to ensure that the manufacturers' facilities are in compliance with
GMP regulations. Such audits generally include review of the vendor's drug
master files, analysis of written standard operating procedures ("SOP"), review
of production records, and observation of operations to ensure that written
SOP's are being followed. Audit reports include recommendations to address any
deficiencies. The Company also advises clients on validation issues concerning
their systems and processes and audits client facilities to assist them in
validating their processes, cleaning, water and air handling systems.
The Company leverages its in-house laboratory training programs by
providing training to clients' employees. In addition, the Company organizes and
conducts seminars worldwide on a number of topical industry issues.
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Clinical Trial Studies
The Company has a 48-bed clinical trial facility at its Research Triangle
Park location. The clinical trial unit is located in the same facility as the
Company's bioanalytical laboratory and permits time-sensitive and rapid-response
analysis in clinical trials. The clinical trial unit is initially intended for
use in bioequivalency studies of generic drug products and Phase I clinical
trials. With the acquisition of L.A.B., the Company expanded its Phase I
clinical trial capabilities and added the ability to conduct Phase II-IV studies
and multi-center trials focused in niche therapeutic areas, including hepatic
disease, chemotherapeutics and hormone replacement therapy. The Company's
Neu-Ulm, Germany operations include a 120-bed facility for conducting certain
Phase I and II clinical trial studies, as well as bioequivalency studies. The
newly expanded facility in Paris, France allows the Company to perform as a
Phase II-IV multi-center clinical trial operation serving many European
pharmaceutical companies.
Product Development Business
The Company dedicates a significant proportion of its technical resources
and operating capacity to internal drug and technology development with the
objective of licensing marketing rights to third parties. The Company does not
independently commercialize products developed internally or otherwise directly
compete with its clients in the marketing or distribution of products and,
accordingly, believes that its internal development efforts are complementary to
its clients' development needs. The Company's internal product and technology
development program has resulted in multiple product applications filed with the
FDA and European regulatory agencies. Many of these products have been licensed
or sold. The internal development program has also resulted in patents covering
drug technology and pending patent applications
Since 1993, the Company has significantly increased its investment in its
internal product development program. Because of the significant time required
for development and approval of pharmaceutical products, the Company has only
recently begun to recognize significant license revenue from its internal
development efforts. The Company anticipates that internal product development
revenues, including royalties and milestone license payments, will represent a
growing proportion of its revenue. However, there can be no assurance that
internal development projects will yield products that will be approved by the
appropriate regulatory authorities or will be attractive to potential clients.
Although there is a risk that any particular development project may not produce
revenues, the Company believes that the profit margins from successful drug and
technology development projects could potentially exceed the margins for
standard fee-for-service engagements.
The Company's research and development committee, composed of
representatives from the formulations development, finance and marketing
departments, identifies potential drug development candidates for the program.
The committee selects development candidates after reviewing market size and
trends, current therapies and potential advances and patent and formulation
issues. In certain instances, the committee has also invited outside consultants
and medical panels to review selections.
In 1994, as part of its internal development program, the Company
organized Endeavor with certain financial investors and an affiliate of Berlex
Laboratories, Inc. to continue the development of certain generic hormone
products then under development by AAI. The Company assigned its rights to such
products to Endeavor in return for approximately 47% of Endeavor's equity during
a private placement of Endeavor stock, and the Company entered into a contract
with Endeavor to continue product development and clinical supply manufacture.
AAI currently owns approximately 40% of the fully diluted common equity of
Endeavor. The
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Company's fee-for-service net sales to Endeavor were approximately $3.2 million,
$6.2 million and $3.5 million in 1997, 1996 and 1995, respectively. The Company
believes that such services are provided at terms that are no less favorable
than terms that would be obtained from an unrelated third party.
Endeavor has had one product approved by the FDA, which will be launched
in early 1998. It is also currently developing another product, in multiple
dosage strengths; however, there can be no assurance that such product will
ultimately be approved by the FDA. Endeavor does not directly market any
products and its revenues are dependent upon licensing fees and royalties from
third parties. Continued product development by Endeavor is dependent upon
revenues from the approved product or additional capital funding.
In 1995 the Company entered into an agreement with Aesgen, Inc.
("Aesgen"), a company organized by the Company with an affiliate of Mayo Clinic,
MOVA Pharmaceutical Corporation and certain financial investors, to develop
certain pharmaceutical products. AAI recognized net sales to Aesgen of $1.9
million, $4.7 million and $5.6 million in 1997, 1996 and 1995, respectively. In
1996, the Company sold to Aesgen marketing rights to a product being developed
by the Company. Under the agreement, Aesgen will pay license fees and additional
royalties upon marketing the product, although there can be no assurance that
the product will be approved by the FDA or marketed. AAI continues to hold a
$1.6 million non-voting, non-convertible preferred stock investment in Aesgen.
In addition to its development work for Endeavor and Aesgen, the Company
has continued its internal development of products to be licensed to third
parties that have marketing and distribution capabilities. The Company has
entered into numerous license agreements for products that are currently in
development. The terms of the license agreements vary as to amounts of milestone
payments, as well as methods and extent of revenue participation. While the
Company anticipates that most of its product license agreements will provide
that prospective clients will ultimately sponsor the approved product, in
certain instances the Company has made submissions for internally developed
products in its own name.
Continuing to leverage its development capabilities, the Company has
moved into product line extension development and has also begun reviewing new
compounds that are chemically similar to currently marketed products with proven
therapeutic and safety profiles, and that offer improved characteristics over
the marketed product. Such improved characteristics would include enhanced or
new therapeutic indices, reduced side effects, improved bioavailability and
improved pharmacokinetics. Because considerable toxicity data already exists for
the marketed product, the Company believes that product lines extensions and
pro-drugs generally could be developed with less risk of failure and in a
shorter time frame than new chemical entity development. The Company believes
that virtual and limited-resource drug companies provide opportunities to enter
into collaborative ventures to identify and develop these types of compounds.
Technology Development Program
As an adjunct to the internal development program, the Company has sought
to protect certain intellectual property it has developed relative to the drug
development process. The Company has established a patent committee that meets
regularly to review employee-generated submissions of possible patentable
subject matter. The patent committee reviews the novelty and usefulness of the
submission and, with input from the marketing department as to commercial
viability, determines to either pursue a patent application or designate the
submission as a trade secret.
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The Company's internal development program has yielded multiple issued
patents and has several pending applications. For example, the Company's
patented Pro-Sorb(TM) formulation technology has been shown to facilitate the
oral absorption of a number of non-steroidal anti-inflammatory drugs or NSAIDs,
such as diclofenac, to reduce gastric irritation and speed the onset of
therapeutic activity. In addition, the Company has patented a novel oral
delivery system for certain biotechnology compounds that may currently be
administered only by injection.
The Company has one licensing agreement for a patented technology for the
manufacture of low-dose products which are typically difficult to uniformly
blend and an additional licensing arrangement for its patented chewable
formulations to mask the otherwise bitter taste of certain ulcer drugs. The
Company is seeking licensing partners for its other recently developed
technologies.
Information Technology
The Company has made significant investments in information technology.
The Company's LTS system tracks laboratory workflow and enables the Company to
monitor and plan work through the Company's laboratories. The LTS system
monitors the progress of a client's project, records time expended by laboratory
personnel, tracks sample locations and controls document revisions. The
Company's customized data management system connects analytical instruments with
multiple software architectures permitting automated data capture.
The Company believes that information technology will enable it to
expedite the development process by designing innovative services for individual
client needs, providing project execution, monitoring and control capabilities
that exceed a client's internal capabilities, streamlining and enhancing data
presentation to the FDA and enhancing its own internal operational productivity
while maintaining its quality.
Disclosure regarding the impact of year 2000 is included on page 16 of
the Annual Report and is incorporated herein by reference.
Clients
The Company has provided services to most of the large pharmaceutical
companies in the world. The Company believes that concentration of business
among certain large clients is not uncommon in the contract research
organization (CRO) industry. The Company has experienced such concentration in
the past and may experience such concentration in the future. Although AAI
strives to reduce its reliance on a limited number of major clients, there can
be no assurance that the Company's business will not be dependent upon certain
major clients, the loss of which could have a material adverse effect on the
Company. In addition, due to the project nature of the Company's business, there
can be no assurance that significant clients in any one period will continue to
be significant clients in other periods.
Marketing and Business Development
Since its inception, the Company has taken a customer-focused approach in
marketing its services, often placing the Company's technical personnel with its
clients' development teams to participate in planning meetings for the
development of a product. The Company assigns sales and technical personnel as
contacts for its larger clients, understanding that technical personnel may be
better able to identify the full scope of the client's needs and suggest
innovative approaches before the client formally develops the parameters of an
anticipated project. Generally, the Company also hosts more than ten technical
seminars per year for the
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pharmaceutical and biotechnology industries addressing a variety of formulation
development issues, stability testing and other topics.
Contractual Arrangements
The Company's fee-for-service contracts are typically evidenced by signed
service estimates establishing an estimated fee for identified services. During
the Company's performance of a project, clients often adjust the scope of
services to be provided by the Company in light of interim project results, at
which time the amount of fees is adjusted accordingly.
Generally, the Company's fee-for-service contracts are terminable by the
client upon notice of 30 days or less, although certain major formulation
development and manufacturing agreements are not unilaterally terminable by the
client. Although the contracts typically permit payment of certain fees for
winding down a project, the loss of a large contract or the loss of multiple
contracts could adversely affect the Company's future revenue and profitability.
Contracts may be terminated for a variety of reasons, including the client's
decision to forego a particular study, the failure of product prototypes to
satisfy safety requirements and unexpected or undesired results of product
testing.
Backlog
Backlog consists of anticipated net sales from signed service estimates
and other fee-for-service contracts that have not been completed and provide for
a readily ascertainable price. Once contracted work begins, net sales are
recognized as the service is performed on the percentage of completion basis. In
certain cases, the Company begins work for a client before a contract is signed.
Accordingly, backlog does not include anticipated net sales for which the
Company has begun work but for which the Company does not have a signed service
estimate, or for any variable-priced contracts. In addition, during the course
of a project the client may substantially adjust the requested scope of services
and corresponding adjustments are made to the price of services under the
contract.
