<PAGE> 1
SCHEDULE 14A
(RULE 14A-101)
INFORMATION REQUIRED IN PROXY STATEMENT
SCHEDULE 14A INFORMATION
PROXY STATEMENT PURSUANT TO SECTION 14(A) OF THE SECURITIES
EXCHANGE ACT OF 1934 (AMENDMENT NO. )
Filed by the Registrant [X]
Filed by a Party other than the Registrant [ ]
Check the appropriate box:
<TABLE>
<S> <C>
[ ] Preliminary Proxy Statement [ ] Confidential, for Use of the Commission
Only (as permitted by Rule 14a-6(e)(2))
[X] Definitive Proxy Statement
[ ] Definitive Additional Materials
[ ] Soliciting Material Pursuant to Rule 14a-11(c) or Rule 14a-12
</TABLE>
APPLIED ANALYTICAL INDUSTRIES, INC.
- --------------------------------------------------------------------------------
(Name of Registrant as Specified In Its Charter)
- --------------------------------------------------------------------------------
(Name of Person(s) Filing Proxy Statement, if other than the Registrant)
Payment of Filing Fee (Check the appropriate box):
[X] No fee required.
[ ] Fee computed on table below per Exchange Act Rules 14a-6(i)(1) and 0-11.
(1) Title of each class of securities to which transaction applies:
(2) Aggregate number of securities to which transaction applies:
(3) Per unit price or other underlying value of transaction computed
pursuant to Exchange Act Rule 0-11 (set forth the amount on which the
filing fee is calculated and state how it was determined):
(4) Proposed maximum aggregate value of transaction:
(5) Total fee paid:
[ ] Fee paid previously with preliminary materials:
[ ] Check box if any part of the fee is offset as provided by Exchange Act Rule
0-11(a)(2) and identify the filing for which the offsetting fee was paid
previously. Identify the previous filing by registration statement number,
or the Form or Schedule and the date of its filing.
(1) Amount Previously Paid:
(2) Form, Schedule or Registration Statement No.:
(3) Filing Party:
(4) Date Filed:
<PAGE> 2
[AAI LOGO]
APPLIED ANALYTICAL INDUSTRIES, INC.
5051 NEW CENTRE DRIVE
WILMINGTON, NORTH CAROLINA 28403
---------------------
NOTICE OF ANNUAL MEETING OF STOCKHOLDERS
TO BE HELD MAY 19, 1999
---------------------
To the Stockholders of Applied Analytical Industries, Inc.:
NOTICE IS HEREBY GIVEN that the annual meeting of stockholders of Applied
Analytical Industries, Inc. (the "Company") will be held on Wednesday, May 19,
1999 at 10:00 a.m., North Carolina time, at the corporate office of the Company,
located at 5051 New Centre Drive, Suite 208, Wilmington, North Carolina 28403.
1. To elect two (2) directors to serve for three-year terms and until
their successors are elected and qualified;
2. To ratify and approve the appointment of Ernst & Young LLP as the
independent public accountants for the Company for the fiscal year ending
December 31, 1999; and
3. To consider and act upon any other matters that may properly come
before the meeting or any adjournment thereof.
The Board of Directors of the Company has designated the close of business
on April 8, 1999 as the record date for the determination of stockholders
entitled to notice of and to vote at the meeting or any adjournment thereof.
Only stockholders of record of the Company's Common Stock at the close of
business on that date will be entitled to vote.
You are cordially invited to attend the meeting. However, whether or not
you plan to be personally present at the meeting, please complete, date and sign
the enclosed proxy and return it promptly in the enclosed envelope. If you later
desire to revoke your proxy, you may do so at any time before it is exercised.
By Order of the Board of Directors,
R. Forrest Waldon
Secretary
Wilmington, North Carolina
April 15, 1999
YOUR VOTE IS IMPORTANT. ACCORDINGLY, PLEASE COMPLETE, SIGN,
DATE AND RETURN THE ACCOMPANYING PROXY CARD WHETHER OR
NOT YOU PLAN TO ATTEND THE MEETING.
<PAGE> 3
[AAI LOGO]
APPLIED ANALYTICAL INDUSTRIES, INC.
5051 NEW CENTRE DRIVE
WILMINGTON, NORTH CAROLINA 28403
PROXY STATEMENT
FOR
ANNUAL MEETING OF STOCKHOLDERS
April 15, 1999
This Proxy Statement is furnished in connection with the solicitation of
the enclosed proxy by the Board of Directors of Applied Analytical Industries,
Inc. (the "Company") for use at the annual meeting of stockholders (the "Annual
Meeting") to be held on Wednesday, May 19, 1999 at 10:00 a.m., North Carolina
time, at the corporate office of the Company, located at 5051 New Centre Drive,
Suite 208, Wilmington, North Carolina 28403, and at any adjournment thereof, for
the purposes set forth in the Notice of Annual Meeting of Stockholders. This
Proxy Statement and the form of proxy enclosed are being mailed to stockholders
with the Company's 1998 Annual Report on Form 10-K commencing on or about April
21, 1999.
VOTING RIGHTS AND PROCEDURES
Only stockholders of record of the Common Stock of the Company at the close
of business on April 8, 1999 will be entitled to vote at the Annual Meeting. As
of that date, a total of 17,205,391 shares of Common Stock were outstanding,
each share being entitled to one vote. There is no cumulative voting. If a
stockholder returns a proxy withholding authority to vote the proxy with respect
to any or all of the nominees for director, then the shares of the Common Stock
covered by such proxy shall be deemed present at the Annual Meeting for purposes
of determining a quorum and for purposes of calculating the vote with respect to
such nominee, but shall not be deemed to have been voted for such nominee or
nominees. If a stockholder abstains from voting as to any matter, then the
shares held by such stockholder shall be deemed present at the meeting for
purposes of determining a quorum and for purposes of calculating the vote with
respect to such matter, but shall not be deemed to have been voted in favor of
such matter. If a broker returns a "non-vote" proxy, indicating a lack of
authority to vote on such matter, then the shares covered by such non-vote shall
be deemed present at the Annual Meeting for purposes of determining a quorum,
but shall not be deemed to be present and entitled to vote at the Annual Meeting
for purposes of calculating the vote with respect to any such matter.
Shares of the Company's Common Stock represented by proxies in the form
solicited will be voted in the manner directed by the stockholder. If no
direction is given, the proxy will be voted for the election of the nominees for
director named in this Proxy Statement and for the ratification and approval of
Ernst & Young LLP as the Company's independent public accountants. Management of
the Company is not aware of any matters to be acted upon at the Annual Meeting
other than those set forth in the accompanying Notice of Annual Meeting. In the
event that any other matters properly come before the Annual Meeting and call
for a vote of stockholders, the persons named as proxies in the enclosed form of
proxy will vote in accordance with their best judgment on these matters. A proxy
may be revoked at any time before being exercised by delivery to an officer of
the Company of a written notice of termination of the proxy's authority or a
duly elected proxy bearing a later date.
<PAGE> 4
ELECTION OF DIRECTORS
The business and affairs of the Company are managed under the direction of
its Board of Directors, which is presently comprised of six members. The Board
of Directors is classified, with the directors serving staggered three-year
terms. Two directors have been nominated for election to the Company's Board of
Directors at the Annual Meeting to hold office until the meeting of stockholders
in year 2002 and until their successors have duly elected and qualified (except
in the case of earlier death, resignation or removal). The accompanying proxy
may not be voted for more than two directors. The nominees for director have
indicated their willingness to serve, but in case they are not candidates at the
Annual Meeting, the person named as proxies in the enclosed form of proxy may
vote for a substitute nominees in their discretion. The Board of Directors has
no reason to believe that any nominee will be unable or unwilling to serve as
director if elected. The affirmative vote of a majority of the shares of Common
Stock present and entitled to vote at the Annual Meeting is necessary to elect
the nominees for director. The Board of Directors recommends a vote FOR the
election of the nominees for director. Information concerning the nominees for
director and for each director whose term will continue after the Annual Meeting
is set forth below.
NOMINEES FOR DIRECTOR
TERM TO EXPIRE 2002
John M. Ryan (age 54) has served as a director of the Company since January
1996. Mr. Ryan serves as managing partner of Ryan Partners, a business advisory
and venture capital firm he founded in July 1996. Prior to founding Ryan
Partners, Mr. Ryan served as a partner of Coopers & Lybrand, L.L.P. (now
PricewaterhouseCoopers), an accounting firm, with which he was associated from
1972 to 1996. Mr. Ryan has served as a director of numerous private companies
and as an officer and director of several not-for-profit corporations.
Joseph H. Gleberman (age 41) joined the Company's Board of Directors in
1995. Mr. Gleberman has been employed by Goldman, Sachs & Co., an investment
banking firm, since 1982 and has been a Partner of Goldman, Sachs & Co. since
1990 and Managing Director since 1996. Mr. Gleberman serves as a director of
Dade Behring Holdings, Inc. and Ticketmaster Online-City Search, Inc.
DIRECTORS CONTINUING IN OFFICE
TERM TO EXPIRE 2000
Frederick D. Sancilio, Ph.D., (age 49) is Chairman of the Board of
Directors, Chief Executive Officer and President of the Company. With more than
20 years' experience in the pharmaceutical industry, Dr. Sancilio worked with
Burroughs-Wellcome Co., Schering-Plough Corporation, and Hoffmann-LaRoche, Inc.
before founding the Company in 1979.
William H. Underwood (age 51) is Executive Vice President, Corporate
Development and Licensing, and has served as Chief Operating Officer from 1995
to 1997, as Executive Vice President of the Company since 1992, as Vice
President from 1986 to 1992, and as a director since January 1996. He has held
positions in the pharmaceutical and cosmetic industries for more than 17 years,
in positions including Director of Quality Assurance and Director of
Manufacturing at Mary Kay Cosmetics, Inc. and Group Leader of Bacteriological
Quality Control at Burroughs-Wellcome Co.
TERM TO EXPIRE 2001
James L. Waters (age 73) has served as a director of the Company since 1981
and as a non-employee officer from 1982 until 1996. Mr. Waters is a private
investor in numerous companies and was the founder of Waters Associates, Inc.,
now known as Waters Corporation, a scientific instrumentation manufacturer.
James G. Martin, Ph.D., (age 63) joined the Company's Board of Directors on
March 9, 1999. Dr. Martin served as Governor of the State of North Carolina from
1984-1992 and currently is Vice President,
2
<PAGE> 5
Research, Carolinas HealthCare System. Dr. Martin also serves on the Boards of
Duke Energy Corporation, J.A. Jones Construction, and Family Dollar Stores, Inc.
MEETINGS AND COMMITTEES OF THE BOARD OF DIRECTORS
The Board of Directors has an Audit Committee consisting of Messrs.
Gleberman and Ryan, and a Compensation Committee consisting of Mr. Ryan. The
Audit Committee's function is to review and make recommendations to the Board of
Directors with respect to certain financial and accounting matters. The Audit
Committee met two (2) times during the fiscal year ended December 31, 1998. The
Compensation Committee's function is to review and make certain determinations
with respect to matters concerning the remuneration of employees, officers and
directors and administer the Company's stock option plans. The Compensation
Committee met two (2) times during the 1998 fiscal year. The Board of Directors
does not a have a standing nominating committee.
During the 1998 fiscal year, the Board of Directors held thirteen meetings.
Each incumbent director attended at least 75% of the total number of meetings of
the Board of Directors and committees on which he served that were held during
the period he was a member of the Board of Directors or such committees.
COMPENSATION OF DIRECTORS
In March 1999, the Company amended its policy to compensate non-employee
directors for Board participation. Under the amended policy, all non-employee
directors of the Company receive $3,000 for each meeting of the Board of
Directors and $1,000 for each meeting of a committee of the Board of Directors
not held in connection with a regular Board meeting attended by such
non-employee director. Non-employee directors receive $500 for each telephonic
Board or committee meeting in which they participate. All directors are
reimbursed for expenses incurred in connection with attending meetings of the
Board of Directors and committees thereof.
PRINCIPAL STOCKHOLDERS
The following table sets forth certain information known to the Company
with respect to beneficial ownership of the Company's Common Stock as of April
8, 1999 by (i) each stockholder known by the Company to be the beneficial owner
of more than 5% of the Company's Common Stock, (ii) each director, (iii) each
executive officer and (iv) all executive officers and directors as a group.
<TABLE>
<CAPTION>
NUMBER OF SHARES PERCENT OF
NAME OF BENEFICIAL OWNER BENEFICIALLY OWNED(a) SHARES
- ------------------------ --------------------- ----------
<S> <C> <C>
Frederick D. Sancilio, Ph.D.(b)............................. 4,628,891 26.9%
James L. Waters(c).......................................... 2,415,561 14.0%
The Goldman Sachs Group, L.P.(d)............................ 2,875,385 16.7%
J.P. Morgan & Co. Incorporated(e)........................... 1,135,900 6.6%
Joseph H. Gleberman(f)...................................... -- --
John M. Ryan................................................ 22,667 *
James G. Martin, Ph.D. ..................................... -- --
William H. Underwood(g)..................................... 220,583 1.3%
Eugene T. Haley............................................. 19,434 *
Frances M. Sakers........................................... 19,234 *
William J. Blank............................................ -- --
Joachim Rexhaus............................................. 10,667 *
All executive officers and directors as a group (10
persons).................................................. 7,333,051 42.6%
</TABLE>
- ---------------
* Less than 1%
(a) Unless otherwise indicated below, the persons and entities named in the
table have sole voting and sole investment power with respect to all shares
beneficially owned, subject to community property laws where applicable.
