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SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549



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FORM 10-Q



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(Mark One)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934.
|- | --------------------------------------------------------------------------------------------



For the quarterly period ended September 30, 2005.



OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
|- | -----------------------------------------------------------------------------------------



For the transition period from  to
.



Commission File Number 0-27570



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PHARMACEUTICAL PRODUCT

DEVELOPMENT, INC.

(Exact
name of registrant as specified in its charter)



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|                                                               |  |                                        
|-------------------------------------------------------------- |  | ---------------------------------------
|North Carolina                                                 |  | 56-1640186                             
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification Number)



3151 South
Seventeenth Street

Wilmington, North Carolina

(Address of principal executive offices)



28412

(Zip Code)



Registrants telephone number, including area code:
(910) 251-0081



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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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the
Act).    Yes  x    No ̈



Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of
the Exchange Act).    Yes ̈No  x



Indicate the number of shares outstanding of each of the issuers classes of common
stock, as of the latest practicable date: 57,798,011 shares of common stock, par value $0.10 per share, as of October 24, 2005.



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##### Table of Contents

INDEX



|                                                                                                                            |  |     
|--------------------------------------------------------------------------------------------------------------------------- |  | ----
|                                                                                                                            |  | Page
|Part I. FINANCIAL INFORMATION                                                                                               |  |     
|                                                                                                                            | 
|Item 1. Financial Statements                                                                                                |  |     
|                                                                                                                            | 
|Consolidated Condensed Statements of Operations for the Three and Nine Months Ended September 30, 2004 and 2005 (unaudited) |  | 3   
|                                                                                                                            | 
|Consolidated Condensed Balance Sheets as of December 31, 2004 and September 30, 2005 (unaudited)                            |  | 4   
|                                                                                                                            | 
|Consolidated Condensed Statements of Cash Flows for the Nine Months Ended September 30, 2004 and 2005 (unaudited)           |  | 5   
|                                                                                                                            | 
|Notes to Consolidated Condensed Financial Statements (unaudited)                                                            |  | 6   
|                                                                                                                            | 
|Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations                               |  | 23  
|                                                                                                                            | 
|Item 3. Quantitative and Qualitative Disclosures about Market Risk                                                          |  | 38  
|                                                                                                                            | 
|Item 4. Controls and Procedures                                                                                             |  | 39  
|                                                                                                                            | 
|Part II. OTHER INFORMATION                                                                                                  |  |     
|                                                                                                                            | 
|Item 6. Exhibits                                                                                                            |  | 40  
|                                                                                                                            | 
|Signatures                                                                                                                  |  | 41  



2



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##### Table of Contents

Part I. FINANCIAL INFORMATION



Item 1. Financial Statements



PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

(unaudited)

(in thousands, except per share data)



|                                                      |  |                                 |         |      |                                |         |      |  |   |         |   |  |   |         |  
|----------------------------------------------------- |  | ------------------------------- | ------- | ---- | ------------------------------ | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                      |  | Three Months EndedSeptember 30, |         |      | Nine Months EndedSeptember 30, |        
|                                                      |  | 2004                            |         | 2005 |                                |         | 2004 |  |   | 2005    |  
|Net Revenue:                                          |  |                                 |         |      |                                |         |      |  |   |         |   |  |   |         |  
|Development                                           |  | $                               | 193,233 |      | $                              | 235,148 |      |  | $ | 551,125 |   |  | $ | 672,931 |  
|Discovery sciences                                    |  |                                 | 2,289   |      |                                | 19,458  |      |  |   | 11,870  |   |  |   | 35,954  |  
|Reimbursed out-of-pockets                             |  |                                 | 20,302  |      |                                | 18,674  |      |  |   | 48,645  |   |  |   | 53,591  |  
|                                                      |  |                                 |         |      |                                |         |      |  |   |         |   |  |   |         |  
|Total net revenue                                     |  |                                 | 215,824 |      |                                | 273,280 |      |  |   | 611,640 |   |  |   | 762,476 |  
|                                                      |  |                                 |         |      |                                |         |      |  |   |         |   |  |   |         |  
|Direct Costs:                                         |  |                                 |         |      |                                |         |      |  |   |         |   |  |   |         |  
|Development                                           |  |                                 | 95,038  |      |                                | 117,414 |      |  |   | 274,082 |   |  |   | 338,531 |  
|Discovery sciences                                    |  |                                 | 1,367   |      |                                | 2,064   |      |  |   | 4,215   |   |  |   | 5,821   |  
|Reimbursable out-of-pocket expenses                   |  |                                 | 20,302  |      |                                | 18,674  |      |  |   | 48,645  |   |  |   | 53,591  |  
|                                                      |  |                                 |         |      |                                |         |      |  |   |         |   |  |   |         |  
|Total direct costs                                    |  |                                 | 116,707 |      |                                | 138,152 |      |  |   | 326,942 |   |  |   | 397,943 |  
|                                                      |  |                                 |         |      |                                |         |      |  |   |         |   |  |   |         |  
|Research and development expenses                     |  |                                 | 4,138   |      |                                | 1,967   |      |  |   | 9,062   |   |  |   | 22,233  |  
|Selling, general and administrative expenses          |  |                                 | 49,303  |      |                                | 61,970  |      |  |   | 142,271 |   |  |   | 176,389 |  
|Depreciation                                          |  |                                 | 7,392   |      |                                | 10,135  |      |  |   | 20,992  |   |  |   | 28,006  |  
|Amortization                                          |  |                                 | 231     |      |                                | 279     |      |  |   | 973     |   |  |   | 846     |  
|Gain on exchange of assets                            |  |                                 |        |      |                                |        |      |  |   |        |   |  |   | (5,144  | )
|Restructuring charges                                 |  |                                 |        |      |                                |        |      |  |   | 2,619   |   |  |   |        |  
|                                                      |  |                                 |         |      |                                |         |      |  |   |         |   |  |   |         |  
|Total operating expenses                              |  |                                 | 177,771 |      |                                | 212,503 |      |  |   | 502,859 |   |  |   | 620,273 |  
|                                                      |  |                                 |         |      |                                |         |      |  |   |         |   |  |   |         |  
|Income from operations                                |  |                                 | 38,053  |      |                                | 60,777  |      |  |   | 108,781 |   |  |   | 142,203 |  
|Interest income, net                                  |  |                                 | 499     |      |                                | 2,400   |      |  |   | 949     |   |  |   | 5,615   |  
|Impairment of investments                             |  |                                 |        |      |                                | (3,797  | )    |  |   | (2,000  | ) |  |   | (3,797  | )
|Other income, net                                     |  |                                 | 495     |      |                                | 403     |      |  |   | 1,750   |   |  |   | 1,260   |  
|                                                      |  |                                 |         |      |                                |         |      |  |   |         |   |  |   |         |  
|Income before provision for income taxes              |  |                                 | 39,047  |      |                                | 59,783  |      |  |   | 109,480 |   |  |   | 145,281 |  
|Provision for income taxes                            |  |                                 | 14,057  |      |                                | 21,402  |      |  |   | 36,412  |   |  |   | 47,627  |  
|                                                      |  |                                 |         |      |                                |         |      |  |   |         |   |  |   |         |  
|Net income                                            |  | $                               | 24,990  |      | $                              | 38,381  |      |  | $ | 73,068  |   |  | $ | 97,654  |  
|                                                      |  |                                 |         |      |                                |         |      |  |   |         |   |  |   |         |  
|Net income per share:                                 |  |                                 |         |      |                                |         |      |  |   |         |   |  |   |         |  
|Basic                                                 |  | $                               | 0.44    |      | $                              | 0.67    |      |  | $ | 1.30    |   |  | $ | 1.71    |  
|                                                      |  |                                 |         |      |                                |         |      |  |   |         |   |  |   |         |  
|Diluted                                               |  | $                               | 0.44    |      | $                              | 0.66    |      |  | $ | 1.29    |   |  | $ | 1.68    |  
|                                                      |  |                                 |         |      |                                |         |      |  |   |         |   |  |   |         |  
|Weighted average number of common shares outstanding: |  |                                 |         |      |                                |         |      |  |   |         |   |  |   |         |  
|Basic                                                 |  |                                 | 56,447  |      |                                | 57,643  |      |  |   | 56,275  |   |  |   | 57,156  |  
|Dilutive effect of stock options                      |  |                                 | 563     |      |                                | 927     |      |  |   | 490     |   |  |   | 877     |  
|                                                      |  |                                 |         |      |                                |         |      |  |   |         |   |  |   |         |  
|Diluted                                               |  |                                 | 57,010  |      |                                | 58,570  |      |  |   | 56,765  |   |  |   | 58,033  |  
|                                                      |  |                                 |         |      |                                |         |      |  |   |         |   |  |   |         |  