The Company believes that its backlog as of any date is not a meaningful
predictor of future results because backlog can be affected by a number of
factors, including variable size and duration of contracts and adjustments in
the scope of a contracted project as interim results become available.
Additionally, contracts generally are subject to termination by clients upon 30
days notice or less. Moreover, the scope of a contract can change over the
course of a project. At December 31, 1997 and 1996 backlog was approximately
$31.5 and $20.3 million, respectively.
Competition
The Company competes primarily with in-house research, development,
quality control and other support service departments of pharmaceutical and
biotechnology companies, as well as university research laboratories. In
addition, the Company believes that although there are numerous competitors in
its industry, there are few competitors that offer the broad array of services
that it provides. Certain of the Company's competitors may have significantly
greater resources than the Company. Competitive conditions for service areas
vary.
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Competitive factors include reliability, turn-around time, reputation for
innovative and quality science, capacity to perform numerous required services,
financial viability and price. The Company believes that it competes favorably
in these areas.
Government Regulation
The services performed by the Company are subject to various regulatory
requirements designed to ensure the quality and integrity of pharmaceutical
products, primarily under the Federal Food, Drug and Cosmetic Act and associated
GMP regulations which are administered by the FDA in accordance with current
industry standards. Services being performed outside the United States or for
products intended to be substituted to non-U.S. jurisdictions may be subject to
additional regulatory requirements and government agencies applicable to that
jurisdiction. U.S. regulations apply to all phases of drug manufacture, testing
and record keeping, including personnel, facilities, equipment, control of
materials, processes and laboratories, packaging, labelling and distribution.
Noncompliance with such regulations by the Company in a project could result in
disqualification of data collected by the Company for such project. Material
violation of regulatory requirements could result in additional regulatory
sanctions. In severe cases violations could result in a mandated closing of the
Company's facilities which would materially and adversely affect the Company's
business.
To help assure compliance with applicable regulations, the Company has
established quality assurance controls at its facilities that monitor ongoing
compliance by auditing test data and regularly inspecting facilities, procedures
and other regulatory compliance parameters. In addition, FDA regulations and
guidelines, as well as applicable international standards, serve as a basis for
the Company's standard operating procedures. Certain of the Company's
development and testing activities are subject to the Controlled Substances Act,
administered by the Drug Enforcement Agency (the "DEA"), which regulates
strictly all narcotic and habit-forming substances. The Company maintains
separate, restricted-access facilities and heightened control procedures for
projects involving such substances due to the level of security and other
controls required by the DEA.
The Company's activities involve the controlled use of hazardous
materials and chemicals. The Company is subject to federal, state and local laws
and regulations governing the use, storage, handling and disposal of such
materials and certain waste products. Although the Company believes that its
safety procedures for handling and disposing of such materials comply with the
standards prescribed by federal, state and local laws and regulations, the risk
of accidental contamination or injury from these materials cannot be completely
eliminated. In the event of such an accident, the Company could be held liable
for any damages that result which could materially and adversely affect the
financial condition of the Company.
Employees
At December 31, 1997, the Company had approximately 850 full-time
equivalent employees, of which approximately 74 hold Ph.D. or M.D. degrees, or
their U.S. equivalent. The Company believes that its relations with its
employees are good. None of the Company's employees in the U.S. are represented
by a union. German law provides certain representative rights to employees.
The Company's performance depends on its ability to attract and retain
qualified professional, scientific and technical staff. The level of competition
among employers for such skilled personnel is high. The Company believes that
its employee benefit plans, including its health benefit, profit-sharing and
employee stock option plans, enhance employee morale,
11
<PAGE> 14
professional commitment and work productivity and provide an incentive for
employees to remain with the Company. In addition, the Company operates an
employee day-care and after-school program facility at its Wilmington, North
Carolina campus as a benefit to its employees. While the Company has not
experienced any significant problems in attracting or retaining qualified staff,
there can be no assurance that the Company will be able to avoid these problems
in the future.
All employees enter into confidentiality agreements protecting the
Company's proprietary information, as well as client-confidential material. New
U.S.-based technical employees are generally required to sign non-competition
agreements, prohibiting the employee from engaging in activities in competition
with the Company for a period of one year after termination of employment.
Special Item. Executive Officers of the Company.
The following table sets forth the name, age, principal occupation and
business experience for the executive officers of the Company.
Frederick D. Sancilio, Ph.D., 48, Chairman of the Board, President, Chief
Executive Officer and Director. Dr. Sancilio has served in his current capacity
for more than five years. Before founding the Company in 1979 Dr. Sancilio's
experience in the pharmaceutical industry included various positions with
Burroughs-Wellcome Co., Schering-Plough Corporation, and Hoffmann-LaRoche, Inc.
He has published more than 30 scientific articles discussing various aspects of
pharmaceutical chemistry and regularly makes scientific presentations at
pharmaceutical seminars and meetings worldwide.
Dr. Werner Gorlich, M.D., Ph.D., 50, Executive Vice President. Dr. Gorlich has
served as Executive Vice President since June 1997. Prior to joining the Company
he served as Medical Director of Research and Development at Glaxo, GmbH. Dr.
Gorlich has also held positions as Co-Managing Director of EuMcCom, a Glaxo
subsidiary; as a member of Glaxo Group's International Medical Board and other
management positions with both SmithKline and Sandoz.
Eugene T. Haley, 48, Executive Vice President and Chief Financial Officer. Mr.
Haley has served as Executive Vice President and Chief Financial Officer since
February 1998. Prior to joining the Company he served as the Chief Financial
Officer of Kodak Worldwide Consumer Imaging Services during 1997 and as Senior
Vice President of Qualex (an Eastman-Kodak subsidiary) from 1993 to 1997.
Martin S. Hunicutt, 47, Executive Vice President. Mr. Hunicutt has served as
Executive Vice President since May 1997. He had served as Vice President of
Marketing and Sales from 1994 to 1997. Prior to joining AAI in 1994, Mr.
Hunicutt was a Director of Marketing for Burroughs-Wellcome Co. and has 24 years
of experience in the pharmaceutical industry.
Kenneth Lomartire, 51, Executive Vice President Worldwide Research &
Development. Mr. Lomartire has served as Executive Vice President Worldwide
Research & Development since January 1997. Prior to joining the Company he was
Director, Pharmaceutical Development for Astra USA from 1990 to 1996. Mr.
Lomartire has over 28 years in the pharmaceutical industry.
12
<PAGE> 15
Frances M. Sakers, 40, Executive Vice President and Chief Operating Officer. Ms.
Sakers has served in her current position since September 1997. Prior to joining
the Company, Ms. Sakers was Executive Director of Quality Control at Novartis
Pharmaceuticals U.S. and has held various positions in Pharmaceutical Operations
at CIBA-Geigy Corporation for 14 years.
William H. Underwood, 50, Executive Vice President and Director. Mr. Underwood
has served in his current position since 1992 and has been a Director since
1996. He also served as Chief Operating Officer from 1995 to May 1997. He has
held various positions in the pharmaceutical and cosmetic industries, prior to
joining the Company in 1986, with Mary Kay Cosmetics, Inc. and
Burroughs-Wellcome Co.
R. Forrest Waldon, 35, Executive Vice President, General Counsel and Secretary.
Mr. Waldon has served as Executive Vice President since May 1997 and as General
Counsel and Secretary since 1989. He has been a Vice President since 1993. Prior
to his employment at the Company, Mr. Waldon practiced law with Thrasher &
Whitley, P.C. in Atlanta, Georgia.
Item 2. Properties.
The Company's principal executive offices are located in Wilmington,
North Carolina, in a 19,000-square foot leased facility. The Company's primary
U.S. facilities are located in Wilmington and Research Triangle Park, North
Carolina constituting approximately 150,000 square feet of operational and
administrative space. The Company's primary European facilities are located in
Neu-Ulm, Germany and include approximately 120,000 square feet of operational
and administrative space. This facility is leased under renewable leases
expiring in 2001. The Company maintains other operating units at leased
facilities in Munich, Germany; Paris, France; London, England; and Arnheim,
Netherlands. The Company maintains sales offices in Chicago, Illinois; Boston,
Massachusetts; San Diego and San Francisco, California; Elmwood Park, New
Jersey; Copenhagen, Denmark; London, England; Milan, Italy and Tokyo, Japan. The
Company believes that its facilities are adequate for the Company's operations
and that suitable additional space will be available when needed.
Item 3. Legal Proceedings.
The Company may be party to lawsuits and administrative proceedings
incidental to the normal course of its business which are not considered
material. In connection with the 1995 issuance of preferred stock, James L.
Waters and Frederick D. Sancilio (directors and significant stockholders of the
Company) have agreed to indemnify the Company for certain, then existing, claims
if any losses are incurred. Management does not believe that any liabilities
related to such lawsuits or proceedings will have a material adverse effect on
the Company's financial condition, results of operations or cash flows.
In December 1997, the North Carolina Supreme Court overturned a
judgement against the Company in the action, Kurtzman v. Applied Analytical
Industries, Inc. and directed the trial court to enter a judgment in favor of
the Company on all matters under the suit. Accordingly, such litigation was
ended.
Item 4. Submission of Matters to a Vote of Security Holders
None during the quarter ended December 31, 1997.
13
<PAGE> 16
PART II
Item 5. Market for the Registrant's Common Equity and Related Stockholder
Matters.
Market and other related information required by Item 5 is included on
page 28 of the Annual Report and is incorporated herein by reference.
Use of Proceeds.
In 1996, the Company completed the sale of 3,105,000 shares of common
stock through an offering filed on Registration Statement Form S-1 (No.
333-5535) which became effective on September 19, 1996. The net offering
proceeds to the Company after underwriting discounts and other expenses, as
previously disclosed in other Company filings, was $44,793,000. A reasonable
estimate for the application of such proceeds is described below. Such
information represents cumulative totals through the reporting date of this
periodic report and all amounts, unless indicated otherwise, are for direct or
indirect payments to others.