Information in the table reflects options granted under the Company's 1995
Stock Option
3
<PAGE> 6
Plan, 1996 Stock Option Plan and the 1997 Stock Option Plan to the extent
such options are or become exercisable within 60 days. Accordingly, the
totals for the following executive officers and directors and all executive
officers and directors as a group includes the following shares represented
by options: Mr. Ryan, 21,667 shares; Mr. Underwood, 27,094 shares; Mr.
Haley, 16,334 shares; Mrs. Sakers, 16,334 shares; Mr. Rexhaus, 10,667
shares; and all executive officers and directors as a group, 92,096 shares.
(b) Dr. Sancilio's address is 5051 New Centre Drive, Wilmington, North Carolina
28403.
(c) Includes 461,057 shares of Common Stock beneficially owned by Mr. Waters'
spouse. Mr. Waters address is 47 New York Avenue, Framingham, Massachusetts
01701.
(d) Based on certain filings with the Securities and Exchange Commission,
represents 2,875,385 shares owned by certain investment partnerships, of
which affiliates of The Goldman Sachs Group, L.P. ("GS Group") are the
general partner, managing general partner or general manager. Includes
1,428,549 shares held of record by GS Capital Partners II, L.P.; 567,908
shares held of record by G.S. Capital Partners II Offshore, L.P.; 120,552
shares held of record by Bridge Street Fund 1995, L.P.; 107,132 shares held
of record by Stone Street Fund 1995, L.P.; 52,691 shares held of record by
Goldman, Sachs & Co. Verwaltungs GmbH, as nominee for GS Capital Partners II
Germany Civil Law Partnership; 264 shares held by Greene Street 1998
Exchange Fund, L.P. ("Greene Street"), an affiliate of Goldman, Sachs & Co.
and the GS Group is the general partner of Greene Street, 40 shares acquired
in the ordinary course of trading activities, and 598,249 shares held in
managed accounts. GS Group disclaims beneficial ownership of the shares
owned by such investment partnerships to the extent attributable to
partnership interests therein held by persons other than GS Group and its
affiliates. Each of such investment partnerships shares voting and
investment power with certain of its respective affiliates. The address of
the GS Group is 85 Broad Street, New York, New York 10004.
(e) Based on Schedule 13G filed by J.P. Morgan & Co. Incorporated with the
Securities and Exchange Commission dated December 31, 1998. The address of
J.P. Morgan & Co. Incorporated is 60 Wall Street, New York, New York 10260.
(f) Mr. Gleberman, a managing director of Goldman, Sachs & Co., disclaims
beneficial ownership of the 2,875,385 shares which may be deemed
beneficially owned by GS Group as described in note (d) above.
(g) Includes 925 shares beneficially owned by Mr. Underwood's children.
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934 (the "Exchange Act")
requires the Company's officers and directors, as well as any holders of more
than 10% of the Company's Common Stock, to file with the Securities Exchange
Commission certain reports of ownership and changes in ownership of Common Stock
and other equity securities of the Company. Based solely on review of such
reports and certain representations furnished to it, the Company believes that
during the fiscal year ended December 31, 1998, all officers and directors
complied with all applicable Section 16(a) filing requirements, except Mr. Haley
was one day late filing a report with respect to a purchase of shares.
4
<PAGE> 7
EXECUTIVE COMPENSATION
The following Summary Compensation Table sets forth all compensation
awarded to, earned by or paid for services rendered to the Company in all
capacities in 1998 by: (i) the Company's chief executive officer and (ii) the
Company's next four most highly compensated executive officers who were serving
as executive officers on December 31, 1998 (collectively, the "Named Executive
Officers"):
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION AWARDS
ANNUAL COMPENSATION ----------------------
NAME AND ----------------------- SECURITIES UNDERLYING ALL OTHER
PRINCIPAL POSITION YEAR SALARY($)(a) BONUS($) OPTIONS/SARS(#) COMPENSATION($)(d)
- ------------------ ---- ------------ -------- ---------------------- ------------------
<S> <C> <C> <C> <C> <C>
Frederick D. Sancilio, Ph.D. 1998 341,667(b) 0 0 19,818(e)
President and 1997 350,000(c) 0 0 15,768
Chief Executive Officer 1996 350,000(c) 0 0 13,207
William H. Underwood 1998 165,000 0 40,000 2,348
Executive Vice President 1997 163,209 0 20,000 6,018
1996 159,993 0 7,680 3,082
Joachim Rexhaus(f) 1998 161,996 11,388 35,000 4,678(g)
Executive Vice President 1997 76,568 0 11,000 2,002(h)
1996 0 0 0 0
Eugene T. Haley(i) 1998 201,923 0 65,000 7,488(j)
Executive Vice President 1997 0 0 0 0
1996 0 0 0 0
Frances M. Sakers(k) 1998 170,769 13,333 40,000 52,117(l)
Executive Vice President 1997 45,538 0 0 10,742(l)
1996 0 0 0 0
</TABLE>
- ---------------
(a) Includes amounts deferred pursuant to the Company's 401(k) plan.
(b) Includes $91,667 in salary paid by Endeavor Pharmaceuticals Inc.
(c) Includes $100,000 in salary paid by Endeavor Pharmaceuticals Inc., a
company 40% owned by the Company.
(d) Such amounts include the Company's contributions under its 401(k) and profit
sharing plans in the following amounts: Dr. Sancilio, $3,082 in 1996, $6,018
in 1997 and $2,348 in 1998; Mr. Underwood, $3,082 in 1996, $6,018 in 1997
and $2,348 in 1998.
(e) Includes $17,470 in expense reimbursements paid pursuant to Dr. Sancilio's
employment agreement with the Company.
(f) Mr. Rexhaus joined the Company in July 1997.
(g) Includes $4,324 car allowance and $355 in deferred compensation.
(h) Includes $1,853 car allowance and $149 in deferred compensation.
(i) Mr. Haley joined the Company in February 1998.
(j) Entire amount was for relocation expense payments.
(k) Mrs. Sakers joined the Company in September 1997.
(l) Entire amount was for relocation expense payments.
5
<PAGE> 8
The following table sets forth certain information with respect to options
granted during 1998 to the executive officers named in the Summary Compensation
Table.
STOCK OPTION GRANTS IN 1998
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS POTENTIAL REALIZABLE
------------------------------------------------------- VALUE AT ASSUMED
NUMBER OF ANNUAL RATES OF
SECURITIES PERCENT OF TOTAL STOCK PRICE
UNDERLYING OPTIONS/SARS APPRECIATION FOR
OPTIONS GRANTED TO EXERCISE OPTION TERM(a)
NAME AND GRANTED EMPLOYEES IN PRICE EXPIRATION ---------------------
PRINCIPAL POSITION (#)(b) FISCAL YEAR ($/SH) DATE 5%($) 10%($)
- ------------------ ---------- ---------------- -------- ---------- -------- ----------
<S> <C> <C> <C> <C> <C> <C>
Frederick D. Sancilio,
Ph.D. ....................... 0 0% 0 0 0 0
William H. Underwood........... 40,000 4% 12.813 05-05-08 322,289 816,773
Joachim Rexhaus................ 35,000 4% 12.813 05-05-08 282,002 714,676
Eugene T. Haley................ 65,000 7% 12.813 05-05-08 523,719 1,327,256
Frances M. Sakers.............. 40,000 4% 12.813 05-05-08 322,289 816,773
</TABLE>
- ---------------
(a) Potential realizable value is based on an assumption that the price of the
common stock appreciates at the annual rate shown (compounded annually)
from the date of grant until the end of the ten-year option term. The
numbers are calculated based on the requirements promulgated by the
Securities and Exchange Commission and do not reflect the Company's
estimate of future stock price growth.
(b) The options granted in 1998 to Named Executive Officers under the 1997 Stock
Option Plan vest in 20% increments at each of the twelfth, twenty-fourth,
thirty-sixth, forty-eighth and sixtieth month anniversaries of the grant
date.
The following table sets forth certain information with respect to the
value of options held at fiscal year end by the Named Executive Officers:
AGGREGATED 1998 YEAR-END OPTION VALUES
<TABLE>
<CAPTION>
NUMBER OF SECURITIES VALUE OF UNEXERCISED
UNDERLYING IN-THE-MONEY
UNEXERCISED OPTIONS OPTIONS AT
AT FISCAL YEAR-END(#) FISCAL YEAR-END($)(a)
SHARES --------------------- ---------------------
NAME AND ACQUIRED ON VALUE EXERCISABLE/ EXERCISABLE/
PRINCIPAL POSITION EXERCISE(#) REALIZED($) UNEXERCISABLE UNEXERCISABLE)
------------------ ----------- ----------- --------------------- ---------------------
<S> <C> <C> <C> <C>
Frederick D. Sancilio, Ph.D. ...... 0 0 0/0 0/0
William H. Underwood............... 0 0 12,427/55,253 74,885/245,607
Joachim Rexhaus.................... 0 0 3,667/42,333 19,252/198,168
Eugene T. Haley.................... 0 0 0/65,000 0/296,530
Frances M. Sakers.................. 0 0 8,334/56,666 43,754/269,977
</TABLE>
- ---------------
(a) Market value of underlying securities at fiscal year end minus the exercise
price of "in-the-money" options.
EMPLOYMENT AND COMPENSATION AGREEMENTS
On November 17, 1995 (the "Signing Date"), the Company and Frederick D.
Sancilio entered into an employment agreement (the "Employment Agreement") to
secure Dr. Sancilio's services as Chairman of the Board and President of the
Company. The Employment Agreement has an initial three-year term that is
automatically extended for an additional one-year period on each anniversary of
the Signing Date unless either party gives the other notice prior to the
anniversary date of its intention not to extend the term of the Employment
Agreement. Under the Employment Agreement, Dr. Sancilio will serve as the
Company's Chairman of the Board, President and chief executive officer, and the
Company is required to use its best efforts to cause Dr. Sancilio to be
re-elected to the Company's Board of Directors and to the boards of directors of
affiliates of the Company on which boards of directors Dr. Sancilio was serving
on the Signing
6
<PAGE> 9
Date and to be elected a director of any majority-owned subsidiary of the
Company acquired after the Signing Date.
The Employment Agreement was amended in March 1999 such that Dr. Sancilio's
annual salary was increased to $400,000 (including any Endeavor Pharmaceuticals
Inc. salary paid to Dr. Sancilio) from the initial annual aggregate salary of
$350,000 set in November 1995. The salary amount may be increased by the Board
of Directors and once increased may not be reduced. The Employment Agreement
provides that Dr. Sancilio will be eligible to receive bonus compensation of up
to 50% of his annual salary if the Company attains certain performance
objectives set jointly by the Board of Directors and Dr. Sancilio. In addition,
Dr. Sancilio will be eligible to participate in employee benefit plans made
available generally to the Company's executive officers and any other Company
compensation or incentive plans of a long or short-term nature, to receive an
automobile allowance and to receive other perquisites not to exceed, in the
aggregate, $10,000 per year.
Under the Employment Agreement, the Company may terminate Dr. Sancilio's
employment at any time, with or without cause, as defined in the Employment
Agreement. In the event that the Company terminates Dr. Sancilio's employment
without cause or in the event that Dr. Sancilio terminates his employment within
90 days of an event of constructive discharge (defined in the Employment
Agreement to include, among other things, the removal of Dr. Sancilio from, or
the failure of Dr. Sancilio to be elected to, the positions of Chairman of the
Board or President, a reduction in Dr. Sancilio's responsibilities or relocation
of the Company's principal executive offices by more than 30 miles from its
current location), Dr. Sancilio would be entitled to receive payments
aggregating three times his then current annual salary to be paid in monthly
installments over two years, during which time Dr. Sancilio would continue to
receive medical and life insurance benefits. The Employment Agreement requires
Dr. Sancilio to refrain from certain activities in competition with the Company
for a period of two years after the termination of his employment for any
reason.
The Employment Agreement obligates the Company to use its reasonable best
efforts to cause Endeavor to employ Dr. Sancilio as a senior management employee
at an annual salary of at least $100,000 with bonus compensation of up to 50% of
annual salary to be paid if performance targets are attained and greater amounts
if targets are exceeded. Endeavor has employed Dr. Sancilio on such terms, and
should Endeavor fail to continue to employ him on such terms, it is anticipated
that Dr. Sancilio's annual salary and bonus paid by AAI would be increased by
similar amounts.
REPORT OF THE COMPENSATION COMMITTEE
COMPENSATION POLICY
The Compensation Committee of the Board of Directors (the "Committee") is
responsible for establishing compensation policies applicable to the Company's
executive officers and administering the Company's stock option plans. The goal
of the Committee is to attract, retain and reward high-quality executives by
aligning their compensation with the long-term financial health of the Company
and long-term stockholder interests. The Committee is to be composed entirely of
independent, outside directors of the Company. In establishing salary levels and
the amount of bonus compensation to be paid to officers other than the Chief
Executive Officer, the Committee relies in part on the recommendations of the
Chief Executive Officer, Dr. Frederick D. Sancilio. The Committee's compensation
policies are intended to provide compensation at levels competitive with other
companies of similar size in the contract research organization industry.