The accompanying notes
are an integral part of these consolidated condensed financial statements.



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##### Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



CONSOLIDATED CONDENSED BALANCE SHEETS



(in thousands)



|                                                                      |  |                  |         |                   |   |           |  
|--------------------------------------------------------------------- |  | ---------------- | ------- | ----------------- | - | --------- | -
|                                                                      |  | December 31,2004 |         | September 30,2005 |  
|                                                                      |  |                  |         | (unaudited)       |  
|Assets                                                                |  |                  |         |                   |   |           |  
|Current assets:                                                       |  |                  |         |                   |   |           |  
|Cash and cash equivalents                                             |  | $                | 144,348 |                   | $ | 335,707   |  
|Short-term investments                                                |  |                  | 105,020 |                   |   |          |  
|Accounts receivable and unbilled services, net                        |  |                  | 265,067 |                   |   | 269,184   |  
|Income tax receivable                                                 |  |                  | 6,321   |                   |   | 5         |  
|Investigator advances                                                 |  |                  | 15,251  |                   |   | 14,846    |  
|Prepaid expenses and other current assets                             |  |                  | 28,189  |                   |   | 34,465    |  
|Deferred tax assets                                                   |  |                  | 10,867  |                   |   | 11,675    |  
|                                                                      |  |                  |         |                   |   |           |  
|Total current assets                                                  |  |                  | 575,063 |                   |   | 665,882   |  
|                                                                      |  |                 
|Property and equipment, net                                           |  |                  | 136,501 |                   |   | 202,186   |  
|Goodwill                                                              |  |                  | 179,781 |                   |   | 209,279   |  
|Investments                                                           |  |                  | 66,658  |                   |   | 22,558    |  
|Intangible assets                                                     |  |                  | 3,895   |                   |   | 3,049     |  
|Deferred tax assets                                                   |  |                  | 12,374  |                   |   | 10,477    |  
|Other assets                                                          |  |                  | 929     |                   |   | 6,526     |  
|                                                                      |  |                  |         |                   |   |           |  
|Total assets                                                          |  | $                | 975,201 |                   | $ | 1,119,957 |  
|                                                                      |  |                  |         |                   |   |           |  
|Liabilities and Shareholders Equity                                  |  |                  |         |                   |   |           |  
|Current liabilities:                                                  |  |                  |         |                   |   |           |  
|Accounts payable                                                      |  | $                | 12,863  |                   | $ | 10,070    |  
|Payables to investigators                                             |  |                  | 43,726  |                   |   | 44,053    |  
|Accrued income taxes                                                  |  |                  | 5,118   |                   |   | 10,709    |  
|Other accrued expenses                                                |  |                  | 101,714 |                   |   | 113,813   |  
|Deferred tax liabilities                                              |  |                  | 770     |                   |   | 160       |  
|Unearned income                                                       |  |                  | 153,170 |                   |   | 145,632   |  
|Current maturities of long-term debt and capital lease obligations    |  |                  | 599     |                   |   | 1,831     |  
|                                                                      |  |                  |         |                   |   |           |  
|Total current liabilities                                             |  |                  | 317,960 |                   |   | 326,268   |  
|Long-term debt and capital lease obligations, less current maturities |  |                  | 6,371   |                   |   | 6,004     |  
|Accrued additional pension liability                                  |  |                  | 9,923   |                   |   | 9,121     |  
|Deferred tax liabilities                                              |  |                  | 370     |                   |   | 3,490     |  
|Deferred rent and other                                               |  |                  | 5,267   |                   |   | 17,193    |  
|                                                                      |  |                  |         |                   |   |           |  
|Total liabilities                                                     |  |                  | 339,891 |                   |   | 362,076   |  
|Shareholders equity:                                                 |  |                  |         |                   |   |           |  
|Common stock                                                          |  |                  | 5,662   |                   |   | 5,779     |  
|Paid-in capital                                                       |  |                  | 293,200 |                   |   | 330,707   |  
|Retained earnings                                                     |  |                  | 325,269 |                   |   | 422,923   |  
|Deferred compensation                                                 |  |                  |        |                   |   | (1,915    | )
|Accumulated other comprehensive income                                |  |                  | 11,179  |                   |   | 387       |  
|                                                                      |  |                  |         |                   |   |           |  
|Total shareholders equity                                            |  |                  | 635,310 |                   |   | 757,881   |  
|                                                                      |  |                  |         |                   |   |           |  
|Total liabilities and shareholders equity                            |  | $                | 975,201 |                   | $ | 1,119,957 |  
|                                                                      |  |                  |         |                   |   |           |  



