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QUINTILES TRANSNATIONAL HOLDINGS INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Cautionary Statement for Forward-Looking Information You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our condensed consolidated financial statements and the notes thereto included elsewhere in this Quarterly Report on Form 10-Q and with our audited consolidated financial statements and the notes thereto included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013. In addition to historical condensed consolidated financial information, the following discussion contains forward-looking statements that reflect, among other things, our current expectations and anticipated results of operations, all of which are subject to known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements, market trends, or industry results to differ materially from those expressed or implied by such forward-looking statements. Therefore, any statements contained herein that are not statements of historical fact may be forward-looking statements and should be evaluated as such. Without limiting the foregoing, the words "anticipates," "believes," "estimates," "expects," "intends," "may," "plans," "projects," "should," "targets," "will" and the negative thereof and similar words and expressions are intended to identify forward-looking statements. We assume no obligation to update any such forward-looking information to reflect actual results or changes in the factors affecting such forward-looking information. We caution you that any such forward-looking statements are further qualified by important factors that could cause our actual operating results to differ materially from those in the forward-looking statements, including without limitation, that most of our contracts may be terminated on short notice, and we may be unable to maintain large customer contracts or to enter into new contracts; our financial results may be adversely affected if we underprice our contracts, overrun our cost estimates or fail to receive approval for or experience delays in documenting change orders; the historical indications of the relationship of our backlog to revenues may not be indicative of their future relationship; we may be unable to maintain our information systems or effectively update them; customer or therapeutic concentration could harm our business; our business is subject to risks associated with international operations, including economic, political and other risks, such as compliance with a myriad of laws and regulations, complications from conducting clinical trials in multiple countries simultaneously and changes in exchange rates; the market for our services may not grow as we expect; government regulators or our customers may limit the scope of prescription or withdraw products from the market, and government regulators may impose new regulatory requirements or may adopt new regulations affecting the biopharmaceutical industry; we may be unable to successfully develop and market new services or enter new markets; our failure to perform services in accordance with contractual requirements, regulatory standards and ethical considerations may subject us to significant costs or liability, which could also damage our reputation and cause us to lose existing business or not receive new business; our services are related to treatment of human patients, and we could face liability if a patient is harmed; we may be unable to successfully identify, acquire and integrate businesses, services and technologies; and we have substantial indebtedness and may incur additional indebtedness in the future, which could adversely affect our financial condition. For a further discussion of the risks relating to our business, see "Risk Factors" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013. Overview We are the world's largest provider of biopharmaceutical development services and commercial outsourcing services. We are positioned at the intersection of business services and healthcare and conduct business in approximately 100 countries with approximately 32,100 employees. We use the breadth and depth of our service offerings, our global footprint and our therapeutic, scientific and analytics expertise to help our biopharmaceutical customers, as well as other healthcare customers, to be more successful in an increasingly complex healthcare environment. Our business is currently organized in two reportable segments, Product Development and Integrated Healthcare Services. For the three months ended September 30, 2014, our service revenues increased $128.3 million, or 13.8%, at actual foreign exchange rates compared to the same period last year. Our growth in service revenues, excluding the impact of foreign currency fluctuations ("constant currency"), was 14.0%, with 7.9% growth in the Product Development segment and 33.9% growth in the Integrated Healthcare Services segment. For the nine months ended September 30, 2014, our service revenues increased $297.4 million, or 10.6%, to $3.1 billion at actual foreign exchange rates compared to the same period last year. The year to date growth in service revenues on a constant currency basis was 10.3%, with 7.7% growth in the Product Development segment and 18.9% growth in the Integrated Healthcare Services segment. Income from operations was $149.1 million, net income attributable to Quintiles Transnational Holdings Inc. was $92.7 million and diluted earnings per share was $0.71 for the three months ended September 30, 2014. Income from operations was $431.5 million, net income attributable to Quintiles Transnational Holdings Inc. was $268.0 million and diluted earnings per share was $2.03 for the nine months ended September 30, 2014. 