Construction of plant, building and facilities $ 4,951,000
Purchase and installation of machinery and equipment $ 8,630,000
Repayment of indebtedness $ 1,221,000
Working capital $ 5,654,000
Research and development $ 9,032,000
Temporary investments (short-term, investment
grade, Interest-bearing) $15,305,000
Use of proceeds $44,793,000
Item 6. Selected Financial Data.
The information required by Item 6 is included on page 13 of the Annual
Report and is incorporated herein by reference.
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
The information required by Item 7 is included on pages 14 through 16
of the Annual Report and is incorporated herein by reference.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
This item is not applicable.
Item 8. Financial Statements and Supplementary Data.
The information required by Item 8 is included on pages 17 through 28
of the Annual Report and is incorporated herein by reference.
14
<PAGE> 17
Item 9. Changes In and Disagreements with Accountants on Accounting and
Financial Disclosure.
None.
PART III
Item 10. Directors and Executive Officers of the Registrant.
The directors of the Company and their business experience are set
forth on page 2 of the Company's Notice of Annual Meeting of Stockholders, dated
approximately April 10, 1998 (the "Proxy Statement") and are incorporated herein
by reference. The discussion of executive officers of the Company is included in
Part I under "Executive Officers of the Company."
Item 11. Executive Compensation.
A description of the compensation of the Company's executive officers
is set forth on pages 5 through 8 of the Proxy Statement and is incorporated
herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
A description of the security ownership of certain beneficial owners
and management is set forth on pages 3 and 4 of the Proxy Statement and is
incorporated herein by reference.
Item 13. Certain Relationships and Related Transactions.
Certain relationships and related transactions with management are
described on pages 10 and 12 of the Proxy Statement and in Items 11 and 12, and
are incorporated herein by reference.
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.
Exhibits:
A list of the exhibits required to be filed as part of this Report on
Form 10-K is set forth in the "Exhibit Index", which immediately precedes such
exhibits, and is incorporated herein by reference.
Financial Statement Schedules:
The consolidated balance sheets as of December 31, 1997 and 1996, and
related consolidated statements of income, cash flows and stockholders' equity
for each of the three years in the period ended December 31, 1997 and the
related notes to financial statements, together with the report of independent
accountants thereon of Price Waterhouse LLP, dated March 18, 1998, appearing on
pages 17 through 28 of the Annual Report, are incorporated herein by reference.
With the exception of the aforementioned information and the information
incorporated by reference in Items 1, 5 through 8, the Annual Report is not to
be deemed filed as part of this report. The additional financial data listed
below should be read in
15
<PAGE> 18
conjunction with the financial statements in the Annual Report. Schedules not
included with this additional financial data have been omitted because they are
not applicable or the required information is shown in the financial statements
or notes thereto.
Reports on Form 8-K:
None filed during the quarter ended December 31, 1997.
Additional Financial Data
Page
Applied Analytical Industries, Inc., for years ended
December 31, 1997, 1996 and 1995:
Report of Independent Accountants F-1
Financial Statement Schedule:
Schedule II - Valuation and Qualifying Accounts F-2
16
<PAGE> 19
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned thereunto duly authorized.
/s/ STEPHEN F. RIZZO Vice President and April 9, 1998
- ------------------------- Controller (Principal
Stephen F. Rizzo Accounting Officer)
17
<PAGE> 20
REPORT OF INDEPENDENT ACCOUNTANTS
ON FINANCIAL STATEMENT SCHEDULE OF REGISTRANT
To the Board of Directors
of Applied Analytical Industries, Inc.
Our audits of the consolidated financial statements referred to in our report
dated March 18, 1998 appearing in the 1997 Annual Report to Shareholders of
Applied Analytical Industries, Inc. (which report and consolidated financial
statements are incorporated by reference in this Annual Report on Form 10-K)
also included an audit of the Financial Statement Schedule listed in Item 14 of
this Form 10-K. In our opinion, this Financial Statement Schedule presents
fairly, in all material respects, the information set forth therein when read in
conjunction with the related consolidated financial statements.
PRICE WATERHOUSE LLP
Raleigh, North Carolina
March 18, 1998
F-1
18
<PAGE> 21
Schedule II
APPLIED ANALYTICAL INDUSTRIES, INC.
Valuation and Qualifying Accounts
(In thousands)
<TABLE>
<CAPTION>
Balance at Charged to Balance at
beginning costs and Deductions end of
Description of period expenses - describe period
----------- --------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Allowance for doubtful accounts
1995 $125 23 78 (1) $ 70
1996 $ 70 4 1 (1) $ 73
1997 $ 73 36 - (1) $109
</TABLE>
(1) Represents amounts written off as uncollectible accounts receivable.
F-2
19
<PAGE> 22
APPLIED ANALYTICAL INDUSTRIES, INC.
Exhibit Index
Exhibit
No. Description
3.1 - Amended and Restated Certificate of Incorporation of the
Company (incorporated by reference to Exhibit 3.1 to the
Company's Quarterly Report on Form 10-Q for the quarter ended
September 30, 1996)
3.2 - Restated By-laws of the Company (incorporated by reference to
Exhibit 3.2 to the Company's Registration Statement on Form
S-1 (Registration No. 333-5535))
4.1 - Articles Fourth, Seventh, Eleventh and Twelfth of the form of
Amended and Restated Certificate of Incorporation of the
Company (included in Exhibit 3.1)
4.2 - Article II of the form of Restated By-laws of the Company
(included in Exhibit 3.2)
4.3 - Specimen Certificate for shares of Common Stock, $.001 par
value, of the Company (incorporated by reference to Exhibit
4.3 to the Company's Registration Statement on Form S-1
(Registration No. 333-5535))
10.1 - Employment Agreement dated November 17, 1995 between the
Company and Frederick D. Sancilio (incorporated by reference
to Exhibit 10.1 to the Company's Registration Statement on
Form S-1 (Registration No. 333-5535))
10.2 - Applied Analytical Industries, Inc. 1995 Stock Option Plan
(incorporated by reference to Exhibit 10.3 to the Company's
Registration Statement on Form S-1 (Registration No.
333-5535))
10.3 - Applied Analytical Industries, Inc. 1996 Stock Option Plan
(incorporated by reference to Exhibit 10.4 to the Company's
Registration Statement on Form S-1 (Registration No.
333-5535)
10.4 - Applied Analytical Industries, Inc. 1997 Stock Option Plan
(incorporated by reference to Exhibit 10.5 to the Company's
Quarterly Report on Form 10-Q for the quarter ended September
30, 1997)
10.5 - Stockholder Agreement dated as of November 17, 1995 among the
Company, GS Capital Partners II, L.P., GS Capital Partners II
Offshore, L.P., Goldman, Sachs & Co. Verwaltungs GmbH, Stone
Street Fund 1995, L.P., Bridge Street Fund 1995, L.P.,
Noro-Moseley Partners III, L.P., Wakefield Group Limited
Partnership, James L. Waters, Frederick D. Sancilio and the
parties listed on Schedule 1 thereto (incorporated by
reference to Exhibit 10.5 to the Company's Registration
Statement on Form S-1 (Registration No. 333-5535))
10.6 - Lease Agreement dated as of March 7, 1994 between 5051 New
Centre Drive, L.L.C., as landlord, and the Company, as tenant
(incorporated by reference to Exhibit 10.10 to the Company's
Registration Statement on Form S-1 (Registration No.
333-5535))
20
<PAGE> 23
10.7 - Development Agreement dated as of April 25, 1994 between the
Company and Endeavor Pharmaceuticals Inc. (formerly, GenerEst,
Inc.) (incorporated by reference to Exhibit 10.12 to the
Company's Registration Statement on Form S-1 (Registration No.
333-5535))
10.8 - Development Agreement dated as of April 4, 1995 between the
Company and Aesgen, Inc. (incorporated by reference to Exhibit
10.13 to the Company's Registration Statement on Form S-1
(Registration No. 333-5535))
10.9 - Loan Agreement dated as of December 30, 1996 between
NationsBank, N.A. and the Company (incorporated by reference
to Exhibit 10.14 to the Company's Annual Report on Form 10-K
for the year ended December 31, 1996)
10.10 - Registration Rights Agreement dated as of November 17, 1995
among the Company, GS Capital Partners II, L.P., Wakefield
Group Limited Partnership, James L. Waters, Frederick D.