The accompanying notes
are an integral part of these consolidated condensed financial statements.



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##### Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS



(unaudited)

(in thousands)



|                                                                                  |  |                                |          |   |      |   |         |  
|--------------------------------------------------------------------------------- |  | ------------------------------ | -------- | - | ---- | - | ------- | -
|                                                                                  |  | Nine Months EndedSeptember 30, |         
|                                                                                  |  | 2004                           |          |   | 2005 |  
|Cash flows from operating activities:                                             |  |                                |          |   |      |   |         |  
|Net income                                                                        |  | $                              | 73,068   |   |      | $ | 97,654  |  
|Adjustments to reconcile net income to net cash provided by operating activities: |  |                                |          |   |      |   |         |  
|Impairment of investments                                                         |  |                                | 2,000    |   |      |   | 3,797   |  
|Depreciation and amortization                                                     |  |                                | 21,965   |   |      |   | 28,852  |  
|Stock compensation amortization                                                   |  |                                |         |   |      |   | 274     |  
|Restructuring charges                                                             |  |                                | 2,619    |   |      |   |        |  
|Gain on exchange of assets                                                        |  |                                |         |   |      |   | (5,144  | )
|Loss on disposition of property and equipment, net                                |  |                                | 74       |   |      |   | 177     |  
|Provision for doubtful accounts                                                   |  |                                | 651      |   |      |   | 124     |  
|(Benefit) provision for deferred income taxes                                     |  |                                | (6,101   | ) |      |   | 4,167   |  
|Change in operating assets and liabilities, net of acquisitions                   |  |                                | 19,800   |   |      |   | 12,115  |  
|                                                                                  |  |                                |          |   |      |   |         |  
|Net cash provided by operating activities                                         |  |                                | 114,076  |   |      |   | 142,016 |  
|                                                                                  |  |                                |          |   |      |   |         |  
|Cash flows from investing activities:                                             |  |                                |          |   |      |   |         |  
|Purchases of property and equipment                                               |  |                                | (34,337  | ) |      |   | (89,083 | )
|Proceeds from sale of property and equipment                                      |  |                                | 241      |   |      |   | 3,926   |  
|Purchases of available-for-sale investments                                       |  |                                | (650,664 | ) |      |   | (24,720 | )
|Maturities and sales of available-for-sale investments                            |  |                                | 632,261  |   |      |   | 129,740 |  
|Purchases of investments                                                          |  |                                | (5,833   | ) |      |   | (11,576 | )
|Proceeds from sale of investment                                                  |  |                                |         |   |      |   | 25,000  |  
|Cash refunded related to business acquired                                        |  |                                | 1,450    |   |      |   |        |  
|                                                                                  |  |                                |          |   |      |   |         |  
|Net cash (used in) provided by investing activities                               |  |                                | (56,882  | ) |      |   | 33,287  |  
|                                                                                  |  |                                |          |   |      |   |         |  
|Cash flows from financing activities:                                             |  |                                |          |   |      |   |         |  
|Principal repayments of long-term debt                                            |  |                                | (259     | ) |      |   | (275    | )
|Repayment of capital leases obligation                                            |  |                                | (724     | ) |      |   | (1,301  | )
|Proceeds from exercise of stock options and employee stock purchase plan          |  |                                | 9,259    |   |      |   | 24,471  |  
|                                                                                  |  |                                |          |   |      |   |         |  
|Net cash provided by financing activities                                         |  |                                | 8,276    |   |      |   | 22,895  |  
|                                                                                  |  |                                |          |   |      |   |         |  
|Effect of exchange rate changes on cash and cash equivalents                      |  |                                | 572      |   |      |   | (6,839  | )
|                                                                                  |  |                                |          |   |      |   |         |  
|Net increase in cash and cash equivalents                                         |  |                                | 66,042   |   |      |   | 191,359 |  
|Cash and cash equivalents, beginning of the period                                |  |                                | 60,677   |   |      |   | 144,348 |  
|                                                                                  |  |                                |          |   |      |   |         |  
|Cash and cash equivalents, end of the period                                      |  | $                              | 126,719  |   |      | $ | 335,707 |  
|                                                                                  |  |                                |          |   |      |   |         |  



The accompanying notes
are an integral part of these consolidated condensed financial statements.