BASE SALARIES
The Company has not utilized specific formulas to determine executive
compensation. The Committee has received information and industry surveys from
independent consulting professionals concerning the compensation and benefits
accorded other executive management in similar industries. Individual salaries
are established by the Committee based on this information and a subjective
analysis of the individual's
7
<PAGE> 10
performance, after taking into account recommendations of the Chief Executive
Officer concerning the overall effectiveness of the executive and contribution
to the success of the Company.
CASH BONUSES
Cash bonuses are to be paid to individual senior executive officers based
on the Committee's subjective analysis of the individual's contribution to the
Company, the Company's overall performance and the anticipated compensation to
be received by the individual, including compensation in the form of stock
options. In light of the stock options awarded senior executives, no
discretionary bonuses were paid in 1998.
In 1998, the Company paid bonuses of $13,333 and $11,388 to Frances M.
Sakers, Chief Operations Officer, and Joachim Rexhaus, Executive Vice President,
respectively. The bonuses were paid for achieving certain operating objectives
in 1997 which were agreed upon between the aforementioned executives and Company
management. In addition, the Company has agreed to pay William J. Blank,
Executive Vice President, Marketing and Sales, up to a certain percentage of his
annual salary if certain objectives are met in his area of responsibility.
STOCK OPTIONS
The Committee recognizes the importance of stock ownership by its senior
executives and that such options are an integral component of executive
compensation. The goals of the Company's option plans are to promote the growth
and profitability of the Company and its subsidiaries by increasing the personal
participation of officers and key employees in the financial performance of the
Company. The opportunity for individual financial growth tied to the financial
growth of the Company helps ensure that the executive's and Company's interests
are similarly focused. The Committee in 1998 extended from three years to five
years the option period previously provided to executive option grants. The
Committee granted larger option grants to executives. The modification is
intended to provide greater potential ownership and employee commitment to the
Company's long-term goals.
The Company adopted two stock option plans in November 1995, but did not
grant any options to employees until April 1996. The Company's stockholders
approved an additional Stock Option Plan in May 1997 and amended the Plan in
1998 to increase the number of options which may be granted. The Company granted
205,000 options to the executive officers, as a group, in 1998.
COMPENSATION PAYABLE TO THE CHIEF EXECUTIVE OFFICER
The 1998 salary of the Company's Chief Executive Officer and President, Dr.
Sancilio, was determined pursuant to a renewable three-year employment agreement
with the Company dated November 17, 1995. The Company entered into the
employment agreement in connection with, and as a part of, the Company's sale of
preferred stock to certain institutional investors on November 17, 1995 (the
preferred stock was converted into common stock upon completion of the Company's
initial public offering in September 1996). The Board of Directors has delegated
to the Committee its authority under the agreement to set Dr. Sancilio's base
salary and determine the amount and performance criteria for the payment of
bonuses. Under the agreement, Dr. Sancilio's base salary is to be reviewed at
least annually. Dr. Sancilio agreed to forego any salary increase in 1998. The
agreement provides that base salary may be increased in light of Dr. Sancilio's
performance, competitive levels of compensation and other factors the Committee
deems relevant. Dr. Sancilio's Employment Agreement was amended in March 1999
increasing the base salary to $400,000 from $350,000 (including any Endeavor
Pharmaceutical Inc. salary paid to Dr. Sancilio).
The agreement also provides for a bonus, at least equal to 50% of base
salary, if the Company attains target performance objectives agreed upon by the
Committee and Dr. Sancilio. At Dr. Sancilio's request, the Committee agreed not
to pay a bonus for 1998. This decision does not reflect the Committee's view of
Dr. Sancilio's and the Company's performance in 1998, and the Committee
anticipates that bonuses may be paid in the future for the level of performance
increases attained in 1998.
8
<PAGE> 11
Under the agreement, Dr. Sancilio is also eligible to participate in other
compensation or incentive plans in which other senior executives are eligible to
participate. The Committee did not award any options to Dr. Sancilio in 1998 at
his request, allocating the limited option pool to other officers and employees
of the Company. The Committee believes, however, that options provide
appropriate incentive compensation and may award options to Dr. Sancilio in the
future.
CAP ON DEDUCTION OF EXECUTIVE COMPENSATION
Under Section 162(m) of the Internal Revenue Code, a public company may not
deduct more than $1 million in compensation paid to one of its senior executive
officers, unless the excess amount is performance-based compensation satisfying
certain rules. The Company's stock option plans are designed to qualify under
the performance-based compensation requirements of this provision. Due to
current salary levels and anticipated bonus targets, the Committee believes that
it is unlikely that application of Section 162(m) will prevent the Company from
claiming a deduction for the amount of compensation paid to senior executive
officers.
Compensation Committee
John M. Ryan
9
<PAGE> 12
PERFORMANCE GRAPH
The rules of the Securities and Exchange Commission require the Company to
include in this Proxy Statement a line graph presentation comparing cumulative
total stockholder returns for the period beginning September 19, 1996 and ending
on December 31, 1998 with a published industry index or line-of-business index.
The Company has selected the Nasdaq Industrial Average and a composite peer
group consisting of ClinTrials Research Inc., Parexel International,
Pharmaceutical Product Development, Inc. and Quintiles Transnational Corp. The
graph assumes that $100 was invested on September 19, 1996 in AAI stock (at the
initial public offering price) and in the index and peer group on September 19,
1996, and the reinvestment of all dividends. The composite peer group differs
from last year's peer group in that IBAH, Inc., previously included in the
group, was acquired by another company in 1998. Thus, IBAH, Inc. is not included
in this year's peer group and has been omitted from all prior period peer group
calculations. The past performance of Company Common Stock is not necessarily
indicative of future performance.
<TABLE>
<CAPTION>
AAI NASDQ INDUSTRIAL PEER GROUP
--- ---------------- ----------
<S> <C> <C> <C>
09/19/96 100.00 100.00 100.00
12/31/96 119.53 101.29 92.41
12/31/97 103.13 143.34 76.61
12/31/98 108.59 119.05 78.85
</TABLE>
10
<PAGE> 13
CERTAIN TRANSACTIONS
TRANSACTIONS INVOLVING MANAGEMENT
The Company leases its headquarters facility from 5051 New Centre Drive,
LLC ("New Centre"), an entity in which each of Mr. Waters and Dr. Sancilio owns
a one-third interest. Pursuant to the lease agreement between the Company and
New Centre, the Company pays rent at an annual base rate of $12.50 per square
foot of space leased, subject to adjustment for increases in the landlord's
expense in maintenance and insurance of the facility. The effective rate per
square foot was increased to the current rate of $13.30 commencing in June 1995
to reflect such increased expenses. Under the agreement, the Company may lease
portions of the entire facility as needed and upon agreement of New Centre. At
December 31, 1997, the Company leased approximately 19,000 square feet of space
under the agreement. The initial term of the lease agreement expired in March
1999, but the agreement has been extended for successive one-year periods until
one party provides the other, at least 90 days prior to the scheduled expiration
of the agreement, notice of its intent not to renew the lease. The lease rate
for any renewal term is to be set by mutual agreement of the parties.
Approximately 40% of the capital stock of Endeavor Pharmaceuticals Inc.
("Endeavor") on a fully diluted basis is held by the Company, and certain
directors and officers of the Company serve as directors and officers of
Endeavor. Pursuant to an agreement among the Endeavor stockholders, the Company
has the right to designate two of the six members of the Endeavor board of
directors. The Company realized $1.6 million in net sales to Endeavor in 1998.
The Company provides product development services pursuant to an agreement
with Endeavor in connection with hormone pharmaceutical products that Endeavor
is developing. The Company has agreed to manufacture products developed by
Endeavor at the Company's manufacturing facility located at 1726 North 23rd
Street, Wilmington, North Carolina, until Endeavor achieves a specified
development milestone. The Company has agreed that at such time, it will grant
to Endeavor a lease/purchase option to either lease for 15 years or purchase the
portion of such facility intended for use by the Company in manufacturing
Endeavor's products. Upon achievement of the milestone by Endeavor, the Company
will also sell to Endeavor the equipment and inventory of raw materials, assign
to Endeavor its raw materials supply agreements relating to Endeavor's products
and make available certain personnel to Endeavor so that Endeavor can assume its
manufacturing operations. Upon exercise of either the option to lease or the
option to purchase, Endeavor is required to pay an exercise price of $2 million
to the Company in addition to lease payments or a purchase price based on the
fair market value of the facility. If Endeavor exercises the option to lease but
does not subsequently exercise the option to purchase and does not achieve
certain development milestones by a specified date, the Company must repay the
option exercise price to Endeavor. The facility subject to the option is
currently used by the Company for clinical trial supply and niche manufacturing.
The Company has expanded its clinical supply and niche manufacturing facilities
which could be used to manufacture Endeavor's products currently under
development or, if Endeavor exercises its option to manufacture such product
itself, for other client work. The Company has also agreed to permit Endeavor
under certain circumstances the first right to purchase additional proprietary
hormone pharmaceutical products developed by the Company at a price equal to the
amount of development work expended by the Company at its standard hourly rates
and out-of-pocket expenses, and the Company would continue the development work
with respect to such product under the agreement with Endeavor.
In addition to his duties at the Company, Dr. Sancilio is employed by
Endeavor as a senior management employee. Pursuant to his employment agreement
with Endeavor, Dr. Sancilio is to be based at the Company's principal executive
offices and does not have day-to-day responsibilities in the operation of
Endeavor and is assigned responsibilities from time to time by Endeavor's board
of directors. Dr. Sancilio receives an annual salary of $100,000 and is eligible
for bonus compensation of up to 50% of salary. Dr. Sancilio's employment
agreement with Endeavor had an initial two-year term which expired on November
17, 1997 and renews for successive one-year periods unless either party elects
not to renew the agreement. The employment agreement renewed by its terms for an
additional one-year term expiring
11
<PAGE> 14
November 17, 1999. Dr. Sancilio devotes the substantial majority of his time to
the management of the Company.
The Company provides product development services to Aesgen, which develops
generic pharmaceutical products. Approximately 30% of Aesgen's outstanding
common stock is held by the holders of a majority of the Company's currently
outstanding shares of capital stock. In addition, Mr. Waters and Dr. Sancilio
serve on the ten-member board of directors of Aesgen. The Company realized
$180,000 in net sales to Aesgen in 1998. The Company has the right under its
development agreement with Aesgen to provide certain product development and
support services to Aesgen with respect to certain drugs currently being
developed by Aesgen, provided that the Company's fees for such services are
comparable to those of a reasonably comparable firm. In addition, under such
development agreement, the Company has agreed, absent certain circumstances, not
to develop for its own account or for any other person, any formulation of a
product intended to be therapeutically equivalent to the same reference product
for any of the products currently under development by Aesgen and any additional
drugs that the Company agrees to develop for Aesgen under the development
agreement. The Company believes that the terms of such agreement are no less
favorable than terms that would be obtained in a transaction with an unrelated
third party.
The Company holds a $1.6 million nonconvertible, non-voting preferred stock
investment in Aesgen, and the Company's directors and executive officers
beneficially own the following percentages of the fully diluted common equity of
Aesgen: Dr. Sancilio, 9.4%, Mr. Waters, 9.0% and Mr. Underwood, 0.8%.
In November 1995, in connection with the purchase by GS Capital Partners
II, L.P., G.S. Capital Partners II Offshore, L.P., Bridge Street Fund 1995,
L.P., Stone Street Fund 1995, L.P., and Goldman, Sachs & Co. Verwaltungs GmbH
(the "Goldman Investors") and certain other investors of shares of preferred
stock described below, Mr. Waters purchased shares of preferred stock
(convertible into 119,833 shares of Common Stock), on substantially the same
terms and conditions, including price, as other purchasers of shares of
preferred stock. In connection with such transaction, the Company granted
certain stockholders, including Mr. Waters and Dr. Sancilio, rights to cause the
Company to register for sale shares of Common Stock acquired upon conversion of
the preferred stock. All shares of preferred stock were converted into Common
Stock automatically upon completion of the Company's initial public offering in
September 1996. In addition, in connection with the Company's issuance of shares
of preferred stock, Mr. Waters and Dr. Sancilio agreed to indemnify the Company
against certain matters including the imposition of certain federal income tax
liabilities, if any, in connection with the Company's election to be treated as
an S corporation, and the payment of any amount due in connection with the
resolution of an assessment against the Company of a North Carolina use tax
deficiency of approximately $340,000 plus penalties and interest assessed
against the Company. In addition, and as part of the same transaction, Mr.
Waters and Dr. Sancilio have agreed to sell to the Company up to a total of
242,539 shares of Common Stock to provide the shares for issuance pursuant to
the 1995 Stock Option Plan. Such shares are required to be sold by Mr. Waters
and Dr. Sancilio upon the exercise of options under the 1995 Stock Option Plan
at the exercise price of such options. As of December 31, 1998, options to
acquire 175,395 shares of Common Stock were granted under the 1995 Stock Option
Plan at an exercise price per share of $8.35, except for options for 2,214
shares at an exercise price of $9.10. In 1998, Dr. Sancilio received $2,346 and
Mr. Waters received $1,912 under this arrangement.
In 1988, the Company secured financing with variable rate North Carolina
industrial revenue bonds which are supported by a letter of credit issued by a
bank. Dr. Sancilio and Mr. Waters guaranteed the Company's obligation to repay
amounts drawn under such letter of credit.
The Company loaned $82,775 to Mr. Underwood in 1993 in connection with a
purchase of shares of Common Stock. Such loan was evidenced by a promissory
note, which was paid in full in 1998 by Mr. Underwood.