16 -------------------------------------------------------------------------------- Table of Contents Net new business was $1,512 million and $4,014 million for the three and nine months ended September 30, 2014, respectively. This net new business contributed to an ending backlog of $10,746 million at September 30, 2014. "Net new business" and "backlog" are defined under "Net New Business Reporting and Backlog" below. Product Development Product Development provides services and expertise that allow biopharmaceutical companies to outsource the clinical development process from first-in-man trials to post-launch monitoring. Our comprehensive service offerings provide the support and functional expertise necessary at each stage of development, as well as the systems and analytical capabilities to help our customers improve product development efficiency and effectiveness. Product Development is comprised of clinical solutions and services and consulting. Clinical solutions and services provides services necessary to develop biopharmaceutical products. These services include project management and clinical monitoring functions for conducting multi-site trials (generally Phase II-IV) (collectively "core clinical"). These also include clinical trial support services that improve clinical trial decision-making, such as global laboratories, data management, biostatistical, safety and pharmacovigilance, early clinical development trials (generally Phase I), and strategic planning and design services, which help improve decisions and performance. We also provide functional services that cover a range of areas. Consulting provides strategy and management consulting services based on life science expertise and advanced analytics, as well as regulatory and compliance consulting services. Integrated Healthcare Services Integrated Healthcare Services provides a broad array of services including commercial services, such as providing contract pharmaceutical sales forces in key geographic markets, as well as a growing number of healthcare business services for the broader healthcare sector. Our customized commercialization services are designed to accelerate the commercial success of biopharmaceutical and other health-related products. Service offerings include commercial services (sales representatives, strategy, marketing communications and other areas related to commercialization), real-world and late phase research (drug therapy analysis, real-world research and evidence-based medicine, including research studies to prove a drug's value), other healthcare services (comparative and cost-effectiveness research capabilities, decision support services, medication adherence and health outcome optimization services, and web-based systems for measuring quality improvement), and electronic health record implementation and advisory services. On July 1, 2014, we completed the acquisition of Encore Health Resources, LLC, or Encore, for approximately $91.5 million in cash (net of approximately $2.2 million of acquired cash). Reimbursed Expenses Reimbursed expenses may fluctuate from period to period due, in part, to where we are in the lifecycle of the many contracts that are in progress at a particular point in time. For instance, these pass-through costs tend to be higher during the early phases of clinical trials as a result of patient recruitment efforts. As reimbursed expenses are pass-through costs to our customers with little to no profit to us, we believe that the fluctuations in reimbursed expenses from period to period are not meaningful to our underlying performance and we do not provide analysis of the fluctuation in these items or their impact on our financial results. Foreign Currency Fluctuations The impact from foreign currency fluctuations and constant currency information assumes constant foreign currency exchange rates based on the rates in effect for the comparable prior-year period were used in translation. We believe that providing the impact of fluctuations in foreign currency rates on certain financial results can facilitate analysis of period-to-period comparisons of business performance. Results of Operations Backlog and Net New Business We began 2014 with backlog of $9,855 million, which was 13% higher than at the beginning of 2013. Backlog at September 30, 2014 was $10,746 million. 17-------------------------------------------------------------------------------- Table of Contents Net new business grew 13% in the third quarter of 2014 to $1,512 million from $1,341 million in third quarter of 2013, driven by growth in Product Development. Product Development's net new business increased 47% to $1,268 million in the third quarter of 2014 as compared to $862 million for the same period in 2013, led by higher growth in net new business primarily related to the renewal of a five year contract for clinical and data management functional resourcing services as well as net new business generated from the acquisition of Novella Clinical Inc., or Novella, that was completed in the third quarter of 2013. Integrated Healthcare Services' net new business decreased 49% to $244 million in the third quarter of 2014 as compared to $479 million for the same period in 2013, primarily related to lower contract signings for commercial services in North America and Japan. This decline in contract signings is an example of the fluctuation in our net new business levels from period to period resulting from the receipt of a small number of relatively large orders in any given reporting period. Because of the timing of these large orders, our net new business in that reporting period may reach levels above our historical average and may not be sustained in subsequent reporting periods. Net new business grew 12% in the first nine months of 2014 to $4,014 million from $3,600 million in the first nine months of 2013, driven by growth in both Product Development and Integrated Healthcare Services. Product