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##### Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS



(unaudited)



1. SIGNIFICANT
ACCOUNTING POLICIES



The significant accounting policies
followed by Pharmaceutical Product Development, Inc. and its subsidiaries (collectively the Company) for interim financial reporting are consistent with the accounting policies followed for annual financial reporting. We prepared these
unaudited consolidated condensed financial statements in accordance with Rule 10-01 of Regulation S-X and, in managements opinion, we have included all adjustments of a normal recurring nature necessary for a fair presentation. The
accompanying consolidated condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto in the Companys Annual Report on Form 10-K for the year ended December 31, 2004. The
results of operations for the three-month and nine-month periods ended September 30, 2005 are not necessarily indicative of the results to be expected for the full year or any other period. The amounts in the December 31, 2004 consolidated
condensed balance sheet are derived from the audited financial statements included in the Companys Annual Report on Form 10-K for the year ended December 31, 2004.



Use of estimates in the preparation of financial statements



The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.



Principles of consolidation



The accompanying unaudited consolidated condensed financial statements include the accounts and results of operations of the Company. All intercompany
balances and transactions have been eliminated in consolidation.



Earnings per share



The computation of basic
income per share information is based on the weighted average number of common shares outstanding during the period. The computation of diluted income per share information is based on the weighted average number of common shares outstanding during
the period plus the effects of any dilutive common stock equivalents.



Reclassification



The Company has reclassified
certain 2004 financial statement amounts to conform to the 2005 financial statement presentation. A significant reclassification was made to the statement of cash flows to reflect cash inflows and outflows for the purchases and sales of Auction Rate
Securities.



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##### Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS



(unaudited)



1. SIGNIFICANT ACCOUNTING POLICIES (continued)



Stock-based compensation



The Company has adopted the disclosure requirements of Statement of
Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, and Statement of Financial Accounting Standards No. 148, Accounting for Stock Based Compensation - Transition and Disclosure - an Amendment
of FASB Statement No. 123, which require compensation expense to be disclosed in the notes based on the fair value of the options granted at the date of the grant. Had compensation cost for the Companys stock option plan been
determined based on the fair value at the grant dates for awards under the plan consistent with the method required by SFAS No. 123, the Companys net income and diluted net income per common share would have been the pro forma amounts
indicated below.



|                                                                                                                                          |  |                                 |        |                                |   |        |  |      |        |  |   |       
|----------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------ | ------------------------------ | - | ------ |  | ---- | ------ |  | - | ------
|                                                                                                                                          |  | Three Months EndedSeptember 30, |        | Nine Months EndedSeptember 30,
|(in thousands, except per share data)                                                                                                     |  | 2004                            |        | 2005                           |   | 2004   |  | 2005
|Net income, as reported                                                                                                                   |  | $                               | 24,990 |                                | $ | 38,381 |  | $    | 73,068 |  | $ | 97,654
|Add: Stock-based employee compensation expense included in reported net income, net of related tax effects                                |  |                                 |       |                                |   | 117    |  |      |       |  |   | 184   
|Less: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax
effects |  |                                 | 1,469  |                                |   | 2,076  |  |      | 4,395  |  |   | 7,736 
|                                                                                                                                          |  |                                 |        |                                |   |        |  |      |        |  |   |       
|Pro forma net income                                                                                                                      |  | $                               | 23,521 |                                | $ | 36,422 |  | $    | 68,673 |  | $ | 90,102
|                                                                                                                                          |  |                                 |        |                                |   |        |  |      |        |  |   |       
|Net income per share:                                                                                                                     |  |                                 |        |                                |   |        |  |      |        |  |   |       
|Basic  as reported                                                                                                                       |  | $                               | 0.44   |                                | $ | 0.67   |  | $    | 1.30   |  | $ | 1.71  
|Basic  pro forma                                                                                                                         |  | $                               | 0.42   |                                | $ | 0.63   |  | $    | 1.22   |  | $ | 1.58  
|                                                                                                                                          |  |                                 |        |                               
|Diluted  as reported                                                                                                                     |  | $                               | 0.44   |                                | $ | 0.66   |  | $    | 1.29   |  | $ | 1.68  
|Diluted  pro forma                                                                                                                       |  | $                               | 0.41   |                                | $ | 0.62   |  | $    | 1.21   |  | $ | 1.55  



Restructuring
charges



During the nine months ended September 30,
2004, the Company recorded a $2.6 million restructuring charge associated with exiting the Companys chemistry facility in Research Triangle Park, North Carolina. These charges include lease payments and termination costs, net of sublease
rentals, of approximately $2.1 million and a loss on sale of assets used in the chemistry services business of approximately $0.5 million. The lease termination liability will be paid over the remaining life of the lease, which terminates in 2015.
During the three months ended September 30, 2004 and 2005, the Company paid lease payments, termination costs and related expenses of $0.4 million and $0.2 million, respectively. During the nine months ended September 30, 2004 and 2005,
the Company paid lease payments, termination costs and related expenses of $0.4 million and $0.7 million, respectively. At September 30, 2005, the Company recorded the remaining restructuring liability of $0.5 million in the consolidated
condensed balance sheet as a component of other accrued expenses and deferred rent and other.



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##### Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS



(unaudited)



1. SIGNIFICANT ACCOUNTING POLICIES (continued)



Inventory



Inventories, which consist principally of laboratory supplies, are valued at
the lower of cost (first-in, first-out method) or market. As of December 31, 2004 and September 30, 2005, inventories totaling $2.2 million were included in prepaid expenses and other current assets.