CERTAIN BUSINESS RELATIONSHIPS
In November 1995, the Goldman Investors and certain other investors
purchased shares of preferred stock of the Company. All outstanding shares of
preferred stock were converted into Common Stock in
12
<PAGE> 15
conjunction with the Company's public offering of Common Stock in September
1996. The Goldman Investors own 2,276,832 shares of Common Stock, which were
purchased at $8.35 per share. Pursuant to a Stockholder Agreement entered into
in November 1995 in connection with the purchase of preferred stock, the Goldman
Investors have the right to designate one member of the Board of Directors for
so long as the Goldman Investors and their affiliates (which include Goldman,
Sachs & Co.) beneficially own 10% or more of the outstanding shares of Common
Stock. Pursuant to such Agreement, Mr. Gleberman, a managing director of
Goldman, Sachs & Co., serves as one of the Company's directors.
In connection with the purchase by the Goldman Investors and certain other
investors of shares of preferred stock in November 1995, the Company agreed that
so long as the Goldman Investors beneficially own 5% or more of the outstanding
shares of Common Stock, the Company will retain Goldman, Sachs & Co. or an
affiliate to perform all investment banking services for the Company for which
an investment banking firm is retained and to serve as managing underwriter of
any offering of the Company's capital stock on customary terms, consistent with
an arm's-length transaction. In the event that the Company and Goldman, Sachs &
Co. or their affiliates cannot agree to the terms of such engagement after good
faith discussions, the agreement permits the Company to engage any other
investment banking firm, although Goldman, Sachs & Co. are entitled to serve as
co-managing underwriter in any underwritten offering of the Company's capital
stock. Goldman, Sachs & Co. served as lead underwriter in the Company's initial
public offering of its Common Stock in September 1996 and in connection
therewith the underwriting syndicate purchased approximately 3.1 million shares
of Common Stock at an underwriting discount of $3.5 million to the aggregate
public offering price. The Company has agreed to indemnify Goldman, Sachs & Co.
and their affiliates against certain liabilities, including liabilities under
the Securities Act of 1933.
Goldman Sachs & Co. makes a market in the Common Stock. Because of the
affiliation of Goldman, Sachs & Co. with the Company, Goldman, Sachs & Co. is
required to deliver a current prospectus to any purchaser in connection with any
such market-making transactions. The Company agreed with Goldman, Sachs & Co. to
register such transactions under the Securities Act of 1933, and effected such
registration in connection with its initial public offering by including in its
registration statement for the initial public offering a market-making
prospectus required to be used by Goldman, Sachs & Co. The Company has agreed to
make from time to time certain amendments or supplements to the market-making
prospectus and to pay certain expenses relating to such amendments or
supplements. Such expenses were less than $60,000 in 1998.
Approximately 14.2% of the capital stock of Endeavor on a fully diluted
basis and 4.1% of the common equity of Aesgen on a fully diluted basis is held
by the Goldman Investors.
APPROVAL OF INDEPENDENT PUBLIC ACCOUNTANTS
The Board of Directors has appointed Ernst & Young LLP as independent
public accountants of the Company for the fiscal year ending December 31, 1999.
A proposal to ratify the appointment of Ernst & Young LLP will be presented at
the Annual Meeting. Representatives of Ernst & Young LLP are expected to be
present at the Annual Meeting, will have an opportunity to make a statement if
they desire to do so, and will be available to answer appropriate questions from
stockholders.
STOCKHOLDER PROPOSALS FOR 2000 ANNUAL MEETING
Under the applicable rules of the Securities and Exchange Commission, a
stockholder who wishes to submit a proposal for inclusion in the proxy statement
of the Board of Directors for the annual meeting of stockholders to be held in
the spring of 2000 must submit such proposal in writing to the Secretary of the
Company at the Company's principal executive offices no later than December 16,
1999.
The By-laws of the Company establish an advance notice procedure for
stockholder proposals to be brought before a meeting of stockholders of the
Company and for nominations by stockholders of candidates for election as
directors at an annual meeting at which directors are to be elected. Subject to
any other applicable requirements, only such business may be conducted at a
meeting of stockholders as has been brought before the meeting by, or at the
direction of, the Board of Directors or by a stockholder who has given
13
<PAGE> 16
to the Secretary of the Company timely written notice, in proper form, of the
stockholder's intention to bring that business before the meeting. The presiding
officer at such meeting has the authority to make such determinations. Only
persons who are selected and recommended by the Board of Directors or by a
committee of the Board of Directors designated to make nominations, or who are
nominated by a stockholder who has given timely written notice, in proper form,
to the Secretary prior to a meeting at which directors are to be elected, will
be eligible for election as directors of the Company.
To be timely, notice of nominations or other business to be brought before
any meeting must be received by the Secretary of the Company not later than 120
days in advance of the anniversary date of the Company's proxy statement for the
previous year's annual meeting or, in the case of special meetings, at the close
of business on the tenth day following the date on which notice of such meeting
is first given to stockholders. Accordingly, any notice of nominations or other
business to be brought before the 2000 annual meeting of stockholders must be
received by the Secretary of the Company by December 16, 1999. The notice of any
stockholder proposal or nomination for election as a director must set forth the
various information required under the By-laws. The person submitting the notice
of nomination and any person acting in concert with such person must provide,
among other things, the name and address under which they appear on the
Company's books (if they so appear) and the class and number of shares of the
Company's capital stock that are beneficially owned by them. Any stockholder
desiring a copy of the Company's By-laws will be furnished one without charge
upon written request to the Secretary of the Company at 5051 New Centre Drive,
Wilmington, North Carolina 28403.
OTHER MATTERS
The Board knows of no other matters which will be presented to the Annual
Meeting. If, however, any other matter is properly presented at the Annual
Meeting, the proxy solicited by this Proxy Statement will be voted in accordance
with the judgment of the person or persons holding such proxy.
By Order of the Board of Directors,
R. Forrest Waldon
Secretary
Wilmington, North Carolina
April 15, 1999
YOU ARE CORDIALLY INVITED TO ATTEND THE MEETING IN PERSON.
WHETHER OR NOT YOU PLAN TO ATTEND THE MEETING, YOU ARE
REQUESTED TO SIGN AND RETURN THE ACCOMPANYING PROXY
IN THE ENCLOSED POSTPAID ENVELOPE.
14
<PAGE> 17
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
---------------------
FORM 10-K
<TABLE>
<C> <S>
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
</TABLE>
COMMISSION FILE NUMBER 0-21185
APPLIED ANALYTICAL INDUSTRIES, INC.
(Exact name of Registrant as specified in its charter)
<TABLE>
<S> <C>
DELAWARE 04-2687849
(State or other jurisdiction of (I.R.S. employer
incorporation or organization) identification no.)
</TABLE>
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 19, 1999 was 17,204,490 shares. The aggregate market value for the voting
stock held by non-affiliates of the Registrant on March 19, 1999 was
approximately $113,039,189.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's 1998 Annual Report to Shareholders are
incorporated by reference in Parts I, II, and IV hereof. Portions of the
Registrant's 1998 Proxy Statement dated approximately April 9, 1999 are
incorporated by reference in Part III hereof.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<PAGE> 18
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 pages 33 and 34 of the 1998 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;
bioanalytical services; clinical supply and niche manufacturing; and regulatory
and compliance consulting.
In addition to the analytical services, AAI offers clinical trial services
on a fee-for-service basis. The clinical business allows AAI to leverage
customer relationships by offering longer term, broad scope contracts which span
from early developmental testing and formulation to post-approval analysis. The
clinical group provides customers a single source provider of pre-clinical and
clinical testing. Being a single source provider of services can decrease the
amount of knowledge transfer lost between separate vendors and can ultimately
decrease the cost of development and speed to market of a drug.
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 portion 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. The Company does
not directly market its internally developed products. Licensing partners, who
are generally pharmaceutical companies, provide all marketing and sales service.
Internal drug development efforts encompass generic products, line extensions
and new 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. 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. was a European
contract research and development organization headquartered in Neu-Ulm, Germany
with principal operating units in Neu-Ulm and Munich, Germany; Paris, France,
and Arnheim, Netherlands as well as a sales office in London, England. The
former L.A.B. operations are now included in the organization referred to as AAI
Europe. AAI Europe 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
1
<PAGE> 19
regulatory consulting. AAI Europe also provides Phase II-IV multi-center
clinical trial studies focused in niche therapeutic areas including hepatic
disease, chemotherapeutics, and hormone replacement therapy.
On September 14, 1998, the Company acquired Kansas City Analytical
Services, Inc. (KCAS) a bioanalytical services company in the Kansas City,
Kansas area. KCAS offers bioanalytical testing of products to large and small
pharmaceutical development companies. The addition of KCAS significantly
increased AAI's bioanalytical testing capacity.
On March 16, 1999, the Company merged with Medical and Technical Research
Associates, Inc., (MTRA) a clinical research organization located near Boston,
Massachusetts. MTRA offers clinical phase II -- IV studies predominately in the
US market to large and small pharmaceutical companies. The addition of MTRA adds
clinical phase II -- IV capabilities in the United States and will significantly
increase AAI's ability to provide clinical testing to U.S. customers and enable
the Company to compete for global clinical trial engagements.
FEE-FOR-SERVICE BUSINESS
The Company provides a broad array of drug development services, including
chemical analysis, synthesis and other laboratory services; formulation
development; bioanalytical services; clinical supply and niche manufacturing;
clinical trial services and monitoring; 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.
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 more than 19 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 climate-controlled facilities in the United States
and Germany to determine impact of a range of storage conditions on product. 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 Laboratory Tracking System (LTS)
tracks client products maintained at the Company's stability storage facilities
and automatically schedules required testing as pull points occur.
2
<PAGE> 20
Raw Materials and Product Release Testing. The Company offers testing
required by the FDA and other regulatory agencies 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 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 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 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 Good Manufacturing Practices (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. in 1996 and KCAS in 1998
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 a compound, including spectroscopy, chromatographic analyses and
other physical chemistry techniques. Additionally, the Company uses such
information for control testing to be performed throughout development and
marketing to confirm consistent drug composition. Once appropriate test methods
are developed and validated, and appropriate reference standards are
characterized and certified, the Company can assist clients by routinely testing
compounds for clinical and commercial use.
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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 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 efficiently 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 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
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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. The Company
has a dedicated 20,000 square foot facility in Wilmington, North Carolina and a
similar facility in Paris, France to distribute and track clinical trial
materials used in clinical studies. 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 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.
CLINICAL SERVICES
The Company has a 48-bed Phase I clinical trial facility located in the
same facility as one of the Company's analytical laboratories in Research
Triangle Park, North Carolina. With the acquisitions of L.A.B. and MTRA, the
Company expanded its Phase I clinical trial capabilities and added the ability
to conduct and monitor 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.
MTRA provides a full range of Phase II-IV clinical services to customers in
the pharmaceutical, biotechnology and medical device industries for assistance
in the drug development and regulatory approval process in North America. The
clinical services include clinical trial management and monitoring, data
management and statistics.
With the addition of MTRA in 1999, the Company anticipates that clinical
services will contribute more significantly to total revenues as clinical
services will be offered on a global scale and have a significant customer base
in the United States.
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PRODUCT DEVELOPMENT BUSINESS
The Company dedicates a portion 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 length of 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.
In 1994, as part of its internal development program, the Company organized
Endeavor with certain financial investors and an affiliate of Schering AG 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 Company's
fee-for-service net sales to Endeavor were approximately $1.6 million, $3.2
million and $6.2 million in 1998, 1997 and 1996, 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 had one product approved by the FDA in 1998 and is 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 $.2 million, $1.9
million and $4.7 million in 1998, 1997 and 1996 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.
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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.
The Company's internal development program has yielded multiple issued
patents and has several pending applications. For example, the Company's
patented Pro-Sorb(R) 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 proprietary 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.
In 1998, the Company began implementation of an enterprise wide financial
and operational integrated management information system including significant
systems licensed from SAP. Certain financial components became operational at
year end 1998, with other operational management systems to follow later in
1999. The new system will be implemented in all subsidiaries and allows for
expansion in a consistent and controlled manner.
Disclosure regarding the impact of year 2000 is included in the section
titled "Management's Discussion and Analysis of Financial Condition and Results
of Operations" of the Annual Report under the caption "Year 2000 Disclosure."
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CLIENTS
The Company has provided services to most of the major 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 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. 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, 1998 and 1997 backlog was approximately
$23.9 and $31.5 million, respectively.
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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.
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 United States Food and
Drug Administration (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 and is insured against losses arising out of the
normal course of business operations. 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, 1998, the Company had approximately 1,000 full-time
equivalent employees, of which approximately 73 hold Ph.D. or M.D. degrees, or
the foreign 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 and French law provide 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 enhance employee morale, professional commitment and
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<PAGE> 27
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 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., 49, 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.
Eugene T. Haley, 49, 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, Inc. (an Eastman-Kodak subsidiary) from 1993
to 1997.
Frances M. Sakers, 41, 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.
Joachim Rexhaus, 45, Executive Vice President, European Operations. Mr.
Rexhaus was elected an Executive Vive President in 1998 and has served the
Company since August 1997 in a number of financial and administrative management
positions in Europe. Prior to joining the Company, Mr. Rexhaus held a number of
financial and administrative management positions, most recently at Hoechst AG,
Syntax and IBM.
William J. Blank, 48, Executive Vice President, Marketing and Sales. Mr.
Blank has served as Executive Vice President, Marketing and Sales since January
1999. Prior to joining the Company, he served as Vice President of Client
Relations at Parexel International Corp. and has held various sales and
marketing positions in the healthcare services industry.