Development's net new business increased 12% to $3,140 million for the first nine months in 2014 as compared to $2,808 million for the same period in 2013, led by higher growth in net new business for functional resourcing business including the renewal of a five year contract for core clinical services and data management services as well as net new business generated from the acquisition of Novella that was completed in the third quarter of 2013. Integrated Healthcare Services' net new business increased 10% to $874 million in the first nine months of 2014 as compared to $792 million for the same period in 2013, related primarily to growth in commercial services in North America as well as an increase in new business from real-world and late phase research services and net new business from the Encore acquisition. Service Revenues Three Months Ended September 30, Change 2014 2013 $ % (dollars in millions) Service revenues $ 1,061.0 $ 932.7 $ 128.3 13.8 % For the three months ended September 30, 2014, our service revenues increased $128.3 million, or 13.8%, as compared to the same period in 2013. This increase is comprised of constant currency service revenue growth of approximately $130.2 million, or 14.0%, and a negative impact of approximately $1.9 million from the effects of foreign currency fluctuations. The constant currency service revenue growth, which includes the impact from the Novella and Encore acquisitions, is comprised of a $56.3 million increase in Product Development and a $73.9 million increase in Integrated Healthcare Services. Nine Months Ended September 30, Change 2014 2013 $ % (dollars in millions) Service revenues $ 3,101.8 $ 2,804.4 $ 297.4 10.6 % For the nine months ended September 30, 2014, our service revenues increased $297.4 million, or 10.6%, as compared to the same period in 2013. This increase is comprised of constant currency service revenue growth of approximately $289.7 million, or 10.3%, and a positive impact of approximately $7.7 million from the effects of foreign currency fluctuations. The constant currency service revenue growth, which includes the impact from the Novella and Encore acquisitions, is comprised of a $165.2 million increase in Product Development and a $124.5 million increase in Integrated Healthcare Services. Costs of Revenue, Service Costs Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 (dollars in millions) Costs of revenue, service costs $ 691.1 $ 600.7 $ 2,009.3 $ 1,829.5 % of service revenues 65.1% 64.4% 64.8% 65.2% When compared to the same period in 2013, service costs in the third quarter of 2014 increased $90.4 million. The increase included a constant currency increase in expenses of approximately $93.8 million, or 15.6%, partially offset by a positive impact of approximately $3.4 million from the effects of foreign currency fluctuations. The constant currency service costs growth was due to incremental costs resulting from the Novella and Encore acquisitions and increases in compensation and related expenses due to annual merit increases and an increase in billable headcount needed to support our higher volume of revenue. These increases in compensation and related expenses were partially offset by efficiencies gained from restructuring activities taken in prior years. 18 -------------------------------------------------------------------------------- Table of Contents When compared to the same period in 2013, service costs in the first nine months of 2014 increased $179.8 million. The increase included a constant currency increase in expenses of approximately $188.8 million, or 10.3%, partially offset by a positive impact of approximately $9.0 million from the effects of foreign currency fluctuations. The constant currency service costs growth was due to incremental costs resulting from the Novella and Encore acquisitions and increases in compensation and related expenses due to (1) annual merit increases, (2) an increase in billable headcount needed to support our higher volume of revenue and (3) a reduction of an accrual for statutory profit sharing of approximately $5.4 million in 2013 as a result of guidance handed down by an administrative court in France. These increases in compensation and related expenses were partially offset by efficiencies gained from restructuring activities taken in prior years. Selling, General and Administrative Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 (dollars in millions) Selling, general and administrative $ 219.0 $ 199.6 $ 657.3 $ 627.7 % of service revenues 20.6% 21.4% 21.2% 22.4% The $19.4 million increase in selling, general and administrative expenses in the third quarter of 2014 included a constant currency increase of $19.0 million, or 9.5%, and an increase of approximately $400,000 from a negative foreign currency impact. The constant currency increase was primarily due to (1) incremental costs from the Novella and Encore acquisitions, (2) an increase in share-based compensation and (3) increases in compensation and related expenses resulting primarily from annual merit increases and an increase in headcount. The $29.6 million increase in selling, general and administrative expenses in the first nine months of 2014 was due to a constant currency increase of $30.1 million, or 4.8%, partially offset by a decrease of approximately $500,000 from a positive foreign currency impact. The constant currency increase was primarily due to (1) incremental costs from the Novella and Encore acquisitions, (2) an increase in share-based compensation and (3) increases in compensation and related expenses resulting primarily from annual merit increases and an increase in headcount. These increases were partially offset by expenses incurred in the first nine months of 2013 that did not recur in 2014 related to a $25.0 million fee paid in connection with the termination of our management