Recent accounting pronouncements



In October 2005, the Financial Accounting Standards Board, or FASB, issued
Staff Position No. 13-1, Accounting for Rental Costs Incurred During a Construction Period, or FSP 13-1. FSP 13-1 states that rental costs associated with ground or building operating leases incurred during a construction period
shall be recognized as rental expense and not capitalized. FSP 13-1 is effective for the first reporting period beginning after December 15, 2005. The Company does not believe adoption of this statement will have a material impact on the
Companys financial statements.



In June 2005, the FASB
issued Staff Position No. 143-1, Accounting for Electronic Equipment Waste Obligations, or FSP 143-1. FSP 143-1 provides guidance on how commercial users and producers of electronic equipment should recognize and measure
asset retirement obligations that arise from European Union (EU) Directive 2002/96/EC on Waste Electrical and Electronic Equipment (the Directive). FSP 143-1 is effective the later of the first reporting period that ends
after June 8, 2005 or the date that the EU-member country adopts a law to implement the Directive. The Company has adopted FSP 143-1 and the statement did not have a material impact on the Companys financial statements.



In October 2004, the EITF finalized its consensuses on EITF 04-01,
Accounting for Preexisting Relationships between the Parties to a Business Combination. The consensuses in EITF 04-01 provide guidance on how to account for the settlement of a preexisting relationship and how it affects the accounting
of the business combination. EITF 04-01 is effective for business combinations consummated in reporting periods beginning after October 13, 2004. In February 2005, the Company recorded a gain on the termination of a preexisting lease
arrangement as part of the acquisition of SurroMed, Inc.s biomarker business in accordance with the guidance in EITF 04-01. See Note 2.



In December 2004, the FASB issued SFAS No. 123 (Revised 2004) Share-Based Payment that will require compensation costs related to
share-based payment transactions to be recognized in the financial statements. With limited exceptions, the amount of compensation cost will be measured based on the fair value on the date of grant of the equity or liability instruments issued. In
addition, liability instruments will be remeasured each reporting period. Compensation cost will be recognized over the period that an employee provides service in exchange for the award. In March 2005, the SEC issued Staff Accounting Bulletin 107
which describes the SEC staffs expectations in determining the assumptions that underlie the fair value estimates and discusses the interaction of SFAS No. 123 (Revised) with existing SEC guidance. In April 2005, the SEC deferred the
effective date for SFAS No. 123 (Revised) to the beginning of the first fiscal year that begins after June 15, 2005. The Company is currently evaluating the impact of the adoption of this statement on the Companys financial
statements.



In December 2004, the FASB issued SFAS
No. 153, Exchange of Nonmonetary Assets, an amendment of APB Opinion No. 29. SFAS No. 153 replaces the exception from fair value measurement included in APB Opinion No. 29 for nonmonetary exchanges of similar
productive assets with a general exception from fair value measurement for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to
change significantly as a result of the exchange. This statement will be applied prospectively and is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The Company does not believe adoption of
this statement will have a material impact on the Companys financial statements.



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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS



(unaudited)



1. SIGNIFICANT ACCOUNTING POLICIES (continued)



In May 2005, the FASB issued SFAS No. 154, Accounting Changes and
Error Corrections, which changes the requirements for the accounting and reporting of a change in accounting principle. SFAS No. 154 applies to all voluntary changes in accounting principle as well as to changes required by an accounting
pronouncement that does not include specific transition provisions. SFAS No. 154 requires that changes in accounting principle be retrospectively applied. SFAS No. 154 is effective for accounting changes and corrections of errors made in
fiscal years beginning after December 15, 2005. The Company does not believe adoption of this statement will have a material impact on the Companys financial statements.



2. ACQUISITIONS



In February 2005, the Company completed its acquisition of substantially all of the assets of SurroMed, Inc.s biomarker business. The assets
acquired consist of equipment, fixtures, leasehold improvements, intellectual property and contracts. The biomarker business supports drug discovery and drug development by identifying biomarkers using biological, chemical and bioinformatics
expertise and technologies. The acquisition expanded the Companys business by adding biomarker discovery and patient sample analysis capability to the services offered by the Company. In exchange for the assets, the Company surrendered to
SurroMed all shares of preferred stock of SurroMed it held. As additional consideration for the acquisition, the Company assumed approximately $3.4 million of SurroMed liabilities under capital leases and additional operating liabilities, and agreed
to guarantee repayment of up to $1.5 million under a SurroMed bank loan. In accordance with the requirements of FASB Statement No. 5, Accounting for Contingencies, as clarified by FASB Interpretation No. 45, the Company has
recorded a liability in the amount of $150,000 for the estimated fair value of the obligation it has assumed under this guarantee. The Company recognized a pre-tax gain on exchange of assets of $5.1 million, primarily related to the $4.9 million
gain on the termination of a preexisting facility lease arrangement with SurroMed in accordance with EITF 04-01, Accounting for Preexisting Relationships between the Parties to a Business Combination. The fair value of the leasing
arrangement was determined based on the discounted cash flows of the difference between the future required rental payments under the lease agreement and the current market rate for similar facilities. The results of operations from the biomarker
assets acquired are included in the Companys consolidated condensed statement of operations as of and since February 1, 2005, the effective date of the acquisition. This biomarker business is part of the Discovery Sciences segment of the
Company.



This acquisition was accounted for using the purchase
method of accounting, using appropriate fair value techniques to allocate the purchase price based on the estimated fair values of the assets acquired and liabilities assumed. Accordingly, the estimated fair value of assets acquired and liabilities
assumed were included in the Companys consolidated condensed balance sheet as of the effective date of the acquisition.