Sancilio and the parties listed on Schedule 1 thereto
(incorporated by reference to Exhibit 10.16 to Post-effective
Amendment No. 1 to the Company's Registration Statement on
Form S-1 (Registration No. 333-5535))
10.11 - Underwriting Agreement dated September 19, 1996 between the
Company and Goldman Sachs & Co., Cowen & Company and Lehman
Brothers, Inc., as representatives of the underwriters listed
on Schedule 1 thereto (incorporated by reference to Exhibit
10.17 to the Company's Quarterly Report on Form 10-Q for the
quarter ended September 30, 1996)
13 - Portions of the 1997 Annual Report to Shareholders
21 - Subsidiaries of Applied Analytical Industries, Inc,*
27.1 - Financial Data Schedule (for SEC use only)
Year ended 12/31/97*
27.2 - Financial Data Schedule (for SEC use only) 9 months ended
9/30/97*
27.3 - Financial Data Schedule (for SEC use only) 6 months ended
6/30/97*
27.4 - Financial Data Schedule (for SEC use only) 3 months ended
3/31/97*
27.5 - Financial Data Schedule (for SEC use only)
Year ended 12/31/96*
27.6 - Financial Data Schedule (for SEC use only) 9 months ended
9/30/96*
27.7 - Financial Data Schedule (for SEC use only) 6 months ended
6/30/96*
27.8 - Financial Data Schedule (for SEC use only) 3 months ended
3/31/96*
- ----------------
* Previously Filed
21
<PAGE> 24
EXHIBIT 13
PORTIONS OF THE 1997 ANNUAL REPORT TO SHAREHOLDERS
<PAGE> 25
<TABLE>
<CAPTION>
Selected Financial Data
Year ended December 31, 1997 1996 1995 1994 1993
In thousands, except per share amounts
<S> <C> <C> <C> <C> <C>
Statement of Income Data:
Net sales $ 65,401 $ 42,162 $ 34,639 $ 32,882 $ 26,378
Cost of sales 33,378 17,621 14,259 14,533 9,731
Selling 8,362 6,357 4,913 4,390 3,654
General and administrative 15,207 8,908 8,171 8,485 8,738
Research and development 7,791 4,216 3,326 2,394 1,273
Unusual item (1) -- 6,600 -- -- --
Other income (expense), net 1,373 494 (1,130) (440) (156)
- ---------------------------------------------------------------------------------------------------------------------
Income (loss) before income taxes 2,036 (1,046) 2,840 2,640 2,826
Provision for income taxes (2) 781 2,102 39 -- --
Equity income (loss) -- -- 444 (444) --
- ---------------------------------------------------------------------------------------------------------------------
Net income (loss) $ 1,255 $ (3,148) $ 3,245 $ 2,196 $ 2,826
- ---------------------------------------------------------------------------------------------------------------------
Basic earnings (loss) per share (3) $ 0.08 $ (0.26) $ 0.31 $ 0.21 $ 0.28
- ---------------------------------------------------------------------------------------------------------------------
Weighted average shares outstanding 16,290 12,039 10,348 10,317 10,181
- ---------------------------------------------------------------------------------------------------------------------
Diluted earnings (loss) per share (3) $ 0.08 $ (0.26) $ 0.30 -- --
- ---------------------------------------------------------------------------------------------------------------------
Weighted average shares outstanding 16,459 12,039 10,667 -- --
- ---------------------------------------------------------------------------------------------------------------------
Pro forma data (unaudited) (2):
Net income, as reported $ 3,245 $ 2,196 $ 2,826
Pro forma income taxes 1,129 1,118 1,125
- ---------------------------------------------------------------------------------------------------------------------
Pro forma net income $ 2,116 $ 1,078 $ 1,701
- ---------------------------------------------------------------------------------------------------------------------
Pro forma earnings per share (3) $ 0.20 $ 0.10 $ 0.17
- ---------------------------------------------------------------------------------------------------------------------
Weighted average shares outstanding 10,667 10,317 10,181
- ---------------------------------------------------------------------------------------------------------------------
Balance Sheet Data, at period end:
Working capital $ 32,637 $ 35,755 $ 12,374 $ (1,181) $ 601
Property and equipment, net 25,326 19,216 10,904 10,782 9,121
Total assets 100,449 104,478 39,156 22,402 18,443
Long-term debt 6,578 6,671 3,379 2,738 3,273
Total stockholders' equity (4) 66,076 63,995 21,990 5,856 5,549
- ---------------------------------------------------------------------------------------------------------------------
</TABLE>
(1) In connection with the acquisition of L.A.B., the Company recognized an
unusual item representing the write-off of certain in-process research
and development costs with an appraised value of approximately $6.6
million as of December 31, 1996.
(2) Pro forma information is presented prior to 1996 to reflect pro forma
provisions for income taxes for the periods prior to November 17,1995,
when the Company was treated as an S corporation for income tax
purposes.
(3) The Company has restated all earnings per share data in accordance with
SFAS No. 128.
(4) The Company completed an initial public offering of its common stock in
September 1996.
APPLIED ANALYTICAL INDUSTRIES 13
<PAGE> 26
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
The Company derives its revenue primarily on a fee-for-service basis by
performing contract development and support services for the pharmaceutical and
biotechnology industries, including chemical analysis, synthesis and other
laboratory services; drug formulation development; clinical supply and niche
manufacturing; clinical and bio-analytical studies; and regulatory and
compliance consulting. In general, the Company provides services to a client
under an estimate that establishes the anticipated price and scope of a project,
although estimates may be adjusted during the term of the project. The terms of
the Company's engagements vary, ranging from less than one month to several
years, and generally may be terminated upon notice of 30 days or less by the
client.
In addition to its fee-for-service business, the Company allocates a
portion of its technical resources and operating capacity to its internal
product development projects. Product development projects are undertaken to
develop targeted drugs and proprietary drug technologies with the intention of
licensing the marketing rights to third parties. The Company has also entered
into selective shared-risk development projects, reducing its fees for
development services in return for license fees, typically paid upon performance
of certain milestones, and royalties based on a percentage of product sales or
profit. Substantially all of the Company's research and development expenses are
the result of internal development projects.
On December 31, 1996, the Company acquired the outstanding equity in
L.A.B. Gesellschaft fur pharmakologische Untersuchungen mbH & Co. ("L.A.B."), a
European contract research and development organization headquartered in
Neu-Ulm, Germany with operational units in Neu-Ulm and Munich, Germany, as well
as in France, Netherlands and England. L.A.B. focuses on both clinical and
non-clinical pharmaceutical product development and provides services that
include drug formulation development; chemical analysis; Phase I clinical
studies; bio-analytical testing; and European regulatory consulting. The firm
also provides Phase II-IV studies and multi-center trials. The acquisition of
L.A.B. significantly expanded the Company's bio-analytical capabilities and
allowed the Company to offer multi-center clinical testing services. Analytical
and clinical work conducted in Europe is generally interchangeable with work
performed in the United States for purposes of seeking U.S. regulatory approval.
Thus, the acquisition of L.A.B. provided the Company with significant additional
capacity for clinical and non-clinical services to its entire global client
base.
This Annual Report contains certain forward-looking statements that
involve risks and uncertainties. The Company's actual results may differ
significantly from the results discussed in those forward-looking statements.
Factors that might cause such differences include, but are not limited to, the
Company's dependence on and effect of government regulation; its management of
growth and acquisition risks; the level of outsourcing of research, development
and testing activities in the pharmaceutical and biotechnology industries; its
dependence on key personnel, and its dependence on third-party marketing and
distribution of internally developed drugs.
Results of Operations
1997 Compared to 1996
Net sales increased by 55% in 1997 compared to 1996. The increase in
net sales was primarily attributable to the inclusion of L.A.B. net sales in
1997. The fee-for-service sales
14 APPLIED ANALYTICAL INDUSTRIES
<PAGE> 27
increased by 47% in 1997 compared to 1996 and product development revenues
increased by nearly 300% in 1997 compared to 1996.
Gross margins in the fee-for-service business declined to 44% in 1997
compared to 57% in 1996. This decrease is primarily attributable to the
inclusion of L.A.B. in 1997 with lower operating margins than the historical
levels attained by AAI. Margins were also impacted by increases in professional
staffing in 1997 to meet increased client demand.
Selling expense increased 32%, in 1997 compared to 1996, primarily as a
result of the inclusion of L.A.B. in 1997. Selling expense as a percent of net
sales declined to 13% in 1997 compared to 15% in 1996. General and
administrative expense increased 71% in 1997 compared to 1996, primarily as a
result of the inclusion of L.A.B. in 1997. General and administrative expense as
a percentage of net sales increased to 23% in 1997 from 21% in 1996. The Company
experienced a higher level of general corporate type expenses in 1997 as a
result of being a public company. Management believes these general corporate
type items should not increase significantly as a percent of net sales in future
years.
Research and development expense increased 85% in 1997 compared to
1996. Research and development expense represented 12% of net sales in 1997
compared to 10% of net sales in 1996. The increase in research and development
expense reflects the Company's decision to allocate an increasing proportion of
its development capabilities to internal product development to accelerate
certain drug development activities. The Company anticipates that research and
development expense will continue to increase over the next several years,
consistent with its business strategy of investing approximately 10% of net
sales.
The Company terminated certain business combination discussions during
the third quarter of 1997. In relation to these discussions, the Company
recognized a net credit of $400,000 in other income, representing a $1 million
payment made to its L.A.B. subsidiary and approximately $600,000 of expenses
incurred by AAI.
1996 Compared to 1995
Net sales increased 22% in 1996 compared to 1995. The increase was
principally due to the performance of a greater number of laboratory service
projects and increased licensing revenue. Net sales from fee-for-service
business increased 20% in 1996 compared to 1995. Product development revenues
increased 103% in 1996 compared to 1995.
Gross margins in the fee-for-service business declined to 57% for 1996
compared to 58% for 1995. This change reflects the increased resources needed to
perform the greater inflow of work from our fee-for-service clients.
Selling expense increased 29% in 1996 compared to 1995. The increase
was primarily attributable to the opening of sales locations in Boston,
Massachusetts; San Diego and San Francisco, California; Copenhagen, Denmark and
London, England, as well as higher commission expense associated with increased
sales. As a percentage of net sales, selling expense increased to 15% for 1996
from 14% for 1995. General and administrative expense increased 9% in 1996
compared to 1995. The increase in general and administrative expense is
primarily a function of the Company's growth with no significant change
attributable to any specific items. As a percentage of net sales, the Company's
general and administrative expense continued a downward trend, decreasing to 21%
for 1996 from 24% for 1995.
Research and development expense increased by 27% in 1996 compared to
1995, and represented approximately 10% of net sales for both years. The
increase in research and development expense reflects the Company's decision to
allocate an increasing proportion of its development capabilities to its
internal product development program.
APPLIED ANALYTICAL INDUSTRIES 15
<PAGE> 28
In connection with the acquisition of L.A.B., the Company recognized an
unusual item representing the write-off of certain in-process research and
development ("R&D") costs with an appraised value of approximately $6.6 million
as of December 31, 1996.
The Company recognized no activity associated with its investment in
Endeavor during 1996 because Endeavor had a loss and the Company had no book
value on its investment. During the fourth quarter of 1995, the Company's
obligations under a credit facility to Endeavor were terminated and equity
income of $444,000 was recognized as the reversal of a previously recorded
liability in 1994.
The provision for income taxes for 1996 was greater than 1995 because
no income taxes were recognized for most of 1995 because the Company was treated
as an S corporation for federal and state income tax purposes through November
1995. Additionally, no tax benefits were recognized for the write-off of certain
in-process R&D in 1996.
Liquidity and Capital Resources
The Company has funded its business through operating cash flows,
proceeds from borrowings and the issuance of equity securities. During 1996 and
1995, the Company generated $2.4 million and $3.8 million, respectively, in cash
flow from operations and raised $45.0 million and $21.5 million in net proceeds
in its 1996 and 1995 sales of equity securities, respectively.