agreement with affiliates of certain of our shareholders and a $1.5 million fee paid in connection with the modification of an agreement for the business usage of an airplane owned by GF Management Company, LLC, or GFM, a company controlled by our Executive Chairman. Restructuring Costs Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 (in millions) Restructuring costs $ 1.8 $ 7.2 $ 3.7 $ 11.9 In 2014, our Board of Directors, or our Board, approved restructuring plans of approximately $13 million to better align our resources with our strategic direction. We recognized $1.8 million and $3.7 million of restructuring charges, net of reversals for changes in estimates, during the three and nine months ended September 30, 2014, respectively, which was primarily related to the 2014 restructuring plans. These actions are expected to occur throughout 2014 and are expected to result in severance for approximately 350 positions. We believe that this plan will result in annualized cost savings of approximately $20.0 to $25.0 million. Interest Income and Interest Expense Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 (in millions) Interest income $ (0.6 ) $ (1.1 ) $ (2.9 ) $ (2.4 ) Interest expense $ 25.1 $ 28.8 $ 74.6 $ 96.7 Interest income includes interest received from bank balances and investments. 19 -------------------------------------------------------------------------------- Table of Contents Interest expense during the three and nine months ended September 30, 2014 was lower than the same periods in 2013 in part due to a decrease in the average rate of interest. The average rate of interest on the term loan under our senior secured credit facility during the three and nine months ended September 30, 2014 was 75 basis points lower than it was during the same periods in 2013 due to a reduction in the interest rate pursuant to the terms and conditions in the credit agreement as well as from the refinancing transaction we completed in the fourth quarter of 2013. In addition to the lower average rate of interest, interest expense during the nine months ended September 30, 2014 also benefited from a decrease in the average debt outstanding as a result of the repayment of the $300.0 million term loan, which Quintiles Transnational Holdings Inc. obtained in February 2012 and paid in full in May 2013, the pay down of $50.0 million of outstanding indebtedness under our senior secured credit facilities in May 2013 and the mandatory prepayment of $33.8 million of outstanding indebtedness under our senior secured credit facilities in the first quarter of 2013. Loss on Extinguishment of Debt Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 (in millions) Loss on extinguishment of debt $ - $ - $ - $ 16.5 In May 2013, we recognized a $16.5 million loss on extinguishment of debt related to payment of all amounts outstanding under the $300.0 million term loan and a $50.0 million pay down of outstanding indebtedness under our senior secured credit facilities. The loss on extinguishment of debt included approximately $5.6 million of unamortized debt issuance costs, $4.8 million of unamortized discount and $6.1 million of fees and expenses. Other (Income) Expense, Net Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 (in millions) Other (income) expense, net $ (7.8) $ 3.2 $ (9.6) $ 1.4 Other (income) expense, net for the third quarter of 2014 includes income of approximately $8.8 million related to the change in fair value of contingent consideration from an acquisition, partially offset by other expenses, primarily consisting of $926,000 of foreign currency net losses. Other (income) expense, net for the nine months of 2014 includes income of approximately $8.6 million related to the change in fair value of contingent consideration from an acquisition as well as a gain from the sale of marketable equity securities of approximately $5.0 million, partially offset by other expenses, primarily consisting of $4.3 million of foreign currency net losses. The three and nine months ended September 30, 2013 included income of approximately $1.2 million and $1.4 million, respectively, due to changes in the estimated fair value of contingent consideration from acquisitions, which was more than offset by other expenses, primarily consisting of $4.3 million and $3.4 million of foreign currency net losses, respectively. Income Tax Expense Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 (dollars in millions) Income tax expense $ 41.3 $ 27.5 $ 111.0 $ 68.4 Effective income tax rate 31.1% 29.1% 30.1% 30.7% Due to the potential for expiration of various federal, state, and foreign statutes of limitation, our unrecognized income tax benefits may change within the next 12 months by a range of zero to $16.6 million. Equity in Earnings (Losses) of Unconsolidated Affiliates Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 (in millions) Equity in earnings (losses) of unconsolidated affiliates $ 1.5 $ (0.4) $ 9.8 $ (1.6) Equity in earnings (losses) of unconsolidated affiliates for both the three and nine month periods of 2014 increased as compared to the same periods in 2013 primarily due to gains from our investment in the NovaQuest Pharma Opportunities Fund III, L.P. 20 -------------------------------------------------------------------------------- Table of Contents Segments Service revenues and income from operations by segment are as follows (dollars in millions): Three Months Ended September 30, 2014 and 2013 Service Revenues Income from Operations Operating Profit Margin 2014 2013 2014 2013 2014 2013 Product Development $ 771.4 $ 714.2 $ 158.2 $ 140.6 20.5% 19.7% Integrated Healthcare Services 289.6 218.5 19.9 11.7 6.9 5.3 Total segment 1,061.0 932.7 178.1 152.3 16.8% 16.3% General corporate and unallocated expenses (27.2) (19.8) Restructuring costs (1.8) (7.2) Consolidated $ 1,061.0 $ 932.7 $ 149.1 $ 