The total purchase price for the acquisition was allocated to the estimated fair value of assets acquired and liabilities assumed as set forth in the
following table:



|                                         |  |   |        |  
|---------------------------------------- |  | - | ------ | -
|(in thousands)                           |  |   |       
|Condensed balance sheet:                 |  |   |        |  
|Current assets                           |  | $ | 186    |  
|Property and equipment, net              |  |   | 8,780  |  
|Deferred rent and other                  |  |   | (742   | )
|Current liabilities                      |  |   | (3,512 | )
|Long-term liabilities                    |  |   | (2,267 | )
|                                         | 
|Value of identifiable intangible assets: |  |   |        |  
|Goodwill                                 |  |   | 33,001 |  
|                                         |  |   |        |  
|Total                                    |  | $ | 35,446 |  
|                                         |  |   |        |  



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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS



(unaudited)



2. ACQUISITIONS (continued)



The purchase price allocation has been finalized for this acquisition.
Goodwill will be evaluated annually as required by SFAS 142. The Company expects goodwill related to SurroMed to be deductible for tax purposes.



The unaudited pro forma results from operations for the Company assuming the acquisition was consummated as of January 1, 2004 were as follows:



|                                      |  |                                 |         |                                |   |         |  |      |         |  |   |        
|------------------------------------- |  | ------------------------------- | ------- | ------------------------------ | - | ------- |  | ---- | ------- |  | - | -------
|                                      |  | Three Months EndedSeptember 30, |         | Nine Months EndedSeptember 30,
|(in thousands, except per share data) |  | 2004                            |         | 2005                           |   | 2004    |  | 2005
|Total revenue                         |  | $                               | 217,997 |                                | $ | 273,280 |  | $    | 617,753 |  | $ | 763,138
|Net income                            |  | $                               | 23,949  |                                | $ | 38,381  |  | $    | 69,489  |  | $ | 97,454 
|Net income per share:                 |  |                                 |         |                                |   |         |  |      |         |  |   |        
|Basic                                 |  | $                               | 0.42    |                                | $ | 0.67    |  | $    | 1.23    |  | $ | 1.71   
|Diluted                               |  | $                               | 0.42    |                                | $ | 0.66    |  | $    | 1.22    |  | $ | 1.68   



The above amounts are
based upon assumptions and estimates the Company believes are reasonable, but they do not reflect any benefit from economies that might be achieved from combined operations. Pro forma adjustments were made to income tax benefit, increasing net
income by $0.6 million, $0, $1.8 million and $0.1 million for the three-month and nine-month periods ended September 30, 2004 and 2005, respectively. These adjustments are reflected in the above table. The pro forma financial information
presented above is not necessarily indicative of either the results of operations that would have occurred had the acquisition taken place at the beginning of the period indicated or of future results of operations of the Company.



3. ACCOUNTS RECEIVABLE AND UNBILLED SERVICES



Accounts receivable and unbilled services consisted of the
following:



|                                |  |                  |         |   |                   |   |         |  
|------------------------------- |  | ---------------- | ------- | - | ----------------- | - | ------- | -
|(in thousands)                  |  | December 31,2004 |         |   | September 30,2005 |  
|Billed                          |  | $                | 183,765 |   |                   | $ | 173,361 |  
|Unbilled                        |  |                  | 85,404  |   |                   |   | 99,817  |  
|Provision for doubtful accounts |  |                  | (4,102  | ) |                   |   | (3,994  | )
|                                |  |                  |         |   |                   |   |         |  
|                                |  | $                | 265,067 |   |                   | $ | 269,184 |  
|                                |  |                  |         |   |                   |   |         |  



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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS



(unaudited)



4. PROPERTY AND EQUIPMENT



Property and equipment, stated at cost, consisted of the following:



|                                                        |  |                  |          |   |                   |   |          |  
|------------------------------------------------------- |  | ---------------- | -------- | - | ----------------- | - | -------- | -
|(in thousands)                                          |  | December 31,2004 |          |   | September 30,2005 |  
|Land                                                    |  | $                | 7,392    |   |                   | $ | 9,628    |  
|Buildings and leasehold improvements                    |  |                  | 45,493   |   |                   |   | 57,657   |  
|Construction in progress and software under development |  |                  | 21,649   |   |                   |   | 20,615   |  
|Furniture and equipment                                 |  |                  | 99,778   |   |                   |   | 149,474  |  
|Computer equipment and software                         |  |                  | 86,367   |   |                   |   | 110,393  |  
|                                                        |  |                  |          |   |                   |   |          |  
|                                                        |  |                  | 260,679  |   |                   |   | 347,767  |  
|Less accumulated depreciation and amortization          |  |                  | (124,178 | ) |                   |   | (145,581 | )
|                                                        |  |                  |          |   |                   |   |          |  
|                                                        |  | $                | 136,501  |   |                   | $ | 202,186  |  
|                                                        |  |                  |          |   |                   |   |          |  



Capitalized costs for
the new corporate headquarters facility included in construction in progress and software under development as of December 31, 2004 and September 30, 2005 were $0.1 million and $11.3 million, respectively.



In February 2005, the Company acquired a Dassault Falcon 900EX aircraft for
$30.5 million. The Company uses the aircraft for corporate purposes. The Company financed the acquisition from available cash.



Property and equipment under capital leases, stated at cost, consisted of the following as of September 30, 2005:



|                                               |  |   |       |  
|---------------------------------------------- |  | - | ----- | -
|(in thousands)                                 |  |   |      
|Leasehold improvements                         |  | $ | 824   |  
|Computer equipment and software                |  |   | 656   |  
|Furniture and equipment                        |  |   | 2,114 |  
|                                               |  |   |       |  
|                                               |  |   | 3,594 |  
|Less accumulated depreciation and amortization |  |   | (866  | )
|                                               |  |   |       |  
|                                               |  | $ | 2,728 |  
|                                               |  |   |       |  



As of
December 31, 2004, the Company did not have any property and equipment under capital lease. As of September 30, 2005, the Company had $2.5 million in net book value of property and equipment under capital lease from the acquisition of
SurroMeds biomarker business. The remaining $0.2 million in net book value of property and equipment under capital lease related to a lease for scientific equipment used at the Companys Phase I clinic in Austin, Texas.