Total capital expenditures were $10.9 million in 1997, $7.6 million in
1996 and $1.7 million in 1995. Capital expenditures were incurred predominantly
for new equipment and improvements to existing facilities. The Company
anticipates capital expenditures in 1998 to be at or below the 1997 level.
Working capital was $32.6 million at December 31, 1997 compared to
$35.8 million at December 31, 1996. The Company has available a $20 million
credit facility to supplement its liquidity needs. The Company expects to
continue expanding its operations through internal growth and strategic
acquisitions. The Company expects such activities will be funded from existing
cash and cash equivalents, cash flow from operations and borrowings under its
credit facility. The Company believes that such sources of cash will be
sufficient to fund operations for the current and foreseeable future and to pay
existing debt as it becomes due and other capital obligations. The Company is
constantly evaluating acquisition or other growth opportunities. At some point
in the future there may be opportunities that require additional external
financing, and the Company may from time to time seek to obtain funds from the
public or private issuance of equity or debt securities. There can be no
assurances that such financing will be available on terms acceptable to the
Company.
Year 2000 Disclosure
The Company is in the process of completing its assessment of the
impact to computer systems and equipment when the year 2000 arrives. Over the
past few years a number of computer systems that were not year 2000 compatible
have either been upgraded or replaced. While management does not believe this
issue will materially affect its products, services or competitive condition, it
has not fully completed its assessment at this time.
Inflation
The Company believes the effects of inflation generally do not have a
material adverse effect on its results of operations or financial condition.
16 APPLIED ANALYTICAL INDUSTRIES
<PAGE> 29
Consolidated Statement of Income
In thousands, except per share amounts
<TABLE>
<CAPTION>
For the years ended December 31, 1997 1996 1995
<S> <C> <C> <C>
Net sales (includes related party net
sales of $5,170; $10,916 and $9,088) $ 65,401 $ 42,162 $34,639
Operating costs and expenses:
Cost of sales 33,378 17,621 14,259
Selling 8,362 6,357 4,913
General and administrative 15,207 8,908 8,171
Research and development 7,791 4,216 3,326
Unusual item -- 6,600 --
-------- -------- --------
64,738 43,702 30,669
-------- -------- --------
Income (loss) from operations 663 (1,540) 3,970
Other income (expense):
Interest net 608 511 (860)
Other 765 (17) (270)
-------- -------- --------
1,373 494 (1,130)
-------- -------- --------
Income (loss) before income taxes 2,036 (1,046) 2,840
Provision for income taxes 781 2,102 39
Equity income -- -- 444
-------- -------- --------
Net income (loss) $ 1,255 $ (3,148) $ 3,245
-------- -------- --------
Basic earnings (loss) per share $ 0.08 $ (0.26) $ 0.31
-------- -------- --------
Weighted average shares outstanding 16,290 12,039 10,348
-------- -------- --------
Diluted earnings (loss) per share $ 0.08 $ (0.26) $ 0.30
-------- -------- --------
Weighted average shares outstanding 16,459 12,039 10,667
-------- -------- --------
Pro forma data (unaudited):
Net income, as reported $ 3,245
Pro forma income taxes 1,129
--------
Pro forma net income $ 2,116
--------
</TABLE>
The accompanying notes are an integral part of these financial statements.
APPLIED ANALYTICAL INDUSTRIES 17
<PAGE> 30
Consolidated Balance Sheet
In thousands
<TABLE>
<CAPTION>
December 31, 1997 1996
ASSETS
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 26,219 $ 42,225
Accounts receivable 19,415 10,033
Work-in-progress 8,968 9,462
Prepaid and other current assets 4,481 6,318
--------- ---------
Total current assets 59,083 68,038
--------- ---------
Property and equipment, net 25,326 19,216
Goodwill and other intangibles 13,747 14,953
Other assets 2,293 2,271
--------- ---------
Total assets $ 100,449 $ 104,478
--------- ---------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current maturities of long-term
debt and short-term debt $ 5,561 $ 2,092
Accounts payable 4,005 8,429
Customer advances 7,869 7,790
Accrued wages and benefits 3,561 5,127
Other accrued liabilities 5,450 8,845
--------- ---------
Total current liabilities 26,446 32,283
--------- ---------
Long-term debt 6,578 6,671
Other liabilities 1,349 1,529
Commitments and contingencies
Stockholders' equity:
Preferred stock -- --
Common stock, $.001 par value;100 million
shares authorized, 16,295,271 outstanding - 1997;
16,286,236 shares outstanding - 1996 16 16
Paid-in capital 67,545 66,719
Accumulated deficit (1,336) (2,591)
Stock subscriptions receivable (149) (149)
--------- ---------
Total stockholders' equity 66,076 63,995
--------- ---------
Total liabilities and stockholders' equity $ 100,449 $ 104,478
--------- ---------
</TABLE>
The accompanying notes are an integral part of these financial statements.
18 APPLIED ANALYTICAL INDUSTRIES
<PAGE> 31
Consolidated Statement of Cash Flows
In thousands
<TABLE>
<CAPTION>
For the years ended December 31, 1997 1996 1995
<S> <C> <C> <C>
Cash flows from operating activities:
Net income (loss) $ 1,255 $ (3,148) $ 3,245
Adjustments to reconcile to net cash
(used) provided by operating activities:
Depreciation and amortization 5,116 2,062 1,591
Deferred income taxes (510) 25 (16)
Unusual item -- 6,600 --
Equity income -- -- (444)
Other 251 110 278
Changes in assets and liabilities:
Trade and other receivables (9,610) (1,073) 380
Work-in-progress 200 (969) (1,827)
Prepaid and other assets, net (2,225) (494) (385)
Accounts payable (4,090) 245 1,197
Customer advances 540 (943) (509)
Other accrued liabilities (3,921) (48) 301
-------- -------- --------
Net cash (used) provided by operating activities (12,994) 2,367 3,811
-------- -------- --------
Cash flows from investing activities:
Purchase of property and equipment (10,929) (7,609) (1,720)
Acquisition of L.A.B., net of cash acquired -- (2,206) --
Short-term investment 3,961 (3,961) --
Investment in affiliate -- -- (1,593)
Other (376) 31 (249)
-------- -------- --------
Net cash used by investing activities (7,344) (13,745) (3,562)
-------- -------- --------
Cash flows from financing activities:
Net proceeds (payments) short-term debt 3,269 (2,656) (926)
Proceeds from long-term borrowings 1,128 -- 1,505
Payments on long-term borrowings (633) (565) (978)
Issuance of common stock 600 44,794 --
Payment of stockholder note -- -- (1,159)
Sale of preferred stock -- -- 21,510
Dividends -- (1,051) (7,593)
-------- -------- --------
Net cash provided by financing activities 4,364 40,522 12,359
-------- -------- --------
Net (decrease) increase in cash and
cash equivalents (15,974) 29,144 12,608
Effect of exchange rate changes on cash (32) -- --
Cash and cash equivalents, beginning of period 42,225 13,081 473
-------- -------- --------
Cash and cash equivalents, end of period $ 26,219 $42,225 $13,081
-------- -------- --------
Supplemental information, cash paid for:
Interest $ 870 $ 402 $ 938
Income taxes $ 1,378 $ 1,945 $ 146
</TABLE>
The accompanying notes are an integral part of these financial statements.
APPLIED ANALYTICAL INDUSTRIES 19
<PAGE> 32
Consolidated Statement of Stockholders' Equity
In thousands
<TABLE>
<CAPTION>
Accumu-
Common Stock Class B Stock Paid-in lated
Shares Amount Shares Amount Capital (1) Deficit
- ------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Balance at January 1, 1995 447 $ 322 9,887 $ 317 $ -- $ 5,333
Sale of stock to officer (2) -- -- 106 305 -- --
Sale of preferred stock,
Series A, (883 shares) -- -- -- -- 21,510 --
Dividends -- (172) -- (451) -- (8,270)
Net income -- -- -- -- -- 3,245
- ------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1995 447 $ 150 9,993 $ 171 $21,510 $ 308
- ------------------------------------------------------------------------------------------------------------------------
Dividend adjustment -- -- -- -- -- 249
Stock award -- -- 105 490 (490) --
Establish common stock par
value of $0.001 per share -- (150) -- (651) 801 --
Sale of common stock 3,105 3 -- -- 44,788 --
Conversion to common stock:
Preferred stock (883 shares) 2,636 3 -- -- -- --
Class B common stock 10,098 10 (10,098) (10) -- --
Stock options exercised -- -- -- -- 3 --
Deferred compensation earned -- -- -- -- 110 --
Net loss -- -- -- -- -- (3,148)
- ------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1996 16,286 $ 16 -- $-- $66,722 $(2,591)
- ------------------------------------------------------------------------------------------------------------------------
Stock options exercised 10 -- -- -- 75 --
Stock option tax benefits -- -- -- -- 525 --
Stock award forfeitures (1) -- -- -- -- --
Deferred compensation earned -- -- -- -- 228 --
Currency translation adjustment (3) -- -- -- -- (5) --
Net income -- -- -- -- -- 1,255
- ------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1997 16,295 $ 16 -- $-- $67,545 $(1,336)
- ------------------------------------------------------------------------------------------------------------------------
</TABLE>
(1) Paid-in capital includes deferred compensation of $(150) and $(378) at
December 31, 1997 and 1996, respectively, with no amount for 1995.
(2) The sale of stock to an officer in 1995 increased stock subscription
receivable by $(33) to $(149) at December 31, 1995.
(3) This amount also represents the cumulative translation adjustment.
The accompanying notes are an integral part of these financial statements.
20 APPLIED ANALYTICAL INDUSTRIES
<PAGE> 33
Notes to Consolidated Financial Statements
1. Significant Accounting Policies
Basis of presentation
The consolidated financial statements include the accounts of Applied
Analytical Industries, Inc. (the "Company" or "AAI") and its wholly-owned
subsidiaries. All material inter-company transactions have been eliminated. The
Company has ownership of approximately 40%, on a fully diluted basis, in
Endeavor Pharmaceuticals Inc. ("Endeavor") which is accounted for under the
equity method.