125.3 Nine Months Ended September 30, 2014 and 2013 Service Revenues Income from Operations Operating Profit Margin 2014 2013 2014 2013 2014 2013 Product Development $ 2,323.4 $ 2,144.7 $ 477.2 $ 409.4 20.5% 19.1% Integrated Healthcare Services 778.4 659.7 40.5 30.4 5.2 4.6 Total segment 3,101.8 2,804.4 517.7 439.8 16.7% 15.7% General corporate and unallocated expenses (82.5) (92.6) Restructuring costs (3.7) (11.9) Consolidated $ 3,101.8 $ 2,804.4 $ 431.5 $ 335.3 Certain costs are not allocated to our segments and are reported as general corporate and unallocated expenses. These costs primarily consist of share-based compensation and expenses for corporate office functions such as senior leadership, finance, human resources, information technology, or IT, facilities and legal, as well as certain expenses incurred in the second quarter of 2013 including the $25.0 million fee incurred in connection with the termination of the management agreement with affiliates of certain shareholders and the $1.5 million fee paid in connection with the modification of an agreement for the business usage of an airplane owned by GFM. We do not allocate restructuring or impairment charges to our segments. Product Development Three Months Ended September 30, Change 2014 2013 $ % (dollars in millions) Service revenues $ 771.4 $ 714.2 $ 57.2 8.0% Costs of revenue, service costs 458.7 426.1 32.6 7.7 as a percentage of service revenues 59.5% 59.7% Selling, general and administrative 154.5 147.5 7.0 4.7 as a percentage of service revenues 20.0% 20.6% Segment income from operations $ 158.2 $ 140.6 $ 17.6 12.5% as a percentage of service revenues 20.5% 19.7% Nine Months Ended September 30, Change 2014 2013 $ % (dollars in millions) Service revenues $ 2,323.4 $ 2,144.7 $ 178.7 8.3 % Costs of revenue, service costs 1,374.5 1,297.0 77.5 6.0 as a percentage of service revenues 59.2% 60.5% Selling, general and administrative 471.7 438.3 33.4 7.6 as a percentage of service revenues 20.3% 20.4% Segment income from operations $ 477.2 $ 409.4 $ 67.8 16.6 % as a percentage of service revenues 20.5% 19.1% 21 -------------------------------------------------------------------------------- Table of Contents Service Revenues Product Development's service revenues were $771.4 million in the third quarter of 2014, an increase of $57.2 million, or 8.0%, over the same period in 2013. This increase was comprised of constant currency service revenue growth of $56.3 million, or 7.9%, and a positive impact of approximately $900,000 from the effects of foreign currency fluctuations. The constant currency service revenue growth was primarily a result of a volume-related increase of $31.0 million as well as $25.3 million from the Novella acquisition. Product Development's service revenues were $2,323.4 million in the first nine months of 2014, an increase of $178.7 million, or 8.3%, over the same period in 2013. This increase was comprised of constant currency service revenue growth of 165.2 million, or 7.7%, and a positive impact of approximately $13.5 million from the effects of foreign currency fluctuations. The constant currency service revenue growth was primarily a result of a volume-related increase of $75.6 million as well as $89.6 million from the Novella acquisition. The volume-related service revenue growth was primarily from clinical solutions and services for both the three and nine month periods and was related to an increase in global laboratories services, clinical trial support services and clinical solutions provided on a functional resource basis. This growth was due largely to execution on the higher backlog in place as we entered the three and nine month periods. The rate of year-over-year revenue growth was negatively impacted by the wind-down of a large clinical solutions project delivered throughout 2013. Costs of Revenue, Service Costs Product Development's service costs increased approximately $32.6 million in the third quarter of 2014 over the same period in 2013. This increase was comprised of a $34.4 million constant currency increase, or 8.1%, partially offset by a reduction of $1.8 million from the positive effect of foreign currency fluctuations. The constant currency service costs growth was due to incremental costs resulting from the Novella acquisition and increases in expenses directly related to our service contracts to support our higher volume of revenue. These increases in service costs were partially offset by efficiencies gained from restructuring activities taken in prior years. As a percent of service revenues, Product Development's service costs were 59.5% and 59.7% in the third quarters of 2014 and 2013, respectively. The decrease in service costs as a percentage of service revenues was primarily a result of a closer alignment of resources with project requirements (including cost efficiencies gained from restructuring actions taken in prior years). Product Development's service costs increased approximately $77.5 million in the first nine months of 2014 over the same period in 2013. This increase was comprised of a $83.5 million constant currency increase, or 6.5%, partially offset by a reduction of $6.0 million from the positive effect of foreign currency fluctuations. The constant currency service costs growth was due to (1) incremental costs resulting from the Novella acquisition, (2) increases in expenses directly related to our service contracts to support our higher volume of revenue, and (3) a reduction of an accrual for statutory profit sharing of approximately $5.4 million in 2013 as a result of guidance handed down by an administrative court in France. These increases in service costs were partially offset by efficiencies gained from restructuring activities taken in prior years. As a percent of service revenues, Product Development's service costs were 59.2% and 60.5% in the first nine