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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS



(unaudited)



5. GOODWILL AND INTANGIBLE ASSETS



Changes in the carrying amount of goodwill for the twelve months ended
December 31, 2004 and the nine months ended September 30, 2005, by operating segment, were as follows:



|                                                                                                                        |  |             |         |   |           |   |        |  |   |         |  
|----------------------------------------------------------------------------------------------------------------------- |  | ----------- | ------- | - | --------- | - | ------ |  | - | ------- | -
|(in thousands)                                                                                                          |  | Development |         |   | Discovery |   | Total  | 
|Balance as of January 1, 2004                                                                                           |  | $           | 157,461 |   |           | $ | 20,615 |  | $ | 178,076 |  
|Changes in goodwill recorded during the period for prior year acquisitions (finalization of purchase price adjustments) |  |             | (699    | ) |           |   |       |  |   | (699    | )
|Translation adjustments                                                                                                 |  |             | 2,404   |   |           |   |       |  |   | 2,404   |  
|                                                                                                                        |  |             |         |   |           |   |        |  |   |         |  
|Balance as of December 31, 2004                                                                                         |  |             | 159,166 |   |           |   | 20,615 |  |   | 179,781 |  
|Goodwill recorded during the period for current year acquisitions                                                       |  |             |        |   |           |   | 33,001 |  |   | 33,001  |  
|Translation adjustments                                                                                                 |  |             | (3,503  | ) |           |   |       |  |   | (3,503  | )
|                                                                                                                        |  |             |         |   |           |   |        |  |   |         |  
|Balance as of September 30, 2005                                                                                        |  | $           | 155,663 |   |           | $ | 53,616 |  | $ | 209,279 |  
|                                                                                                                        |  |             |         |   |           |   |        |  |   |         |  



Information regarding
the Companys other intangible assets is as follows:



|                                   |  |                         |       |                          |   |       |  |                |       |                         |   |       |  |   |       |  |   |      
|---------------------------------- |  | ----------------------- | ----- | ------------------------ | - | ----- |  | -------------- | ----- | ----------------------- | - | ----- |  | - | ----- |  | - | -----
|                                   |  | As of December 31, 2004 |       | As of September 30, 2005
|(in thousands)                     |  | CarryingAmount          |       | AccumulatedAmortization  |   | Net   |  | CarryingAmount |       | AccumulatedAmortization |   | Net  
|Backlog and customer relationships |  | $                       | 2,733 |                          | $ | 2,381 |  | $              | 352   |                         | $ | 2,733 |  | $ | 2,493 |  | $ | 240  
|Patents                            |  |                         | 280   |                          |   | 271   |  |                | 9     |                         |   | 263   |  |   | 262   |  |   | 1    
|License and royalty agreements     |  |                         | 5,000 |                          |   | 1,466 |  |                | 3,534 |                         |   | 5,000 |  |   | 2,192 |  |   | 2,808
|                                   |  |                         |       |                          |   |       |  |                |       |                         |   |       |  |   |       |  |   |      
|Total                              |  | $                       | 8,013 |                          | $ | 4,118 |  | $              | 3,895 |                         | $ | 7,996 |  | $ | 4,947 |  | $ | 3,049
|                                   |  |                         |       |                          |   |       |  |                |       |                         |   |       |  |   |       |  |   |      



The Company amortizes
all intangible assets on a straight-line basis, based on estimated useful lives of three to five years for backlog and customer relationships, five years for patents and three to ten years for license and royalty agreements. As of September 30,
2005, the approximate weighted average amortization period was 4.1 years for backlog and customer relationships, 5.0 years for patents, 6.4 years for license and royalty agreements, and 6.1 years for all intangibles collectively.



Amortization expense for the three months ended September 30, 2004 and
2005 was $0.2 million and $0.3 million, respectively. Amortization expense for the nine months ended September 30, 2004 and 2005 was $1.0 million and $0.8 million, respectively. As of September 30, 2005, estimated amortization expense for
the next five years was as follows:



|                          |  |   |    
|------------------------- |  | - | ---
|(in thousands)            |  |  
|2005 (remaining 3 months) |  | $ | 275
|2006                      |  |   | 606
|2007                      |  |   | 362
|2008                      |  |   | 333
|2009                      |  |   | 300



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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS



(unaudited)



6. SHORT-TERM INVESTMENTS AND INVESTMENTS



Short-term investments, all of which are available-for-sale securities, and
investments consisted of the following:



|                                         |  |                  |         |                   |   |       
|---------------------------------------- |  | ---------------- | ------- | ----------------- | - | ------
|(in thousands)                           |  | December 31,2004 |         | September 30,2005
|Short-term investments:                  |  |                  |         |                   |   |       
|Preferred stock                          |  | $                | 48,225  |                   | $ |      
|State and municipal securities           |  |                  | 51,850  |                   |   |      
|Other debt securities                    |  |                  | 4,945   |                   |   |      
|                                         |  |                  |         |                   |   |       
|Total short-term investments             |  | $                | 105,020 |                   | $ |      
|                                         |  |                  |         |                   |   |       
|Investments:                             |  |                  |         |                   |   |       
|Cost-basis investments:                  |  |                  |         |                   |   |       
|SurroMed, Inc.                           |  | $                | 29,007  |                   | $ |      
|Syrrx, Inc.                              |  |                  | 25,000  |                   |   |      
|Accentia Biopharmaceuticals, Inc.        |  |                  | 4,771   |                   |   | 14,678
|Spotlight Health, Inc.                   |  |                  | 1,230   |                   |   |      
|Oriel Therapeutics, Inc.                 |  |                  | 1,800   |                   |   | 2,150 
|Bay City Capital LLC                     |  |                  |        |                   |   | 1,293 
|Other equity investments                 |  |                  | 250     |                   |   | 570   
|                                         |  |                  |         |                   |   |       
|Total cost-basis investments             |  |                  | 62,058  |                   |   | 18,691
|Marketable equity securities:            |  |                  |         |                   |   |       
|BioDelivery Sciences International, Inc. |  |                  | 2,850   |                   |   | 1,587 
|Chemokine Therapeutics Corp.             |  |                  | 1,750   |                   |   | 2,280 
|                                         |  |                  |         |                   |   |       
|Total marketable equity securities       |  |                  | 4,600   |                   |   | 3,867 
|                                         |  |                  |         |                   |   |       
|Total investments                        |  | $                | 66,658  |                   | $ | 22,558
|                                         |  |                  |         |                   |   |       