Revenue recognition
Revenues from fee-for-service contracts are generally recognized on a
percentage of completion basis as the work is performed. Licensing revenues are
generally recognized on a percentage of completion basis for interim contract
milestones. Contract milestones based on product approval are recognized when
the applicable product is approved. Royalty revenues are recognized as earned in
accordance with contract terms. Work-in-progress represents revenues recognized
prior to contract billing terms. Provisions for losses on contracts, if any, are
recognized when identified.
Income taxes
The financial statements of the Company prior to November 17, 1995 do
not include a provision for income taxes because, under an S corporation
election, all income and loss passed directly to the stockholders. The Company
no longer qualified as an S corporation as a result of the preferred stock
issuance in November 1995. At that time, AAI was directly subject to federal and
state income taxes and, accordingly, began accounting for income taxes.
Unaudited pro forma data
For information purposes, the Consolidated Statement of Income includes
a pro forma income tax provision for financial reporting purposes using federal
and state tax rates that would have applied if the Company had been directly
subject to income taxes.
Earnings per share
The weighted average shares used in the calculation of earnings per
share have been calculated in accordance with Statement of Financial Accounting
Standards No. 128, "Earnings per Share." As required by this statement all prior
periods have been restated. Shares used to calculate diluted earnings per share
include the impact of stock options in 1997 and convertible preferred stock in
1995.
Cash and cash equivalents
The Company considers all highly liquid investments purchased with a
maturity of three months or less to be cash equivalents.
Accounts receivable
Unbilled accounts receivable represent specific invoices that, in
keeping with certain client billing arrangements, are mailed to clients
approximately 15 days after the month during which the work was completed.
Property and equipment
Property and equipment is recorded at cost. Depreciation is recognized
using the straight-line method over the estimated useful lives of the assets.
Depreciable lives are 31.5 years for buildings and improvements and 3 to 15
years for equipment.
Goodwill, intangibles and other assets
Goodwill, the excess of the purchase price over the fair value of the
net assets of acquired companies, is amortized over 20 years. Other identifiable
intangible assets are amortized, if applicable, on a straight-line basis over
their estimated useful lives, which range from 3 to 17 years.
<PAGE> 34
The Company has an investment in non-voting, mandatorily redeemable
preferred stock of a related party, which is carried at original cost in other
assets. Management monitors this investment for impairment and will write down
the carrying value below cost for any impairment considered to be other than
temporary.
Fair value of financial instruments
The carrying value of cash and cash equivalents, accounts receivable,
the preferred stock investment, current liabilities and long-term debt
approximate fair value. It is not practicable to estimate the fair value of the
Company's equity investment, which is recorded at zero, as no readily
determinable market exists for investments in such entities.
Use of estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the consolidated financial
statements and accompanying notes. Actual results could differ from such
estimates and changes in such estimates may affect amounts reported in future
periods.
APPLIED ANALYTICAL INDUSTRIES 21
<PAGE> 35
New Accounting Pronouncements
The Company has applied the reporting requirements of Statement of
Financial Accounting Standards No. 131, "Disclosures about Segments of an
Enterprise and Related Information," to its financial information by business
segment and geographic area. The effect of adoption of other new accounting
standards has not resulted or should not result in a material impact to the
Company's financial position or results of operations.
Reclassifications
Certain amounts in prior year financial statements have been
reclassified to conform to the current year presentation.
2. Acquisition and Unusual Item
On December 31, 1996, the Company acquired all the outstanding equity
in L.A.B. Gesellschaft fur pharmakologische Untersuchungen mbH & Co. ("L.A.B."),
a European contract research and development organization head-quartered in
Neu-Ulm, Germany with operational units in Neu-Ulm and Munich, Germany as well
as in France, Netherlands and England.
The aggregate purchase price for L.A.B. was approximately 34.3 million
Deutsche marks ($20.5 million), which includes current and future payments to
former equity holders, L.A.B. debt and negative working capital. The acquisition
has been accounted for using the purchase method of accounting. The consolidated
financial statements reflect the allocation of the purchase price to the fair
value of the assets acquired, including goodwill of approximately 24.8 million
Deutsche marks ($13.8 million using December 31, 1997 exchange rates). Goodwill
was adjusted during 1997 by approximately 2.6 million Deutsche marks to reflect
resolution of certain pre-acquisition contingencies. The results of operations
for L.A.B. are included in the consolidated financial statements of AAI in 1997.
In connection with the acquisition of L.A.B. the Company recognized an
unusual item representing the write-off of certain in-process research and
development costs with an appraised value of approximately $6.6 million as of
December 31, 1996.
The following table reflects the unaudited pro forma combined results
of operations of AAI and L.A.B. as if the acquisition had occurred at the
beginning of each period. Such pro forma information is presented for
informational purposes only and is not necessarily indicative of the
consolidated results that would have been achieved had the acquisition been
consummated as of that time.
<TABLE>
<CAPTION>
Year ended December 31, 1996 1995
- ----------------------------------------------------------------------------
In thousands, except per share amounts (unaudited)
<S> <C> <C>
Net sales $60,385 $57,594
Net loss $(8,473) $ (98)
Diluted loss per share $ (0.70) $ (0.01)
</TABLE>
3. Income Taxes
The following table presents the components for the provision for
income taxes.
<TABLE>
<CAPTION>
Year ended December 31, 1997 1996 1995
- ---------------------------------------------------------------------------------------
In thousands
<S> <C> <C> <C>
Income (loss) before income taxes:
United States $ 2,165 $ 5,554 $ 2,840
Non-U.S (129) (6,600) --
- ---------------------------------------------------------------------------------------
$ 2,036 $(1,046) $ 2,840
- ---------------------------------------------------------------------------------------
Provision for income taxes:
Change in tax status $ -- $ -- $ 31
</TABLE>
<PAGE> 36
<TABLE>
<CAPTION>
Year ended December 31, 1997 1996 1995
- ---------------------------------------------------------------------------------------
In thousands
<S> <C> <C> <C>
Current:
Federal 703 1,709 44
Non-U.S 63 -- --
State -- 368 11
------- ------- -------
766 2,077 55
------- ------- -------
Deferred:
Federal (365) 18 (38)
Non-U.S -- -- --
State (145) 7 (9)
------- ------- -------
(510) 25 (47)
------- ------- -------
Stock option tax benefits to paid-in capitol 525 -- --
- ---------------------------------------------------------------------------------------
$ 781 $ 2,102 $ 39
- ---------------------------------------------------------------------------------------
</TABLE>
The following table presents the reconciliation of the provision for
income taxes to the amount computed by applying the U.S. federal statutory
income tax rate.
<TABLE>
<CAPTION>
Year ended December 31, 1997 1996 1995
- --------------------------------------------------------------------------------
In thousands
<S> <C> <C> <C>
Income (loss) before income taxes $ 2,036 $(1,046) $ 2,840
Tax expense (benefit) using statutory
U.S. income tax rate of 34% $ 692 $ (356) $ 966
S corporation election -- -- (965)
Change in tax status -- -- 31
State income taxes, net (96) 247 2
Permanent items, net (239) 35 5
Tax credits (411) (173) --
Non-U.S. operations, net 107 -- --
Write-off of in-process R&D -- 2,244 --
Other, net 203 105 --
Stock options tax benefit 525 -- --
- --------------------------------------------------------------------------------
Provision for income taxes $ 781 $ 2,102 $ 39
- --------------------------------------------------------------------------------
</TABLE>
22 APPLIED ANALYTICAL INDUSTRIES
<PAGE> 37
Deferred income taxes arise from temporary differences between the tax
bases of assets and liabilities and their reported amounts in the financial
statements. The following table presents the deferred tax assets and deferred
tax liability.
<TABLE>
<CAPTION>
December 31, 1997 1996
- ------------------------------------------------------------------------------
In thousands
<S> <C> <C>
Deferred tax assets, resulting from:
Accrued liabilities $ 272 $ 308
Accounts receivable 483 29
Write-off of in-process R&D 2,826 3,300
Non-U.S. net operating losses 1,745 --
Tax credits 226 --
Other items 139 20
Deferred tax liability, resulting from:
Property and equipment (619) (366)
Valuation allowances on tax assets (4,571) (3,300)
- ------------------------------------------------------------------------------
Net deferred tax assets (liability) $ 501 $ (9)
- ------------------------------------------------------------------------------
</TABLE>
Valuation allowances have been provided for certain assets resulting
from the L.A.B. acquisition since realization of such assets can not be
predicted with reasonable certainty at this time.
4. Debt and Credit Line
The following table presents the components of current maturities of
long-term debt and short-term debt.
<TABLE>
<CAPTION>
December 31, 1997 1996
- ------------------------------------------------------------------------------
In thousands
<S> <C> <C>
Industrial revenue bonds $1,125 $1,425
Bank debt 3,778 --
Current maturities of long-term debt 658 667
- ------------------------------------------------------------------------------
$5,561 $2,092
- ------------------------------------------------------------------------------
</TABLE>
The following table presents the components of long-term debt.
<TABLE>
<CAPTION>
December 31, 1997 1996
- ------------------------------------------------------------------------------
In thousands
<S> <C> <C>
Bank term loans $ 7,180 $ 7,186
Other 56 152
------- -------
7,236 7,338
Less current maturities (658) (667)
- ------------------------------------------------------------------------------
$ 6,578 $ 6,671
- ------------------------------------------------------------------------------
</TABLE>
The industrial revenue bonds were secured to finance the acquisition
and construction of facilities in North Carolina. They have a variable interest
rate, which is adjusted annually with a maximum allowable rate of 15%. The rates
at December 31, 1997 and 1996 were 4.35% and 4.45%, respectively. The bonds are
payable in monthly installments of $25,000, plus interest, through November
2000, and are redeemable at the option of the bondholders. The Company has
entered into an agreement with a bank to pay any bonds redeemed under a stand-by
letter of credit covering the outstanding principal of the bonds. The Company
also has a bond re-marketing agreement with such bank to re-market any bonds
presented for early redemption, on a best efforts basis. These bonds have been
classified as short-term debt because of the early redemption feature.