months of 2014 and 2013, respectively. The decrease in service costs as a percentage of service revenues was primarily a result of a closer alignment of resources with project requirements (including cost efficiencies gained from restructuring actions taken in prior years). Selling, General and Administrative As a percent of service revenues, Product Development's selling, general and administrative expenses were 20.0% and 20.6% in the third quarter of 2014 and 2013, respectively. Product Development's selling, general and administrative expenses increased approximately $7.0 million, or 4.7%, in the third quarter of 2014 as compared to the same period in 2013. This increase was primarily caused by the impact from the Novella acquisition and increases in compensation and related expenses resulting from annual merit increases and an increase in headcount. As a percent of service revenues, Product Development's selling, general and administrative expenses were 20.3% and 20.4% in the first nine months of 2014 and 2013, respectively. Product Development's selling, general and administrative expenses increased approximately $33.4 million, or 7.6%, in the first nine months of 2014 as compared to the same period in 2013. This increase was primarily caused by the impact from the Novella acquisition, increases in compensation and related expenses resulting from annual merit increases and an increase in headcount, and a growth related increase in IT costs partially offset by a positive impact of approximately $1.1 million from the effects of foreign currency fluctuations. 22-------------------------------------------------------------------------------- Table of Contents Integrated Healthcare Services Three Months Ended September 30, Change 2014 2013 $ % (dollars in millions) Service revenues $ 289.6 $ 218.5 $ 71.1 32.6% Costs of revenue, service costs 232.3 174.6 57.7 33.1 as a percentage of service revenues 80.2% 79.9% Selling, general and administrative 37.4 32.2 5.2 16.2 as a percentage of service revenues 12.9% 14.8% Segment income from operations $ 19.9 $ 11.7 $ 8.2 70.5% as a percentage of service revenues 6.9% 5.3% Nine Months Ended September 30, Change 2014 2013 $ % (dollars in millions) Service revenues $ 778.4 $ 659.7 $ 118.7 18.0% Costs of revenue, service costs 634.8 532.5 102.3 19.2 as a percentage of service revenues 81.6% 80.7% Selling, general and administrative 103.1 96.8 6.3 6.5 as a percentage of service revenues 13.2% 14.7% Segment income from operations $ 40.5 $ 30.4 $ 10.1 33.3% as a percentage of service revenues 5.2% 4.6% Service Revenues Integrated Healthcare Services' service revenues were $289.6 million in the third quarter of 2014, an increase of $71.1 million, or 32.6%, over the same period in 2013. This increase is comprised of constant currency service revenue growth of $73.9 million, or 33.9%, including $19.2 million from the Encore acquisition, partially offset by a negative impact of approximately $2.8 million due to the effect of foreign currency fluctuations. Integrated Healthcare Services' service revenues were $778.4 million in the first nine months of 2014, an increase of $118.7 million, or 18.0%, over the same period in 2013. This increase is comprised of constant currency service revenue growth of $124.5 million, or 18.9%, including $19.2 million from the Encore acquisition, partially offset by a negative impact of approximately $5.8 million due to the effect of foreign currency fluctuations. For both the three and nine month periods in 2014, the increase in constant currency service revenues was driven by the impact from the Encore acquisition and an increase in commercial services in North America and Japan, as well as growth in real-world and late phase research services. These increases were partially offset by a decline in Europe due to lower revenue from an agreement to distribute pharmaceutical products in Italy as well as lower commercial services revenues. The agreement to distribute pharmaceutical products in Italy will end in the fourth quarter of 2014. Costs of Revenue, Service Costs Integrated Healthcare Services' service costs increased approximately $57.7 million in the third quarter of 2014. This increase was comprised of a $59.3 million constant currency increase, or 34.0%, partially offset by a reduction of $1.6 million from the positive effect of foreign currency fluctuations. Integrated Healthcare Services' service costs increased approximately $102.3 million in the first nine months of 2014. This increase was comprised of a $105.2 million constant currency increase, or 19.8%, partially offset by a reduction of $2.9 million from the positive effect of foreign currency fluctuations. For both the three and nine month periods in 2014, the constant currency increase was primarily due to the impact from the Encore acquisition and increases in compensation and related expenses resulting from an increase in billable headcount needed to support the higher volume of revenue and annual merit compensation increases. These increases in compensation and related expenses were partially offset by a decline in other expenses directly related to the agreement to distribute pharmaceutical products in Italy. Service costs as a percentage of service revenues were 80.2% and 79.9% in the third quarters of 2014 and 2013, respectively, and 81.6% and 80.7% in the first nine months of 2014 and 2013, respectively. The increase in service costs as a percentage of service revenues was primarily in Europe and reflects the competitive pricing environment for our commercial services in that region. 