William H. Underwood, 51, 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.
ITEM 2. PROPERTIES.
The Company's principal executive offices are located in Wilmington, North
Carolina, in a 22,000-square foot leased facility. The Company's primary U.S.
facilities are located in Wilmington, North Carolina; Research Triangle Park,
North Carolina; New Brunswick, New Jersey; Natick, Massachusetts; and Shawnee,
Kansas constituting approximately 278,000 square feet of total 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 San Bruno, California; Munich,
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Germany; Paris, France; and Arnheim, Netherlands. The Company maintains sales
offices in Chicago, Illinois; Boston, Massachusetts; San Diego and San
Francisco, California; Copenhagen, Denmark; London, England; Milan, Italy and
Tokyo, Japan. The Company also has joint operations with Shangai Second Medical
University located in Shangai, China and Tonji University in Wuhan, China. 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. 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.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None during the quarter ended December 31, 1998.
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 in the
section titled "Financial Results by Quarter" of the Annual Report and is
incorporated herein by reference.
ITEM 6. SELECTED FINANCIAL DATA.
The information required by Item 6 is included in the section titled
"Selected Financial Data" 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 in the section titled
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" of the Annual Report and is incorporated herein by reference.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The Company, as a result of global operating activities, is exposed to
risks associated with changes in foreign exchange rates. As foreign exchange
rates change, the U. S. Dollar equivalent of revenues and expensed denominated
in foreign currencies change and can have an adverse impact on the Company's
operating results. To seek to minimize its risk from foreign exchange movement,
the Company uses local debt to fund its foreign operations. If foreign exchange
rates were to change 10%, operating results would have changed by $60,000 in
1998.
The Company is also exposed to changes in interest rates on its variable
rate debt instruments. If interest rates were to change 1%, based on year end
debt amounts subject to variable interest rates, annual interest expense on
variable rate debt would change $40,000.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The information required by Item 8 is included in the "Consolidated
Statements of Income, Consolidated Balance Sheets, Consolidated Statements of
Cash Flows, Consolidated Statement of Stockholders' Equity and Notes to
Consolidated Financial Statements", of the Annual Report and is incorporated
herein by reference.
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ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
On April 30, 1998, the Audit Committee and Board of Directors dismissed
PricewaterhouseCoopers LLP (formerly Price Waterhouse LLP) as its independent
public accountants. The reports of Price Waterhouse on the consolidated
financial statements of the Company for the years ended December 31, 1997 and
1996 contained no adverse opinion or disclaimer of opinion and were not
qualified or modified as to uncertainty, audit scope or accounting principle.
This event was reported in detail in a Form 8-K filed on April 30, 1998.
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 9, 1999 (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 9 and 10 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 sheet as of December 31, 1998, and related
consolidated statements of income, cash flows and stockholders' equity for the
year ended December 31, 1998 and related notes to financial statements, together
with the report of independent auditors thereon of Ernst & Young LLP, dated
February 12, 1999, except Note 11, as to which the date is March 16, 1999; and
the consolidated balance sheet as of December 31, 1997, and related consolidated
statements of income, cash flows and stockholders' equity for each of the two
years in the period ended December 31, 1997 and related notes to financial
statements, together with the report of independent accountants thereon of Price
Waterhouse LLP, dated March 18, 1998, appearing in the Annual Report, are
incorporated herein by reference. With the exception of the aforementioned
information and the information incorporated by reference in Items 1, and 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 conjunction with
the financial statements in the Annual Report. Schedules not included with this
additional
12
<PAGE> 30
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
The Company has recently filed the following Form 8-Ks:
Dated February 16, 1999, to file a press release reporting the
Company's agreement to merge with Medical and Technical Research
Associates, Inc.
Dated March 2, 1999, to file a press release reporting the Company's
audited consolidated financial results for the year ended December 31,
1998.
ADDITIONAL FINANCIAL DATA
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Applied Analytical Industries, Inc., for years ended
December 31, 1998, 1997 and 1996:
Report of Ernst & Young LLP, Independent Auditors...... F-1
Report of PricewaterhouseCoopers LLP, Independent
Accountants........................................... F-2
Financial Statement Schedule:
Schedule II -- Valuation and Qualifying Accounts..... F-3
</TABLE>
13
<PAGE> 31
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.
<TABLE>
<C> <S> <C>
/s/ FREDERICK D. SANCILIO Chairman of the Board, March 31, 1999
- ----------------------------------------------------- President and Chief Executive
Frederick D. Sancilio, Ph.D. Officer
</TABLE>
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons, or in their behalf by
their duly appointed attorney-in-fact, on behalf of the Registrant in the
capacities and on the date indicated.
<TABLE>
<CAPTION>
Signature Title Date
--------- ----- ----
<C> <S> <C>
/s/ FREDERICK D. SANCILIO Chairman of the Board, March 31, 1999
- ----------------------------------------------------- President, Chief Executive
Frederick D. Sancilio, Ph.D. Officer and Director
(Principal Executive Officer)
/s/ EUGENE T. HALEY Executive Vice President March 31, 1999
- ----------------------------------------------------- and Chief Financial Officer
Eugene T. Haley
/s/ GEORGE W. BECKWITH Controller (Principal March 31, 1999
- ----------------------------------------------------- Accounting Officer)
George W. Beckwith
/s/ WILLIAM H. UNDERWOOD Executive Vice President March 31, 1999
- ----------------------------------------------------- and Director
William H. Underwood
/s/ JOSEPH H. GLEBERMAN Director March 31, 1999
- -----------------------------------------------------
Joseph H. Gleberman
/s/ JOHN M. RYAN Director March 31, 1999
- -----------------------------------------------------
John M. Ryan
/s/ JAMES L. WATERS Director March 31, 1999
- -----------------------------------------------------
James L. Waters
/s/ JAMES G. MARTIN Director March 31, 1999
- -----------------------------------------------------
James G. Martin, Ph.D.
</TABLE>
14
<PAGE> 32
EXHIBIT 13
SELECTED FINANCIAL DATA
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------------------------
1998 1997 1996 1995 1994
-------- -------- -------- -------- --------
IN THOUSANDS, EXCEPT PER SHARE AMOUNTS
<S> <C> <C> <C> <C> <C>
STATEMENT OF INCOME DATA:
Net sales................................... $ 80,380 $ 65,401 $ 42,162 $ 34,639 $ 32,882
Cost of sales............................... 39,962 33,378 17,621 14,259 14,533
Selling..................................... 8,618 8,362 6,357 4,913 4,390
General and administrative.................. 17,536 15,207 8,908 8,171 8,485
Research and development.................... 6,131 7,791 4,216 3,326 2,394
Unusual item (1)............................ -- -- 6,600 -- --
Other income (expense), net................. 437 1,373 494 (1,130) (440)
-------- -------- -------- -------- --------
Income (loss) before income taxes........... 8,570 2,036 (1,046) 2,840 2,640
Provision for income taxes (2).............. 2,869 781 2,102 39 --
Equity income (loss)........................ -- -- -- 444 (444)
-------- -------- -------- -------- --------
Net income (loss)................. $ 5,701 $ 1,255 $ (3,148) $ 3,245 $ 2,196
======== ======== ======== ======== ========
Basic earnings (loss) per share............. $ 0.35 $ 0.08 $ (0.26) $ 0.31 $ 0.21
======== ======== ======== ======== ========
Weighted average shares outstanding......... $ 16,322 $ 16,290 $ 12,039 $ 10,348 $ 10,317
======== ======== ======== ======== ========
Diluted earnings (loss) per share........... $ 0.35 $ 0.08 $ (0.26) $ 0.30 --
======== ======== ======== ======== ========
Weighted average shares outstanding......... $ 16,417 $ 16,459 $ 12,039 $ 10,667 --
======== ======== ======== ======== ========
PRO FORMA DATA (UNAUDITED) (2):
Net income, as reported................... $ 3,245 $ 2,196
Pro forma income taxes.................... 1,129 1,118
-------- -------- -------- -------- --------
Pro forma net income...................... $ 2,116 $ 1,078
======== ======== ======== ======== ========
Pro forma earnings per share.............. $ 0.20 $ 0.10
======== ======== ======== ======== ========
Weighted average shares outstanding....... $ 10,667 $ 10,317
======== ======== ======== ======== ========
BALANCE SHEET DATA, AT PERIOD END:
Working capital............................. $ 24,013 $ 32,637 $ 35,755 $ 12,374 $ (1,181)
Property and equipment, net................. 37,600 25,326 19,216 10,904 10,782
Total assets................................ 109,257 100,449 104,478 39,156 22,402
Long-term debt.............................. 6,306 6,578 6,671 6,578 2,738
Total stockholders' equity (3).............. 72,950 66,076 63,995 21,990 5,856
</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 completed an initial public offering of its common stock in
September 1996.
1
<PAGE> 33
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
The Company is engaged in the business of performing contract development
and support services for large and small pharmaceutical companies around the
world and the development of new technologies to improve drug performance. In
implementing this strategy, the Company earns revenue through fee-for-service
contracts with customers and by licensing and selling internally developed
formulas and products.
The fee-for service business consists of two main groups, an analytical and
a clinical group. The analytical group performs laboratory analysis of various
chemical compounds and small scale manufacturing of chemical compounds used for
further testing, or in some cases, for sale to the public. The services
performed by the analytical group include chemical analysis, chemical synthesis,
drug formulation, clinical supply and niche manufacturing, bio-analytical
studies, and regulatory and compliance consulting. All of these services involve
either laboratory work or consulting services. The clinical group performs
testing of new drugs for customers under controlled conditions as part of the
customers' process in gaining approval for the drug. All of the clinical
services involve contact with patients and monitoring clinical studies performed
in hospitals and clinics.
Both the analytical and clinical groups receive requests for services from
a customer, often on a competitive basis. An estimate of costs to perform the
service is delivered to the customer based on the expected resources and
materials required to complete the project. The projects vary in length, some
lasting less than one month and others lasting several years, however, most
projects may be cancelled by the customer with 30 days notice.
The product development business utilizes the resources and operating
capacity of the analytical and clinical groups to study and develop new
technologies that improve existing drugs. The Company licenses the developed
technologies and formulas to customers usually before the development is
complete. In general, the Company is partially paid for its efforts and
innovations at predefined events, defined as milestones, which are intended to
help cover the costs of development. The milestone payments are not refundable.
In most cases, the Company also receives royalties on the eventual sales of the
approved product. The Company bears the risk that some of the development
projects may not be approved or that the eventual sales of the product may not
meet expectations. These development projects generally last several years.
On December 31, 1996, the Company acquired L.A.B. Gesellschaft fur
pharmakologische Untersuchungen mbH & Co. ("L.A.B."), which is now named AAI
Deutschland, GmbH & Co. KG. The operations include analytical and clinical
operations located in Germany, clinical operations in France and the
Netherlands, and a sales office in England. The acquisition 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 analytical and clinical services to its global client base.
On September 14, 1998, the Company acquired Kansas City Analytical
Services, Inc. ("KCAS"). KCAS provides bioanalytical services and has
significantly increased the bioanalytical capacity and expertise of the Company.
Prior to the acquisition of KCAS, the Company's primary bioanalytical operations
were located in Neu-Ulm, Germany.
On March 16, 1999, the Company merged with Medical and Technical Research
Associates, Inc. ("MTRA") in a pooling-of-interests transaction for
approximately 1.3 million shares of stock, including conversion of MTRA stock
options. The addition of MTRA will bring a U.S. based clinical phase II-IV
operation to the Company and significantly increase the Company's clinical
presence and ability to compete for clinical projects.
2
<PAGE> 34
This Annual Report contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, 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, internal Company factors such as the management
of growth and acquisition risks and dependence on key personnel. The factors
that are outside the Company's control include government regulation, the level
of outsourcing in the pharmaceutical and biotechnology industries and the
dependence on third party marketing and distribution of internally developed
drugs.
RESULTS OF OPERATIONS
1998 Compared to 1997
Net sales increased by 23% in 1998 compared to 1997. The increase was due
in part to the acquisition of KCAS, without which the sales increase would have
been 19%. Fee-for-service sales increased 19% while product development revenues
increased 26% in 1998 over 1997.
Gross margins in the fee-for-service business increased to 46% from 44%
partly due to the inclusion of KCAS in 1998. Without KCAS, 1998 margins would
have been 45%.
Selling expenses increased by 1% but decreased as a percentage of sales
from 13% to 11% in 1998 from 1997 levels. General and administrative expenses
increased by 15% in 1998, but decreased as a percentage of fee for service
revenues to 22% in 1998 from 23% in 1997. The increase was due mainly to
increases in staff costs which support the higher volumes and revenues. Both
selling and general and administrative expenses decreased as a percentage of
fee-for-service revenues in 1998 from 1997 levels. Management believes that
while dollar levels of selling and administrative spending will increase, the
level of spending as a percentage of revenues will continue to decline in future
years.
Research and development expenses decreased by 21% in 1998 from 1997
levels. Overall research spending as a percent of net sales also decreased from
12% in 1997 to 8% in 1998. The decrease was due partially to the stage of
development of the internal products. In addition, this decrease was partially
due to the Company internally performing various research activities which had
previously been sent to outside parties. The Company was able to perform these
research activities internally as a result of its acquisitions of L.A.B., KCAS
and through internal expansion. Management believes that performing high cost
research activities with internal resources (which will be further enhanced with
the addition of MTRA) will continue to provide a lower level of research
expenses as a percentage of net sales than had been experienced in prior years.