<PAGE> 38
The bank term loans include approximately $2.7 million and $3.3 million
with a U.S. bank. The loans have variable interest rates based on the 30-day
LIBOR rate plus a margin based on the Company's debt to equity ratio. The loans
are payable in monthly installments including interest. The average interest
rate on these loans was 7.18% and 7.07% for 1997 and 1996, respectively. The
bank term loans also include approximately 8 million and 6 million Deutsche
marks, as of December 31, 1997 and 1996, respectively. The 1997 amount
represents a subsidiary's note payable to a German bank, which is due in March
2000 with interest payable quarterly at 5.85%. AAI has issued a stand-by letter
of credit to this bank to cover borrowings outstanding. The 1996 amount
represents short-term borrowings of L.A.B. which were classified as long-term
debt because of the Company's ability and intent to convert such borrowings into
longer-term borrowings.
In 1996, the Company entered into a revolving credit agreement with a
U.S. bank which, as amended, expires in May 1999. The agreement provides for
borrowings of up to $20 million at variable interest rates, adjusted quarterly.
The rates can be based, at the Company's option, on either the 30-day LIBOR rate
or an applicable CD rate. The rates can be reduced or increased depending on the
Company's ratio of total liabilities to tangible net worth. At the end of the
revolving credit period, any outstanding balances under this facility convert to
a term loan payable in monthly installments, including interest, through the
year 2004. The agreement requires the payment of a nominal commitment fee based
on the unused portion of the line of credit. There were no amounts outstanding
under this agreement at December 31, 1997 or 1996.
Under the terms of the revolving credit facility and the stand-by
letter of credit agreement, the Company is required to comply with various
covenants including, but not limited to, those pertaining to maintenance of
certain financial ratios, and incurring additional indebtedness. The Company was
in compliance with these covenants at December 31, 1997.
Scheduled maturities of long-term debt as of December 31, 1997 are
$658,000 - 1998; $610,000 - 1999; $5,059,000 - 2000; $458,000 - 2001; and
$443,000 - 2002.
5. Stockholders' Equity
The authorized capital stock of the Company at December 31, 1997 and
1996 was 100 million shares of voting common stock, $0.001 par value per share,
and 5 million shares of preferred stock, $0.001 par value per share. The
preferred stock is issuable in one or more series by the Company's Board of
Directors without further stockholder approval. No preferred stock was
outstanding at December 31, 1997. The Company has reserved 970,805 shares of
common stock for issuance under stock option plans.
APPLIED ANALYTICAL INDUSTRIES 23
<PAGE> 39
AAI completed an initial public offering of 3,105,000 shares of common
stock, with net proceeds to the Company of approximately $45 million, in
September 1996 (the "IPO"). Upon the completion of the IPO the Company's then
outstanding Class B common stock, $0.001 par value per share, and Series A
convertible preferred stock, $0.001 par value per share ("Series A Preferred"),
converted to a single class of common stock. Prior to the IPO, the Board of
Directors authorized two stock splits for all common stock resulting in a net
increase to shares outstanding of 126.5 to 1. All numbers of common shares and
per share amounts in the accompanying financial statements were retroactively
adjusted to reflect these stock splits.
Preferred Stock sale in 1995
In November 1995, the Company issued 883 shares of Series A Preferred
resulting in net proceeds to the Company of approximately $21.5 million. This
stock was mandatorily converted into common stock of AAI upon the IPO. Pursuant
to a Stockholder Agreement among the Company and the holders of the Series A
Preferred, certain conditions remain in effect after the IPO regarding
transferability rights and the appointment of one board seat.
Dividends
The Company elected to distribute its S corporation retained earnings
concurrent with the change to a C corporation tax status in November 1995. A
portion was paid in 1995 with the remainder paid in 1996 upon filing the final S
corporation tax returns for the period January 1, 1995 to November 17, 1995.
Stock Option and Award Plans
In 1996, the Board of Directors awarded 104,696 shares of common stock
to certain employees and officers of the Company. The fair value at the time of
such award is recognized as deferred compensation in paid-in capital and is
being expensed over a two-year period.
The Company has three stock option plans, the 1997 Stock Option Plan
("1997 Plan"), the 1996 Stock Option Plan ("1996 Plan") and the 1995 Stock
Option Plan ("1995 Plan"). Under the 1995 Plan, the Board of Directors may grant
options to purchase up to 242,538 shares of common stock. However, the Company
has no obligation to issue the shares upon exercise of such options until it has
purchased an equal number of shares from certain existing stockholders. Under
the 1997 and 1996 Plans, the Board of Directors may grant options to purchase up
to 486,000 and 495,627, respectively, newly issued shares of common stock. The
plans require that the exercise price of options cannot be less than either 100%
(1997 Plan) or 75% (1996 and 1995 Plans) of the estimated fair market value of
the Company's shares of common stock on the date of grant.
The combined activity from all plans is presented in the following
table.
<TABLE>
<CAPTION>
Weighted average
Shares exercise price
- -----------------------------------------------------------------
<S> <C> <C>
Outstanding, January 1, 1996 -
Granted 452,658 $ 8.35
Exercised (334) $ 8.35
Forfeited (9,569) $ 8.35
- -----------------------------------------------------------------
Outstanding, December 31, 1996 442,755 $ 8.35
- -----------------------------------------------------------------
Exercisable, December 31, 1996 110,445 $ 8.35
- -----------------------------------------------------------------
Granted 508,100 $ 14.74
Exercised (92,023) $ 8.36
Forfeited (176,480) $ 15.02
- -----------------------------------------------------------------
Outstanding, December 31, 1997 682,352 $ 11.39
- -----------------------------------------------------------------
Exercisable, December 31, 1997 124,413 $ 8.35
- -----------------------------------------------------------------
</TABLE>
The outstanding options at December 31, 1997 have an exercise range of
$8.35 to $22.00 per share with a weighted average remaining life of 9.0 years.
The weighted average fair value at date of grant for options granted during 1997
and 1996 was $7.84 and $2.20 per option, respectively. The fair value of options
<PAGE> 40
at date of grant was estimated using the Black-Scholes option pricing model with
the following weighted average assumptions: expected life (5 years); interest
rate (5.9 % - 1997, 6.3 % - 1996); volatility factor (0.54 - 1997, none -
1996) and dividend yield (none).
The Company applies APB Opinion 25 and related interpretations in
accounting for its stock option plans; therefore, compensation expense has not
been recognized for all options granted. If compensation cost for the Company's
plans had been determined based on the fair value at the grant dates for awards
under those plans consistent with the method of FASB Statement 123, the
Company's net income (loss) and diluted earnings (loss) per share would have
been changed to the pro forma amounts indicated below.
<TABLE>
<CAPTION>
Net Diluted Earnings
Income (loss) (loss) per share
- --------------------------------------------------------------
<S> <C> <C>
1997 - As reported $ 1,255 $ 0.08
1997 - Pro forma $ 771 $ 0.05
1996 - As reported $(3,148) $ (0.26)
1996 - Pro forma $(3,323) $ (0.28)
</TABLE>
6. Related Party Transactions and Major Customers
Endeavor
In 1994, AAI organized Endeavor with Berlex Laboratories, Inc. and
several other investors to fund the development of hormone pharmaceutical
products, initially focusing on several generic hormone products already under
development by the Company. AAI obtained a 47% equity interest in Endeavor
through the contribution of its accumulated product research and development and
technical know-how. The other
24 APPLIED ANALYTICAL INDUSTRIES
<PAGE> 41
investors contributed cash in exchange for their interests which, for all
investors, was in the form of convertible preferred stock. Based on a subsequent
cash infusion by a new investor in 1995, the Company's interest in Endeavor was
diluted to approximately 40%, on a fully diluted basis.
The Company's initial investment in Endeavor was recorded at zero. The
gain for its share of the cash contributed by the other investors was deferred
over the period the proceeds from such equity were expended by Endeavor. Due to
a commitment to provide financial support under a line of credit, AAI recognized
a liability for its proportionate share of Endeavor's losses, net of
amortization of the deferred gain, in 1994 and part of 1995. As a result of the
1995 cash infusion from a third party, the Company was repaid all amounts
outstanding under the line of credit and terminated its obligation to provide
any further funding under such line of credit. Since AAI had no requirement to
provide any additional funding to Endeavor, the previously recorded liability
was reversed in 1995.
This investment has been recorded at zero value since 1995. Endeavor
has accumulated losses of approximately $16 million. The Company will not be
able to record any income from this investment until Endeavor has earned income
in an amount equal to such accumulated losses and becomes profitable
The Company had net sales to Endeavor for product development services
of approximately $3.2 million, $6.2 million (15% of AAI net sales) and $3.5
million (10% of AAI net sales) for the years ended December 31, 1997, 1996 and
1995, respectively. These services are provided on terms and conditions
management believes are comparable to those afforded unrelated entities.
Additionally, AAI had approximately $2.3 million and $967,000 in accounts
receivable and approximately $184,000 and $372,000 in work-in-progress related
to Endeavor at December 31, 1997 and 1996, respectively. The outstanding
accounts receivable were paid in early 1998.
The Company has agreed, upon the completion of a specified development
milestone, to grant Endeavor an option to lease or purchase certain production
space, at fair market value, intended for use by AAI in manufacturing Endeavor's
products. The facilities subject to this option are currently used by the
Company. The Company has also agreed to permit Endeavor, under certain
circumstances, the first right to purchase additional proprietary hormone
pharmaceutical products developed by AAI.
Aesgen, Inc.
Aesgen, Inc. ("Aesgen") was formally organized with an affiliate of the
Mayo Clinic and MOVA Pharmaceutical Corporation and funded in 1995 via issuance
of approximately $11 million of nonconvertible, non-voting, mandatorily
redeemable, preferred stock. The Company made a cash investment of $1.6 million
in such preferred stock, which is carried at cost, and is included in other
non-current assets on the balance sheet. As the Company did not intend to hold
an equity interest in Aesgen, it entered into a series of related transactions
commencing in 1995 to transfer to a corporation owned by the holders, at that
time, of substantially all of the outstanding capital stock of the Company, all
of its shares of Aesgen common stock in return for $50,000 (amount paid by AAI
for such shares) and such corporation's assumption of an obligation to invest an
additional $1.2 million in Aesgen.