23-------------------------------------------------------------------------------- Table of Contents Selling, General and Administrative Integrated Healthcare Services' selling, general and administrative expenses in the three and nine months ended September 30, 2014 were higher as compared to the same periods in 2013 primarily caused by the impact from the Encore acquisition and higher compensation and related expenses. Liquidity and Capital Resources Overview We assess our liquidity in terms of our ability to generate cash to fund our operating, investing and financing activities. Our principal source of liquidity is operating cash flows. In addition to operating cash flows, other significant factors that affect our overall management of liquidity include: capital expenditures, acquisitions, debt service requirements, dividends, equity repurchases, adequacy of our revolving credit facility and access to the capital markets. We manage our worldwide cash requirements by monitoring the funds available among our subsidiaries and determining the extent to which those funds can be accessed on a cost effective basis. The repatriation of cash balances from certain of our subsidiaries could have adverse income tax consequences. During the second quarter of 2013, we changed our assertion regarding the earnings of most of our foreign subsidiaries and now consider them indefinitely reinvested outside of the United States. Making this assertion limits our ability to repatriate cash from our foreign subsidiaries for the foreseeable future. In making this assertion, we determined that the cash flows expected to be generated in the United States should be sufficient to fund our operating requirements and debt service obligations in the United States and that we intend to use the cash generated by the affected foreign subsidiaries to fund growth outside of the United States. A future distribution or change in this assertion could result in additional tax liability. We had a cash balance of $645.0 million at September 30, 2014 ($203.1 million of which was in the United States), a decrease from $778.1 million at December 31, 2013. On October 30, 2013, our Board approved an equity repurchase program, or the Repurchase Program, authorizing the repurchase of up to $125.0 million of either our common stock or vested in-the-money employee stock options, or a combination thereof. Through September 30, 2014, we have used $65.5 million of cash to purchase $59.1 million of stock options and $6.4 million of common stock under the Repurchase Program. We have used and intend to continue to use cash on hand to fund the Repurchase Program. The Repurchase Program does not obligate us to repurchase any particular amount of common stock or vested in-the-money employee stock options and it can be modified, suspended or discontinued at any time. Repurchases of vested in-the-money employee stock options were made through transactions between us and our employees (other than our executive officers, who were not eligible to participate in the program) and this aspect of the Repurchase Program expired in November 2013. The Repurchase Program for common stock does not have an end date. Additional information regarding our Repurchase Program is presented in Part II, Item 2 "Unregistered Sales of Equity Securities, Use of Proceeds and Issuer Purchases of Equity Securities" of this Quarterly Report on Form 10-Q. On May 28, 2014, we completed the repurchase of 3,287,209 shares of our common stock for $50.23 per share from TPG Quintiles Holdco, L.P., one of our existing shareholders, in a private transaction for an aggregate purchase price of approximately $165.1 million. We funded this private repurchase transaction with cash on hand. This private repurchase transaction was separate from and in addition to the Repurchase Program. On July 1, 2014, we completed the acquisition of Encore for approximately $91.5 million in cash (net of approximately $2.2 million of acquired cash). Encore has operations in the United States and its business is primarily focused on providing electronic health records implementation and advisory services to healthcare providers. 24 -------------------------------------------------------------------------------- Table of Contents Based on our current operating plan, we believe that our available cash and cash equivalents, future cash flows from operations and our ability to access funds under our revolving credit facility, will enable us to fund our operating requirements and capital expenditures and meet debt obligations for at least the next 12 months. We regularly evaluate our debt arrangements, as well as market conditions, and from time to time we may explore opportunities to modify our existing debt arrangements or pursue additional financing arrangements that could result in the issuance of new debt securities by us or our affiliates. We may use our existing cash, cash generated from operations or dispositions of assets or businesses and/or proceeds from any new financing arrangements or issuances of debt or equity securities to repay or reduce some of our outstanding obligations, to repurchase shares from our shareholders or for other purposes. As part of our ongoing business strategy, we also are continually evaluating new acquisition, expansion and investment possibilities or other strategic growth opportunities, as well as potential dispositions of assets or businesses, as appropriate, including dispositions that may cause us to recognize a loss on certain assets. Should we elect to pursue any such transaction, we may seek to obtain debt or equity financing to facilitate those activities. Our ability to enter into any such potential transactions and our use of cash or proceeds is limited to varying degrees by the terms and restrictions contained in our senior secured credit facilities. We cannot provide assurances that we will be able to complete any such alternative financing arrangements or other transactions on favorable terms or at all. Long-Term Debt As of September 30, 2014, we had $2.0 billion of total indebtedness. Additionally, our senior secured credit agreement