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 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.
3
<PAGE> 35
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.
LIQUIDITY AND CAPITAL RESOURCES
The Company has funded its business through cash flows from operations,
borrowings and the sale of equity. In 1998, $1.4 million of cash was generated
from operations. Cash was used in 1998 as follows: $4.0 million to acquire KCAS;
$14.1 million to purchase capital assets; and a $6.8 million increase in
non-cash working capital. The major capital assets purchased in 1998 include a
clinical supply manufacturing and distribution facility in Wilmington, North
Carolina, and the opening of an analytical facility in New Brunswick, New
Jersey.
In 1997, $13.0 million of cash was used by operations predominately to
increase non-cash working capital and $4.4 million was received through
additional borrowings. Cash was used to purchase capital assets in the amount of
$10.9 million.
In 1996, $45.0 million of cash was provided through the sale of equity and
$2.4 million was generated from operations. $7.6 million of cash was used in
1996 to purchase capital assets.
Capital assets purchased were for new equipment and facility improvements
to increase capacity and productivity. The Company anticipates capital
expenditures in 1999 to be at or below the 1998 level.
Working capital was $24.0 million at December 31, 1998 and $32.6 million at
December 31, 1997. The Company has a $20 million credit facility available 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 has commenced efforts to assess and where required, remediate,
issues associated with Year 2000 (Y2K) issues. Generally defined, Y2K issues
arise from computer programs which use only two digits to refer to the year and
which may experience problems when the two digits become "00" in the year 2000.
In addition, imbedded hardware microprocessors may contain time and two-digit
year fields in executing their functions. Much literature has been devoted to
the possible effects such programs may experience in the Year 2000, although
significant uncertainty exists as to the scope and effect the Y2K issues will
have on industry and the Company.
The Company has recognized the need to address the Y2K issue in a
comprehensive and systematic manner and has taken steps to assess the possible
Y2K impact on the Company. Although the Company has not completed a 100%
assessment of all its information technology ("IT") and non-IT systems for Y2K
issues, the Company has completed its assessment of all mission-critical
systems. All mission-critical systems and most of the major applications and
hardware have been assessed to determine the Y2K impact and a plan
4
<PAGE> 36
is in place for timely resolution of potential issues by the end of September
1999. In addition, the Company is asking all of its significant vendors and
clients for an assessment of the impact of Y2K on their operations.
In 1996, the Company developed a strategic plan to identify the IT systems
needed to accomplish the Company's overall growth plans. As part of this
process, potential Y2K issues were considered and addressed through an
enterprise resource planning process. The Company's Board of Directors
authorized approximately $3 million of initial spending to implement portions of
this strategic plan.
In 1997, the Company established an internal multi-discipline task force to
specifically address Y2K issues. The task force has inventoried IT and non-IT
systems and made assessments as to Y2K compliance. In those instances where a
system would be replaced or eliminated through the implementation of our
strategic plan before being impacted by Y2K issues, no further action was deemed
necessary. All mission-critical systems not being addressed in the strategic
plan have been further assessed and protocols have been developed to test
compliance. This testing is ongoing. As issues are identified they are remedied
as soon as possible. In addition, as upgrades are made to the Company's
proprietary software, Company employees are revising the computer code to ensure
Y2K compliance. All Company purchase orders for new equipment and systems
contain representations regarding Y2K compliance. Based on our current
information, the non-IT systems used by the Company are not expected to cause
significant problems or expense to the Company. While AAI relies heavily on its
technical equipment, much of the equipment can be upgraded to Y2K compliant
versions. Items that are not mission-critical can continue to be operated if
they are not linked to other systems.
The Company has communicated with our major customers and suppliers and is
not aware of any such business associates that will cause a material third-party
risk to the Company. While management does not believe this issue will
materially affect its products, services or competitive condition, it has not
fully completed its assessment and remediation process at this time.
The cost of bringing the Company in full compliance should not result in a
material increase in the recent levels of capital spending or any material
one-time expenses. The Company has not been tracking the direct cost of solving
potential Y2K issues. Since 1996, the Company has spent approximately $3.7
million for all IT items. It is not reasonably possible to determine what
portion of such spending was directly related to correcting Y2K issues. This
amount includes spending on replacing systems, as well as upgrading existing
systems. The future spending on IT items is expected to be approximately $2
million per year. Again, the Company has not segregated the direct costs
associated with Y2K issues in its IT capital spending plans.
The failure of either the Company, its vendors or clients to correct the
systems affected by Y2K issues could result in a disruption or interruption of
business operations. The Company uses computer programs and systems in its
operations to collect, assimilate and analyze data. Failure of such programs and
systems could affect the Company's ability to perform contracts to test,
develop, or manufacture pharmaceutical and biotechnology products or perform
clinical trials, thereby causing delays in the development and commercialization
of pharmaceutical and biotechnology products. Similarly, failure of
vendor-provided products and services could result in delay of the Company's
internal development efforts. Although the Company does not believe that any of
the foregoing worst-case scenarios will occur, there can be no assurance that
unexpected Y2K problems of either the Company, its vendors or clients will not
have a material adverse effect on the Company.
While it is difficult to classify the Company's state of readiness,
management believes that the Company's internal plans should have the Company
ready by the end of 1999 to avoid any material Y2K issues. We are in the process
of completing the assessment, testing systems and developing contingency plans.
Management is in frequent communication with the task force and has made and
will continue to make reports to the Company's Board of Directors.
INFLATION
The Company believes the effects of inflation generally do not have a
material adverse effect on its results of operations or financial condition.
5
<PAGE> 37
EURO CONVERSION
On January 1, 1999, the European Community began denominating significant
financial transactions in a new monetary unit, the Euro. The Euro is intended to
replace the traditional currencies of the individual EU member countries. The
Company's operations in Europe are continuing to operate in the traditional
currencies and are not converting internal financial systems to the Euro as a
functional currency. The Company's significant operations all have
multi-currency capable systems and will account for Euro denominated
transactions without additional modification or difficulty. The Company is
evaluating when to convert its local currency in Europe to the Euro with as
little disruption to customer and vendors as possible. The Company does not
intend to make such a conversion in 1999.
6
<PAGE> 38
CONSOLIDATED STATEMENTS OF INCOME
IN THOUSANDS, EXCEPT PER SHARE AMOUNTS
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
---------------------------------
1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
Net sales (includes related party net sales of $1,807,
$5,170 and $10,916)....................................... $80,380 $65,401 $42,162
Operating costs and expenses:
Cost of sales............................................. 39,962 33,378 17,621
Selling................................................... 8,618 8,362 6,357
General and administrative................................ 17,536 15,207 8,908
Research and development.................................. 6,131 7,791 4,216
Unusual item.............................................. -- -- 6,600
------- ------- -------
72,247 64,738 43,702
------- ------- -------
Income (loss) from operations............................... 8,133 663 (1,540)
Other income (expense):
Interest, net............................................. 239 608 511
Other..................................................... 198 765 (17)
------- ------- -------
437 1,373 494
======= ======= =======
Income (loss) before income taxes........................... 8,570 2,036 (1,046)
Provision for income taxes.................................. 2,869 781 2,102
------- ------- -------
Net income (loss)........................................... $ 5,701 $ 1,255 $(3,148)
======= ======= =======
Basic earnings (loss) per share............................. $ 0.35 $ 0.08 $ (0.26)
======= ======= =======
Weighted average shares outstanding -- basic................ 16,322 16,290 12,039
======= ======= =======
Diluted earnings (loss) per share........................... $ 0.35 $ 0.08 $ (0.26)
======= ======= =======
Weighted average shares outstanding -- diluted.............. 16,417 16,459 12,039
======= ======= =======
</TABLE>
The accompanying notes are an integral part of these financial statements.
7
<PAGE> 39
CONSOLIDATED BALANCE SHEETS
IN THOUSANDS, EXCEPT SHARE DATA
<TABLE>
<CAPTION>
DECEMBER 31,
-------------------
1998 1997
-------- --------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents................................. $ 10,802 $ 26,219
Accounts receivable, net.................................. 22,130 19,415
Work-in-progress.......................................... 15,570 8,968
Prepaid and other current assets.......................... 5,352 4,481
-------- --------
Total current assets.............................. 53,854 59,083
-------- --------
Property and equipment, net................................. 37,600 25,326
Goodwill and other intangibles.............................. 15,509 13,747
Other assets................................................ 2,294 2,293
-------- --------
Total assets...................................... $109,257 $100,449
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current maturities of long-term debt and short-term
debt................................................... $ 6,627 $ 5,561
Accounts payable.......................................... 5,494 4,005
Customer advances......................................... 6,818 7,869
Accrued wages and benefits................................ 4,323 3,561
Other accrued liabilities................................. 6,579 5,450
-------- --------
Total current liabilities......................... 29,841 26,446
-------- --------
Long-term debt.............................................. 6,306 6,578
Other liabilities........................................... 160 1,349
Commitments and contingencies Stockholders' equity:
Preferred stock........................................... -- --
Common stock, $.001 par value; 100 million shares
authorized, 16,390,511 outstanding -- 1998; 16,295,271
outstanding -- 1997.................................... 16 16
Paid-in capital............................................. 68,687 67,550
Retained earnings (deficit)................................. 4,365 (1,336)
Accumulated other comprehensive income (losses)............. (53) (5)
Stock subscriptions receivable.............................. (65) (149)
-------- --------
Total stockholders' equity........................ 72,950 66,076
-------- --------
Total liabilities and stockholders' equity........ $109,257 $100,449
======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
8
<PAGE> 40
CONSOLIDATED STATEMENTS OF CASH FLOWS
IN THOUSANDS
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
---------------------------------
1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income (loss)......................................... $ 5,701 $ 1,255 $ (3,148)
Adjustments to reconcile to net cash (used) provided by
operating activities:
Depreciation and amortization.......................... 4,958 5,116 2,062
Deferred income taxes.................................. 752 (510) 25
Unusual item........................................... -- -- 6,600
Other.................................................. (487) 251 110
Changes in assets and liabilities:
Trade and other receivables.......................... (1,453) (9,610) (1,073)
Work-in-progress..................................... (5,838) 200 (969)
Prepaid and other assets, net........................ (538) (2,225) (494)
Accounts payable..................................... 1,067 (4,090) 245
Customer advances.................................... (1,680) 540 (943)
Other accrued liabilities............................ (1,049) (3,921) (48)
-------- -------- --------
Net cash provided (used) by operating
activities...................................... 1,433 (12,994) 2,367
-------- -------- --------
Cash flows from investing activities:
Purchase of property and equipment........................ (14,147) (10,929) (7,609)
Acquisition of L.A.B., net of cash acquired............... -- -- (2,206)
Acquisition of KCAS, net of cash acquired................. (4,008) -- --
Short-term investment..................................... -- 3,961 (3,961)
Other..................................................... (34) (376) 31
-------- -------- --------
Net cash used by investing activities............. (18,189) (7,344) (13,745)
-------- -------- --------
Cash flows from financing activities:
Net proceeds (payments) short-term debt................... 773 3,269 (2,656)
Proceeds from long-term borrowings........................ -- 1,128 --
Payments on long-term borrowings.......................... (617) (633) (565)
Issuance of common stock.................................. 1,080 600 44,794
Dividends................................................. -- -- (1,051)
-------- -------- --------
Net cash provided by financing activities......... 1,236 4,364 40,522
-------- -------- --------
Net (decrease) increase in cash and cash equivalents........ (15,520) (15,974) 29,144
Effect of exchange rate changes on cash..................... 103 (32) --
Cash and cash equivalents, beginning of period.............. 26,219 42,225 13,081
-------- -------- --------
Cash and cash equivalents, end of period.......... $ 10,802 $ 26,219 $ 42,225
======== ======== ========
Supplemental information, cash paid for:
Interest.................................................. $ 887 $ 870 $ 402
Income taxes.............................................. $ 1,977 $ 1,378 $ 1,945
</TABLE>
The accompanying notes are an integral part of these financial statements.