The Company provides product development services to Aesgen at terms and
conditions that management believes are similar to those afforded unrelated
entities. In 1996, the Company sold to Aesgen marketing rights to a product
under development by the Company. Under the agreement, Aesgen paid a license fee
and will pay additional royalties upon marketing the product. AAI recognized net
sales of approximately $1.9 million, $4.7 million (11% of AAI net sales) and
$5.6 million (16% of AAI net sales) from Aesgen for the years ended December 31,
1997, 1996 and 1995, respectively. AAI also had accounts receivable of
approximately $555,000 and $352,000 from Aesgen and work-in-progress balances of
approximately $97,000 and $345,000 at December 31, 1997 and 1996, respectively.
AAI has the right, under its development agreement with Aesgen, to provide
certain product development and support services to Aesgen with respect to some
generic drugs currently being developed by Aesgen, provided that AAI's fees for
such services are comparable to those of a competitor. In addition, under such
development agreement, the Company has agreed not to develop, for its own
account or any other person, a formulation of any of the generic products
currently under development for Aesgen and any additional drugs that AAI agrees
to develop in the future for Aesgen.
Other Major Customer
<PAGE> 42
The Company had one unrelated customer that accounted for 12% of net
sales for the year ended December 31, 1995. Due to the nature of the Company's
business, major customers may vary from year to year.
7. Supplemental Balance Sheet Information
The following table presents the components of accounts receivable.
<TABLE>
<CAPTION>
December 31, 1997 1996
- ------------------------------------------------------------
In thousands
<S> <C> <C>
Trade and other:
Billed $ 13,496 $ 7,235
Unbilled 3,161 1,552
Related parties 2,867 1,319
-------- --------
19,524 10,106
Allowance for doubtful accounts (109) (73)
- ------------------------------------------------------------
$ 19,415 $ 10,033
- ------------------------------------------------------------
</TABLE>
APPLIED ANALYTICAL INDUSTRIES 25
<PAGE> 43
In February 1997, one of the Company's investments in commercial paper
for approximately $4 million was not redeemed because of a cancellation of the
writer's credit facility supporting their commercial paper. This investment was
reclassified from cash and cash equivalents to other current assets as of
December 31, 1996, since it was uncertain whether it would be collected within
three months. This company began making payments for principal and interest
during 1997. In October 1997, management made the decision to sell a portion of
this investment and reserve for a loss on the remaining holdings. The remaining
balance of approximately $1.5 million, has been included in cash and cash
equivalents at December 31, 1997, since the Company intends to liquidate its
position within three months.
The following table presents the components of property and equipment.
<TABLE>
<CAPTION>
December 31, 1997 1996
- ------------------------------------------------------------
In thousands
<S> <C> <C>
Land $ 945 $ 298
Buildings and improvements 10,882 9,864
Machinery and equipment 27,295 17,388
Construction-in-progress 1,586 2,927
-------- --------
40,708 30,477
Less, accumulated depreciation (15,382) (11,261)
- ------------------------------------------------------------
$ 25,326 $ 19,216
- ------------------------------------------------------------
</TABLE>
8. Employee Benefit Plan
The Company provides retirement benefits for all domestic AAI employees
with one year of service through a defined contribution plan qualified under
section 401(k) of the Internal Revenue Code of 1986, as amended. Participants
may elect to contribute a portion of their annual compensation, subject to
limitations. The Company makes matching contributions equal to 50% of a
participant's contribution up to a certain amount. Additionally, the Company
makes profit-sharing contributions at the discretion of the Board of Directors.
The discretionary contributions for the years ended December 31, 1997, 1996 and
1995 were $219,000, $557,000 and $226,000, respectively.
9. Commitments and Contingencies
The Company leases land, buildings and equipment under renewable lease
agreements classified as operating leases. Rent expense under these agreements
for the years ended December 31, 1997, 1996 and 1995 was $2.8 million, $1.3
million and $1.3 million, respectively. Future minimum rentals due under lease
agreements as of December 31, 1997 are $2.3 million - 1998; $1.7 million - 1999;
$1.4 million - 2000; $1.2 million - 2001; $0.6 million - 2002 and $0.9 million
thereafter.
The Company is party to lawsuits and administrative proceedings
incidental to the normal course of its business. In connection with the 1995
issuance of the Series A Preferred, two of the Company's stockholders have
agreed to indemnify the Company for certain losses, if incurred. Management does
not believe that any liabilities related to such lawsuits or proceedings will
have a material adverse effect on the Company's financial condition, results of
operations or cash flows.
10. Financial Information by Business Segment and Geographic Area
The Company operates in two business segments consisting of a
fee-for-service business and a product development business. In the
fee-for-service business, AAI is an integrated contract research organization
("CRO") to the worldwide pharmaceutical and biotechnology industries. In the
product development business, the Company internally develops drugs and
technologies with the objective of licensing marketing rights to third parties
in exchange for license fees and royalties. The Company does not independently
commercialize products developed internally or otherwise directly compete with
its pharmaceutical clients in the marketing or distribution of products. The
majority of the Company's non-U.S. operations are located in Germany.
In determining income from operations, costs are allocated to the
product development business based upon direct labor and materials plus an
allocation of general overhead. The corporate line includes
<PAGE> 44
general corporate overhead costs and goodwill amortization, which are not
directly attributable to a business segment.
<TABLE>
<CAPTION>
Year ended December 31, 1997 1996 1995
- --------------------------------------------------------------------------------
In thousands
<S> <C> <C> <C>
Net sales:
Fee-for-service $ 59,631 $ 40,624 $ 33,901
Product development 5,770 1,538 738
----------------------------------------
$ 65,401 $ 42,162 $ 34,639
----------------------------------------
United States $ 47,959 $ 42,162 $ 34,639
Non-U.S 18,862 -- --
Less inter-geographic sales (1,420) -- --
----------------------------------------
$ 65,401 $ 42,162 $ 34,639
----------------------------------------
Income (loss) from operations:
Fee-for-service $ 4,965 $ 8,779 $ 7,469
Product development (2,021) (9,278) (2,588)
Corporate (2,281) (1,041) (911)
----------------------------------------
$ 663 $ (1,540) $ 3,970
----------------------------------------
United States $ 1,799 $ 5,060 $ 3,970
Non-U.S (1,136) -- --
----------------------------------------
$ 663 $ (1,540) $ 3,970
----------------------------------------
Total assets:
Fee-for-service $ 54,670 $ 42,961 $ 23,013
Product development 5,812 4,378 1,965
Corporate 39,967 57,139 14,178
----------------------------------------
$ 100,449 $ 104,478 $ 39,156
----------------------------------------
United States $ 78,328 $ 82,529 $ 39,156
Non-U.S 22,121 21,949 --
----------------------------------------
$ 100,449 $ 104,478 $ 39,156
----------------------------------------
</TABLE>
26 APPLIED ANALYTICAL INDUSTRIES
<PAGE> 45
Report of Independent Accountants
To the Board of Directors and Stockholders of
Applied Analytical Industries, Inc.
In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of income, of stockholders' equity and of cash
flows present fairly, in all material respects, the financial position of
Applied Analytical Industries, Inc. and its subsidiaries at December 31, 1997
and 1996, and the results of their operations and their cash flows for each of
the three years in the period ended December 31, 1997, in conformity with
generally accepted accounting principles. These financial statements are the
responsibility of the Company's management; our responsibility is to express an
opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with generally accepted auditing
standards which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.
PRICE WATERHOUSE LLP
Raleigh, North Carolina
March 18, 1998
APPLIED ANALYTICAL INDUSTRIES 27
<PAGE> 46
Financial Results by Quarter (Unaudited)
In thousands, except per share amounts
<TABLE>
<CAPTION>
Quarter First Second Third Fourth
1997
<S> <C> <C> <C> <C>
Net sales $15,222 $15,767 $14,021 $20,391
Gross profit $ 7,731 $ 8,201 $ 6,207 $10,064
Net income (loss) $ 910 $ 583 $(1,164) $ 926
Basic earnings (loss) per share (1) $ 0.06 $ 0.04 $ (0.07) $ 0.06
Diluted earnings (loss) per share (1) $ 0.06 $ 0.04 $ (0.07) $ 0.06
1996
Net sales $ 9,925 $10,849 $10,396 $10,992
Gross profit $ 5,807 $ 6,152 $ 6,202 $ 6,380
Net income (loss) (2) $ 655 $ 741 $ 799 $(5,343)
Basic earnings (loss) per share (1)(2) $ 0.06 $ 0.07 $ 0.07 $ (0.33)
Diluted earnings (loss) per share (1)(2) $ 0.05 $ 0.06 $ 0.06 $ (0.33)
</TABLE>
Price range of common stock , traded on the NASDAQ market under the
symbol "AAII" (3):
<TABLE>
<CAPTION>
1997
<S> <C> <C> <C> <C> <C> <C> <C> <C>
High $ 27 1/2 $ 20 1/2 $ 27 1/4 $ 20 3/8
Low $ 17 1/2 $ 11 3/4 $ 19 1/16 $ 11 1/4
1996
High - - $ 25 1/8 $ 30 1/4
Low - - $ 16 $ 19 1/8
</TABLE>
(1) The Company has restated all earnings per share data in accordance with
SFAS No. 128.
(2) In connection with the acquisition of L.A.B., the Company recognized an
unusual item representing the write-off of certain in-process research
and development costs with an appraised value of approximately $6.6
million as of December 31, 1996. Without such write-off, the net income
in the fourth quarter would have been approximately $1.3 million.
(3) The Company completed an initial public offering of its common stock in
September 1996 at $16.00 per share. The Company estimates there were
approximately 1,000 holders of record for its common stock as of
February 28, 1998. The Company has not declared any cash dividends
during 1997 or 1996.
28 APPLIED ANALYTICAL INDUSTRIES