provides for a $300 million revolving credit facility. There were no amounts drawn on this revolving credit facility in the first nine months of 2014. Our long-term debt arrangements contain usual and customary restrictive covenants, and as of September 30, 2014, we believe we were in compliance with these covenants. See "Management's Discussion and Analysis - Liquidity and Capital Resources" and Note 10 to our audited consolidated financial statements, each included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013, for additional details regarding our credit arrangements. Nine months ended September 30, 2014 and 2013 Cash Flow from Operating Activities Nine Months Ended September 30, 2014 2013 (in millions) Net cash provided by operating activities $ 175.8 $ 177.9 Cash provided by operating activities decreased by $2.1 million during the first nine months of 2014 as compared to the same period in 2013. The decrease in operating cash flow reflects less cash received from upfront payments under customer contracts in the first nine months of 2014 as compared to the same period in 2013, higher payments for income taxes ($70.5 million), and higher cash used for incentive compensation. These decreases in operating cash flow were partially offset by an increase in net income as well as lower payments for interest ($20.6 million). In addition, net income for the first nine months of 2013 included cash expenses totaling $32.5 million for a fee paid in connection with the termination of our management agreement with affiliates of certain of our shareholders ($25.0 million), a fee paid in connection with the modification of an agreement for the business usage of an airplane owned by GFM ($1.5 million), and a termination fee for the repayment of the $300.0 million term loan ($6.0 million), which did not recur in the 2014 period. Cash Flow from Investing Activities Nine Months Ended September 30, 2014 2013 (in millions) Net cash used in investing activities $ (145.9) $ (224.0) Cash used in investing activities decreased by $78.1 million during the first nine months of 2014 as compared to the same period in 2013. This decline in the use of cash in the first nine months of 2014 was primarily related to lower cash used for the acquisition of businesses. The 2014 period includes approximately $92.2 million primarily for the acquisition of Encore, as compared to the 2013 period which includes the acquisition of Novella for approximately $145.0 million. Also contributing to the decline was lower cash used for property, equipment and software and an increase in proceeds from the sale of equity securities. 25 -------------------------------------------------------------------------------- Table of Contents Cash Flow from Financing Activities Nine Months Ended September 30, 2014 2013 (in millions)Net cash (used in) provided by financing activities $ (144.4) $ 104.3 Net cash used in financing activities increased by $248.7 million to $144.4 million during the first nine months of 2014, as compared to cash provided by financing activities of $104.3 million in the same period in 2013. The cash used in financing activities in the first nine months of 2014 was primarily related to the repurchase of common stock ($165.1 million) partially offset by stock issued under employee stock purchase and option plans ($23.2 million). The cash provided by financing activities in the first nine months of 2013 was primarily related to the net proceeds from our initial public offering, or IPO, in May 2013 ($489.6 million). The net IPO proceeds were partially offset as a result of repayment of all amounts outstanding under the $300.0 million term loan and $83.8 million of repayments on our senior secured credit facilities, which included a voluntary pay down of $50.0 million and a mandatory prepayment of $33.8 million as a result of excess cash flow (as defined in the credit agreement). Net New Business Reporting and Backlog Net new business is the value of services awarded during the period from projects under signed contracts, letters of intent and, in some cases, pre-contract commitments, which are supported by written communications and adjusted for contracts that were modified or canceled during the period. Consistent with our methodology for calculating net new business during a particular period, backlog represents, at a particular point in time, future service revenues from work not yet completed or performed under signed contracts, letters of intent and, in some cases, pre-contract commitments that are supported by written communications. Once work begins on a project, service revenues are recognized over the duration of the project. Included within backlog at September 30, 2014 is approximately $7,193 million of backlog that we do not expect to generate revenue in the next 12 months. Backlog was as follows: September 30, December 31, 2014 2013 (in millions) Backlog $ 10,746 $ 9,855 Net new business was as follows: Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 (in millions) Net new business $ 1,512 $ 1,341 $ 4,014 $ 3,600 Contractual Obligations and Commitments We have various contractual obligations, which are recorded as liabilities in our consolidated financial statements. Other items, such as operating lease obligations, are not recognized as liabilities in our consolidated financial statements but are required to be disclosed. There have been no material changes, outside of the ordinary course of business, to our contractual obligations as previously disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013. Application of Critical Accounting Policies There have been no material changes to our critical accounting policies as previously disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013. 26 -------------------------------------------------------------------------------- Table of Contents |