9
<PAGE> 41
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
IN THOUSANDS, EXCEPT PER SHARE AMOUNT
<TABLE>
<CAPTION>
ACCUMULATED RETAINED
COMMON STOCK CLASS B STOCK OTHER EARNINGS
--------------- ---------------- PAID-IN COMPREHENSIVE (ACCUMULATED
SHARES AMOUNT SHARES AMOUNT CAPITAL(1) INCOME DEFICIT) TOTAL
------ ------ ------- ------ ---------- ------------- ------------ -------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance, December 31,
1995................... 447 $ 150 9,993 $ 171 $21,510 $ -- $ 308 $22,139
------ ----- ------- ----- ------- ---- ------- -------
Dividend adjustment...... -- -- -- -- -- -- 249 249
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 -- -- 44,791
Conversion to common
stock:................. --
Preferred stock (883
shares)................ 2,636 3 -- -- -- -- -- 3
Class B common stock..... 10,098 10 (10,098) (10) -- -- -- --
Stock options
exercised.............. -- -- -- -- 3 -- -- 3
Deferred compensation
earned................. -- -- -- -- 110 -- -- 110
Net loss................. -- -- -- -- -- -- (3,148) (3,148)
------ ----- ------- ----- ------- ---- ------- -------
Balance, December 31,
1996................... 16,286 16 -- -- 66,722 -- (2,591) 64,147
------ ----- ------- ----- ------- ---- ------- -------
Stock options
exercised.............. 10 -- -- -- 75 -- -- 75
Stock option tax
benefits............... -- -- -- -- 525 -- -- 525
Stock award
forfeitures............ (1) -- -- -- -- -- -- --
Deferred compensation
earned................. -- -- -- -- 228 -- -- 228
Currency translation
adjustment............. -- -- -- -- -- (5) -- (5)
Net income............... -- -- -- -- -- -- 1,255 1,255
-------
Total comprehensive
income................. 1,250
------ ----- ------- ----- ------- ---- ------- -------
Balance, December 31,
1997................... 16,295 16 -- -- 67,550 (5) (1,336) 66,225
------ ----- ------- ----- ------- ---- ------- -------
Stock issued in
acquisition of KCAS.... 27 -- -- -- 291 -- -- 291
Stock options
exercised.............. 69 -- -- -- 602 -- -- 602
Stock option tax
benefits............... -- -- -- -- 99 -- -- 99
Stock award
forfeitures............ -- -- -- -- (6) -- -- (6)
Deferred compensation
earned................. -- -- -- -- 151 -- -- 151
Currency translation
adjustment............. -- -- -- -- -- (48) -- (48)
Net income............... -- -- -- -- -- -- 5,701 5,701
-------
Total comprehensive
income................. 5,653
------ ----- ------- ----- ------- ---- ------- -------
Balance, December 31,
1998................... 16,391 $ 16 -- $ -- $68,687 $(53) $ 4,365 $73,015
====== ===== ======= ===== ======= ==== ======= =======
</TABLE>
The accompanying notes are an integral part of these financial statements.
10
<PAGE> 42
APPLIED ANALYTICAL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION
The Company is a multinational provider of contract research services with
its principal offices in the United States and Germany. The majority of revenues
are earned in the fee-for-service business as explained in Note 10, and a
portion of the Company's resources are devoted to research and development of
new products. Major customers are large and small pharmaceutical companies.
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 intercompany transactions have been eliminated. The
Company has ownership of approximately 40%, on a fully diluted basis, of
Endeavor Pharmaceuticals Inc. ("Endeavor") which is accounted for under the
equity method.
REVENUE RECOGNITION
Revenues from fee-for-service contracts are recognized generally on a
percentage-of-completion basis as the work is performed. Licensing revenues are
recognized generally 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
Income taxes have been provided using the liability method in accordance
with Financial Accounting Standards Board ("FASB") Statement No. 109 "Accounting
for Income Taxes". Deferred tax assets and liabilities are recognized for the
expected tax consequences of temporary differences between the tax bases of
assets and liabilities and their reported amounts.
EARNINGS PER SHARE
Basic earnings per share are based on the weighted average number of common
shares outstanding during the year. The weighted average number of common shares
outstanding was approximately 16,322,000, 16,290,000 and 12,039,000 in 1998,
1997 and 1996, respectively. Diluted earnings per share were computed assuming
that the weighted average number of shares was increased by the conversion of
stock options issued to employees and members of the Company's Board of
Directors. The diluted per share amounts reflect a change in the number of
shares outstanding (the "denominator") to include the options as if they were
converted to shares and issued. In each year presented, the net income (the
"numerator") is the same for both basic and diluted per share computations. The
following table provides a reconciliation of the denominators for
11
<PAGE> 43
APPLIED ANALYTICAL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
the basic and diluted earnings per share computations for each of the years
ended December 31 (In thousands):
<TABLE>
<CAPTION>
1998 1997 1996
------ ------ ------
<S> <C> <C> <C>
Basic Earnings per Share:
Weighted average number of shares......................... 16,322 16,290 12,039
Effect of Dilutive Securities:
Employee and Director stock options....................... 95 169 --
------ ------ ------
Diluted Earnings per Share:
Adjusted weighted average number of shares and assumed
conversions............................................ 16,417 16,459 12,039
====== ====== ======
</TABLE>
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments purchased with a
maturity of three months or less to be cash equivalents. Cash pledged as
security has been included in cash as described in Note 4.
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. Leasehold improvements are amortized over the lesser of the
asset life or the lease term. Depreciation expense was approximately $4.2
million, $4.4 million and $2.0 million for the years ending December 31, 1998,
1997 and 1996, respectively.
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. At December 31, 1998
and 1997, the amounts for accumulated amortization of goodwill were
approximately $806,000 and $694,000 respectively. 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. At December 31, 1998 and
1997, the amounts of accumulated amortization of other intangibles were
approximately $446,000 and $228,000 respectively.
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.
The carrying values of goodwill, intangibles and other assets are reviewed
if the facts and circumstances indicate potential impairment of their carrying
value. Any impairment in the carrying value of such assets is recorded when
identified.
FOREIGN CURRENCY TRANSLATION
The financial statements of foreign subsidiaries have been translated into
U.S. dollars in accordance with FASB Statement No. 52 "Foreign Currency
Translation". All balance sheet accounts have been translated using the exchange
rates in effect at the balance sheet date. Income statement amounts have been
translated
12
<PAGE> 44
APPLIED ANALYTICAL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
using the average exchange rate for the year. The gains and losses resulting
from the changes in exchange rates from year to year have been reported in other
comprehensive income. The effect on the statements of income of transaction
gains and losses is insignificant for all years presented.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
During 1998, the FASB issued Statement No. 130 "Reporting Comprehensive
Income". The statement requires the Company to provide disclosure of all changes
in equity resulting from recognized transactions of the period other than
transactions with owners. The FASB also issued Statement No. 131 "Disclosures
about Segments of an Enterprise and Related Information". This statement
requires that the Company disclose certain information about its major business
lines, as well as certain geographic information. The Company has adopted both
statements.
In June 1998, the FASB issued Statement No. 133 "Accounting for Derivative
and Hedging Activities" which is required to be adopted in years beginning after
June 15, 1999. Because of the Company's minimal use of derivatives, if any,
management does not anticipate that the adoption of this statement will have a
material impact on net earnings or the financial position of the Company.
STOCK BASED COMPENSATION
The Company grants stock options to certain employees with an exercise
price equal to the fair market value at the date of grant. The Company accounts
for stock option grants in accordance with APB Opinion No. 25, "Accounting for
Stock Issued to Employees". Because the exercise price of the stock options
equals the market price of the underlying stock on the date of grant, no
compensation expense is recognized.
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 investments, 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.
2. ACQUISITIONS AND UNUSUAL ITEM
KANSAS CITY ANALYTICAL SERVICES, INC.
On September 14, 1998, the Company acquired all of the outstanding equity
of Kansas City Analytical Services, Inc. (KCAS), a bioanalytical and
pharmaceutical analysis laboratory located near Kansas City, Kansas. The
acquisition has been accounted for using the purchase method of accounting. The
aggregate purchase price was approximately $5.5 million, consisting of cash
($5.2 million) and the issuance of 26,642 shares of common stock. The excess of
the purchase price over the fair value of the assets acquired was $1.5 million
and has been recorded as goodwill which is being amortized on a straight line
basis over 20 years. Accordingly, the results of KCAS's operations have been
included in the Company's consolidated results from the date of acquisition.
13
<PAGE> 45
APPLIED ANALYTICAL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
L.A.B. GESELLSCHAFT FUR PHARMAKOLOGISCHE UNTERSUCHUNGEN MBH & CO.
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 $20.5 million,
which included 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 original goodwill of approximately $12.8 million which is being
amortized on a straight-line basis over 20 years. Goodwill was adjusted during
1997 by approximately $2.0 million 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 and 1998.
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, L.A.B. and KCAS as if the acquisitions had occurred on
January 1, 1996. 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,
------------------------------
1998 1997 1996
-------- -------- --------
IN THOUSANDS, EXCEPT PER SHARE
AMOUNTS (UNAUDITED)
<S> <C> <C> <C>
Net sales................................................. $85,363 $71,204 $67,557
Net income (loss)......................................... 6,075 1,288 (7,710)
Diluted earnings (loss) per share......................... .37 .08 (.64)
</TABLE>
3. INCOME TAXES
The following table presents the components for the provision for income
taxes.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------
1998 1997 1996
------ ------ -------
IN THOUSANDS
<S> <C> <C> <C>
Income (loss) before income taxes:
United States............................................. $8,368 $2,165 $ 5,554
Non-U.S................................................... 202 (129) (6,600)
------ ------ -------
Net income before taxes........................... $8,570 $2,036 $(1,046)
====== ====== =======
Provision for income taxes:
Current:
Federal................................................ $1,972 $1,228 $ 1,709
Non-U.S................................................ 31 63 --
State.................................................. 135 -- 368
------ ------ -------
Total current taxes............................... $2,138 $1,291 $ 2,077
------ ------ -------
</TABLE>
14
<PAGE> 46
APPLIED ANALYTICAL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------
1998 1997 1996
------ ------ -------
IN THOUSANDS
<S> <C> <C> <C>
Deferred:
Federal................................................ $ 627 $ (365) $ 18
Non-U.S................................................ -- -- --
State.................................................. 104 (145) 7
------ ------ -------
Total deferred taxes.............................. $ 731 $ (510) $ 25
====== ====== =======
Total income taxes................................ $2,869 $ 781 $ 2,102
====== ====== =======
</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,
-------------------------
1998 1997 1996
------ ------ -------
IN THOUSANDS
<S> <C> <C> <C>
Income (loss) before income taxes........................... $8,570 $2,036 $(1,046)
------ ------ -------
Tax expense (benefit) using statutory U.S. income tax rate
of 34%.................................................... 2,914 692 (356)
State income taxes, net..................................... 194 (96) 247
Permanent items, net........................................ 198 286 35
Research and Development credits............................ (400) (411) (173)
Non-U.S. operations, net.................................... (37) 107 --
Write-off of in-process R&D................................. -- -- 2,244
Other, net.................................................. -- 203 105
------ ------ -------
Provision for income taxes........................ $2,869 $ 781 $ 2,102
====== ====== =======
</TABLE>
Deferred income taxes arise from temporary differences between the tax
bases of assets and liabilities and their reported amounts in the financial
statements. Deferred taxes are included in prepaids and other current assets and
other accrued liabilities. The following table presents the deferred tax assets
and deferred tax liability.
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------
1998 1997
------- -------
IN THOUSANDS
<S> <C> <C>
Deferred tax assets, resulting from:
Accrued liabilities....................................... $ 84 $ 272
Accounts receivable....................................... 299 483
Write-off of in-process R&D............................... 2,740 2,826
Non-U.S. net operating losses............................. 1,918 1,745
Tax credits............................................... -- 226
Other items............................................... 345 139
Deferred tax liability, resulting from:
Property and equipment.................................... (957) (619)
Valuation allowances on tax assets.......................... (4,658) (4,571)
------- -------
Net deferred tax assets (liability)............... $ (229) $ 501
======= =======
</TABLE>
Valuation allowances have been provided for certain assets resulting from
the L.A.B. acquisition since realization of such assets cannot be predicted with
reasonable certainty at this time.
15
<PAGE> 47
APPLIED ANALYTICAL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
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,
---------------
1998 1997
------ ------
IN THOUSANDS
<S> <C> <C>
Industrial revenue bonds.................................... $ 900 $1,125
Bank debt................................................... 5,117 3,778
Current maturities of long-term debt........................ 610 658
------ ------
Total short-term debt and current maturities of
long-term debt.................................. $6,627 $5,561
====== ======
</TABLE>
The following table presents the components of long-term debt.
<TABLE>
<CAPTION>
DECEMBER 31,
---------------
1998 1997
------ ------
IN THOUSANDS
<S> <C> <C>
Bank term loans............................................. $6,916 $7,180
Other....................................................... -- 56
------ ------
Total long-term debt.............................. $6,916 $7,236
====== ======
Less current maturities of long-term debt................... $ (610) $ (658)
------ ------
Total long-term debt due after one year........... $6,306 $6,578
====== ======
</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, 1998 and 1997 were 4.15% and 4.35%, 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.
The bank term loans include approximately $2.1 million and $2.7 million
with a U.S. bank as of December 31, 1998 and 1997 respectively. 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
6.9% and 7.2% for 1998 and 1997, respectively. The bank term loans also include
approximately 8 million Deutsche marks, as of December 31, 1998 and 1997. This
amount represents a subsidiary's note payable to a German bank, which is due in
March 2000 with interest payable quarterly at 4.85%. AAI has issued a stand-by
letter of credit to this bank to cover borrowings outstanding. Approximately
$6.8 million of cash is held in certificates of deposit, pledged as security for
the letter of credit.
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 are be based on the 30-day LIBOR rate and can be reduced or increased
depending on certain financial ratios of the Company at the end of each quarter.
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, 1998 or 1997.
16
<PAGE> 48
APPLIED ANALYTICAL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
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, 1998.
Scheduled maturities of long-term debt as of December 31, 1998 are
$610,000 -- 1999; $5,405,000 -- 2000; $458,000 -- 2001; and $443,000 -- 2002.
5. STOCKHOLDERS' EQUITY
The authorized capital stock of the Company at December 31, 1998 and 1997
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, 1998 or 1997. The Company has reserved 2,057,636 shares of common
stock for issuance under stock option plans.
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.
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 was
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 1,644,000 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.
17
<PAGE> 49
APPLIED ANALYTICAL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
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, 1997................................ 442,755 $ 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
--------- ------
Granted..................................................... 977,100 13.02
Exercised................................................... (76,679) 9.02
Forfeited................................................... (199,245) 11.87
--------- ------
Outstanding, December 31, 1998.............................. 1,383,528 12.61
--------- ------
Exercisable, December 31, 1998.............................. 207,242 $10.84
</TABLE>
Information regarding stock options outstanding at December 31, 1998 is
summarized in the table below.
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
----------------------- ----------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
SHARES REMAINING EXERCISE SHARES EXERCISE
RANGE OF EXERCISE PRICES OUTSTANDING LIFE PRICE EXERCISABLE PRICE
- ------------------------ ----------- --------- -------- ----------- --------
<S> <C> <C> <C> <C> <C>
$ 8.350 - $12.720 346,596 8.38 $10.413 139,920 $ 9.240
$12.813 770,400 9.34 12.813 -- --
$13.625 - $22.000 266,532 8.69 14.854 67,322 14.159
--------- ---- ------- ------- -------
$ 8.350 - $22.000 1,383,528 8.98 12.605 207,242 10.838
</TABLE>
The weighted average fair value in excess of the exercise price at date of
grant for options granted during 1998 and 1997 was $6.87 and $7.84 per option,
respectively. The fair value of options 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 (5.1% -- 1998, 5.9
% -- 1997); volatility factor (55% -- 1998, 54% -- 1997) and dividend yield
(none).
18
<PAGE> 50
APPLIED ANALYTICAL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
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>
YEARS ENDED DECEMBER 31,
-------------------------
1998 1997 1996
------ ------ -------
(IN THOUSANDS, EXCEPT PER
SHARE AMOUNTS)
<S> <C> <C> <C>
Net income (loss):
As reported............................................... $5,701 $1,255 $(3,148)
Pro forma................................................. 4,577 771 (3,323)
Earnings (loss) per share:
As reported --
Basic.................................................. 0.35 0.08 (0.26)
Diluted................................................ 0.35 0.08 (0.26)
Pro forma --
Basic.................................................. 0.28 0.05 (0.28)
Diluted................................................ 0.28 0.05 (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 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 $1.6 million, $3.2 million and $6.2 million (15% of AAI net sales)
for the years ended December 31, 1998, 1997 and 1996, 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 in accounts receivable at December 31, 1997 and approximately $1.6
million and $184,000 in work-in-progress related to Endeavor at December 31,
1998 and 1997, respectively.
19
<PAGE> 51
APPLIED ANALYTICAL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
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 through the
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 $0.2 million, $1.9 million and $4.7 million (11% of AAI
net sales) from Aesgen for the years ended December 31, 1998, 1997 and 1996,
respectively. AAI also had accounts receivable of approximately $555,000 from
Aesgen at December 31, 1997, and work-in-progress of approximately $145,000 and
$97,000 at December 31, 1998 and 1997 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.
7. SUPPLEMENTAL BALANCE SHEET INFORMATION
The following table presents the components of accounts receivable.
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------
1998 1997
------- -------
IN THOUSANDS
<S> <C> <C>
Trade and other:
Billed.................................................... $18,395 $13,496
Unbilled.................................................. 3,195 3,161
Related parties........................................... 980 2,867
------- -------
Total accounts receivable................................... 22,570 19,524
Allowance for doubtful accounts............................. (440) (109)
------- -------
Total accounts receivable, net.................... $22,130 $19,415
======= =======
</TABLE>
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 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.
20
<PAGE> 52
APPLIED ANALYTICAL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following table presents the components of property and equipment.
<TABLE>
<CAPTION>
DECEMBER 31,
-------------------
1998 1997
-------- --------
IN THOUSANDS
<S> <C> <C>
Land........................................................ $ 990 $ 945
Buildings and improvements.................................. 14,491 10,882
Machinery and equipment..................................... 42,116 27,295
Construction-in-progress.................................... 4,801 1,586
-------- --------
Total cost of property and equipment........................ 62,398 40,708
Less, accumulated depreciation.............................. (24,798) (15,382)
-------- --------
Property and equipment, net....................... $ 37,600 $ 25,326
======== ========
</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 Company has expensed $300,000, $219,000 and $557,000 for the years ended
December 31, 1998, 1997 and 1996, 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, 1998, 1997 and 1996 was $2.5 million, $2.8
million, and $1.3 million, respectively. Future minimum rentals due under lease
agreements as of December 31, 1998 are $3.2 million -- 1999; $2.9
million -- 2000; $2.5 million -- 2001; $1.8 million -- 2002; $1.8
million -- 2003 and $8.3 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.
The Company has entered into an agreement with two banks which allows the
Company to lease a facility being built in Wilmington, North Carolina, adjacent
to the Company's laboratories. When the facility is complete, the Company will
enter into an operating lease for an initial period of 3 years with 2 one year
renewal periods. At the end of the initial term, the Company may elect to
purchase the facility at fair market value, extend the lease or the property may
be sold.
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
21
<PAGE> 53
APPLIED ANALYTICAL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
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 general corporate overhead costs
and goodwill amortization, which are not directly attributable to a business
segment.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------
1998 1997 1996
-------- -------- --------
(IN THOUSANDS)
<S> <C> <C> <C>
NET SALES:
Fee-for-service...................................... $ 73,126 $ 59,631 $ 40,624
Product Development.................................. 7,254 5,770 1,538
-------- -------- --------
80,380 65,401 42,162
-------- -------- --------
United States........................................ 60,331 47,959 42,162
Non-U.S.............................................. 22,102 18,862 --
Less inter-geographic sales.......................... (2,053) (1,420) --
-------- -------- --------
80,380 65,401 42,162
-------- -------- --------
INCOME (LOSS) FROM OPERATIONS:
Fee-for-service...................................... 9,217 4,965 8,779
Product development.................................. 1,123 (2,021) (9,278)
Corporate............................................ (2,207) (2,281) (1,041)
-------- -------- --------
8,133 663 (1,540)
-------- -------- --------
United States........................................ 8,348 1,799 5,060
Non-US............................................... (215) (1,136) (6,600)
-------- -------- --------
8,133 663 (1,540)
-------- -------- --------
TOTAL ASSETS:
Fee-for-service...................................... 64,253 54,670 42,961
Product Development.................................. 4,874 5,812 4,378
Corporate............................................ 40,130 39,967 57,139
-------- -------- --------
109,257 100,449 104,478
-------- -------- --------
United States........................................ 81,532 78,328 82,529
Non-U.S.............................................. 27,725 22,121 21,949
-------- -------- --------
109,257 100,449 104,478
-------- -------- --------
</TABLE>
11. SUBSEQUENT EVENT
On March 16, 1999, the Company merged with Medical and Technical Research
Associates, Inc., (MTRA) a clinical research organization located near Boston,,
Massachusetts for approximately 1.3 million shares of stock including conversion
of MTRA stock options. The merger will be accounted for as a pooling-
of-interests, and accordingly, historical financial information will be restated
in future periods to include MTRA data. The following table reflects the
unaudited combined results of continuing operations of the Company and MTRA as
though the merger would have occurred on January 1, 1996. The results include
only the results of other acquisitions (referred to in Note 2) form the date of
purchase forward.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------
1998 1997 1996
-------- -------- --------
IN THOUSANDS, EXCEPT PER SHARE
AMOUNTS (UNAUDITED)
<S> <C> <C> <C>
Net sales................................................. $98,243 $80,106 $53,728
Net income (loss)......................................... 6,539 1,866 (2,462)
Diluted earnings (loss) per share......................... 0.37 0.10 (0.18)
</TABLE>
22
<PAGE> 54
REPORT OF INDEPENDENT AUDITORS
Applied Analytical Industries, Inc.
The Board of Directors and Shareholders of Applied Analytical Industries, Inc.
We have audited the consolidated balance sheet of Applied Analytical
Industries, Inc. and subsidiaries (the "Company") as of December 31, 1998, and
the related consolidated statements of income, shareholders' equity, and cash
flows for the year then ended. 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 audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards 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. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Applied
Analytical Industries, Inc. and subsidiaries at December 31, 1998, and the
consolidated results of their operations and their cash flows for the year then
ended in conformity with generally accepted accounting principles.
ERNST & YOUNG LLP
Raleigh, North Carolina
February 12, 1999,
except Note 11, as to which
the date is March 16, 1999
23
<PAGE> 55
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of
Applied Analytical Industries, Inc.
In our opinion, the accompanying consolidated balance sheet 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 the
results of their operations and their cash flows for each of the two 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 presentation. We believe that our audits provide a reasonable basis
for the opinion expressed above. We have not audited the consolidated financial
statements of the Company for any period subsequent to December 31, 1997.
PRICEWATERHOUSECOOPERS LLP
Raleigh, North Carolina
March 18, 1998
24
<PAGE> 56
FINANCIAL RESULTS BY QUARTER (UNAUDITED)
IN THOUSANDS, EXCEPT PER SHARE AMOUNTS
<TABLE>
<CAPTION>
QUARTER
-------------------------------------
FIRST SECOND THIRD FOURTH
------- ------- ------- -------
<S> <C> <C> <C> <C>
1998
Net sales................................................. $17,113 $19,426 $20,138 $23,703
Gross profit.............................................. 8,616 10,461 10,284 11,057
Net income (loss)......................................... 1,073 1,306 1,413 1,909
Basic earnings (loss) per share........................... 0.07 0.08 0.09 0.12
Diluted earnings (loss) per share......................... 0.07 0.08 0.09 0.12
1997
Net sales................................................. 15,175 15,814 14,021 20,391
Gross profit.............................................. 7,684 8,248 6,027 10,064
Net income (loss)......................................... 910 583 (1,164) 926
Basic earnings (loss) per share........................... 0.06 0.04 (0.07) 0.06
Diluted earnings (loss) per share......................... 0.06 0.04 (0.07) 0.06
</TABLE>
Price range of common stock, traded on the NASDAQ market under the symbol
"AAII"(1):
<TABLE>
<S> <C> <C> <C> <C>
1998
High........................................................ $19 1/8 $16 1/8 $14 5/8 $18 3/4
Low......................................................... 13 1/4 9 9 5/8 10
1997
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
</TABLE>
- ---------------
(1) The Company estimates there were approximately 1,200 holders of record for
its common stock as of February 28, 1999. The Company has not declared any
cash dividends during 1998 or 1997.
25
<PAGE> 57
REVOCABLE PROXY APPLIED ANALYTICAL INDUSTRIES, INC.
ANNUAL MEETING OF STOCKHOLDERS
TO BE HELD ON MAY 19, 1999
THIS PROXY IS SOLICITED ON BEHALF OF THE BOARD OF DIRECTORS.
The undersigned hereby appoints R. Forrest Waldon and Albert N. Cavagnaro as
Proxies, each with the power to appoint his substitute, and hereby authorizes
each of them to represent and to vote, as designated below, all the shares of
common stock of Applied Analytical Industries, Inc. (the "Company") held of
record by the undersigned on April 8, 1999 at the annual meeting of stockholders
to be held on May 19, 1999 or any adjournment thereof.
1. ELECTION OF DIRECTORS
<TABLE>
<S> <C>
[ ] FOR the nominees listed below [ ] WITHHOLD AUTHORITY
(except as marked to the contrary below) to vote for the nominees listed below
</TABLE>
(INSTRUCTION: TO WITHHOLD AUTHORITY TO VOTE FOR A NOMINEE, STRIKE A LINE THROUGH
THE NOMINEE'S NAME IN THE LIST BELOW.)
Joseph H. Gleberman
John M. Ryan
2. PROPOSAL TO RATIFY THE APPOINTMENT OF ERNST & YOUNG LLP as the independent
accountants for the Company for the fiscal year ending December 31, 1999.
[ ] FOR [ ] AGAINST [ ] ABSTAIN
3. In their discretion, the Proxies are authorized to vote upon such other
business as may properly come before the meeting.
PLEASE SIGN AND DATE ON THE REVERSE SIDE AND RETURN IN THE ENCLOSED
POSTAGE-PREPAID ENVELOPE.
THE BOARD OF DIRECTORS RECOMMENDS A VOTE FOR THE PROPOSAL AND THE ELECTION OF
THE DIRECTOR NOMINEES NAMED HEREIN, AND THIS PROXY WILL BE VOTED FOR THE
PROPOSAL AND FOR THE ELECTION OF THE DIRECTOR NOMINEES NAMED HEREIN UNLESS THE
STOCKHOLDER DIRECTS OTHERWISE, IN WHICH CASE IT WILL BE VOTED AS DIRECTED.
The undersigned acknowledges receipt of the Notice of Annual Meeting and Proxy
Statement dated April 15, 1999, and revokes all proxies heretofore given by the
undersigned.
PLEASE SIGN EXACTLY AS NAME APPEARS BELOW. WHEN SHARES ARE HELD BY JOINT
TENANTS, BOTH SHOULD SIGN. WHEN SIGNING AS ATTORNEY, AS EXECUTOR, ADMINISTRATOR,
TRUSTEE OR GUARDIAN, PLEASE GIVE FULL TITLE AS SUCH. IF A CORPORATION, PLEASE
SIGN IN FULL CORPORATE NAME BY PRESIDENT OR OTHER AUTHORIZED OFFICER. IF A
PARTNERSHIP, PLEASE SIGN IN PARTNERSHIP NAME BY AUTHORIZED PERSON.
Dated:
------------------------ , 1999
-------------------------------
Signature
-------------------------------
Signature if held jointly
PLEASE MARK, SIGN, DATE AND
RETURN THE PROXY CARD PROMPTLY
USING THE ENCLOSED
POSTAGE-PREPAID ENVELOPE.