Short-term
investments



At December 31, 2004, the Companys
short-term investments consisted of Auction Rate Securities, or ARS. ARS generally have stated maturities of 20 to 30 years. However, these securities have economic characteristics of short-term investments due to a rate-setting mechanism and the
ability to liquidate them through a Dutch auction process that occurs on pre-determined intervals of less than 90 days. As such, these investments are classified as short-term investments. The Companys short-term investments were classified as
available-for-sale securities due to managements intent regarding these securities. As of December 31, 2004, there were no unrealized gains or losses associated with these investments and the fair market value equaled the adjusted cost.
The Company disposed of all short-term investments in the first quarter of 2005.



The gross realized gains (losses) on available-for-sale securities were $87,000 and $0 in the three months ended September 30, 2004 and 2005, respectively, and $182,000 and $(17,000) for the nine months ended
September 30, 2004 and 2005, respectively, determined on a specific identification basis.



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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS



(unaudited)



6. SHORT-TERM INVESTMENTS AND INVESTMENTS (continued)



Investments



The Companys equity investments are classified as long-term assets due
to managements intent to hold these securities for more than twelve months.



The Company has equity investments in publicly traded entities. Investments in publicly traded entities are classified as available-for-sale securities and are measured at market value. The Company records net
unrealized gains or losses associated with investments in publicly traded entities as a component of shareholders equity until they are realized or an other-than-temporary decline has occurred. The market value of the Companys equity
investments in publicly traded entities is based on the closing price as quoted by the applicable stock exchange or market on the last day of the reporting period. As of both December 31, 2004 and September 30, 2005, gross unrealized gains
were $1.6 million, and gross unrealized losses as of December 31, 2004 and September 30, 2005 were $0 and $0.7 million, respectively. The unrealized loss as of September 30, 2005 relates to the Companys investment in the common
stock of BioDelivery Sciences International, Inc., or BDSI, a specialty biopharmaceutical company that engages in the development and commercialization of drug delivery technologies of proven therapeutics, nutraceuticals and micronutrients. As of
September 30, 2005, the fair value of the Companys investment in BDSI was $1.6 million, net of unrealized losses of $0.7 million. These securities have been in a loss position for less than 12 months. The Company evaluated the near-term
prospects of the issuer in relation to the severity and duration of the decline in value. The Company believes that the continued progression of BDSI products is a positive indicator of BDSIs business. Additionally, on October 5, 2005,
BDSI announced that it had closed a public offering of 4.4 million shares of common stock resulting in gross proceeds of $8.8 million. Based on these factors, and the Companys ability and intent to hold these investments for a reasonable
period of time sufficient for a forecasted recovery of fair value, the Company does not consider these investments to be other-than-temporarily impaired at September 30, 2005.



The Company also has investments in privately held entities in the form of equity and convertible debt instruments that are
not publicly traded and for which fair values are not readily determinable. The Company records all of its investments in private entities under the cost method of accounting. The Company assesses the net realizable value of these entities on a
quarterly basis to determine if there has been a change in the fair value of these entities, and if so, if the change is other than temporary. This quarterly review includes an evaluation of, among other things, the market condition of the overall
industry, historical and projected financial performance, expected cash needs and recent funding events. The impairment analysis requires significant judgment to identify events or circumstances that would likely have a significant effect on the
fair value of the investment.



In January 2004, the Company
purchased 5.0 million shares of Accentia Biopharmaceuticals, Inc. Series E convertible preferred stock for $5.0 million. At that time, the Company also received a Class A and Class B warrant, each to purchase up to an additional
5.0 million shares of Series E convertible preferred stock for $1.00 per share. The Company received dividends on its Series E convertible preferred stock in excess of Accentias earnings in the first nine months of 2005 and for the full
year of 2004 and thus recorded these as a return of the investment in Accentia. The Company exercised the Class A warrant in January 2005 and the Class B warrant in August 2005. The Company owned approximately 17.5% of the outstanding capital
stock of Accentia as of September 30, 2005. Accentia is a privately held, specialty biopharmaceutical company that focuses on commercializing targeted therapeutics in the respiratory, oncology and critical care areas. In February 2005, Accentia
filed a registration statement with the SEC for its proposed initial public offering of common stock. On October 28, 2005, Accentia completed its initial public offering of 2.4 million shares of common stock for $8.00 per share. Upon
completion of the initial public offering, the Companys 15 million shares of Series E convertible preferred stock were converted to 4,270,323 shares of common stock. The Company may sell its Accentia shares beginning 180 days from the
date of the initial public offering.



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##### Table of Contents

PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS



(unaudited)



6. SHORT-TERM INVESTMENTS AND INVESTMENTS (continued)



In April 2000, the Company purchased 1.0 million shares of Spotlight
Health Series C convertible preferred stock for $5.0 million. The Company recorded a charge to earnings for other than temporary decline in the fair value of its investment in Spotlight Health of $3.9 million in 2003. In July 2003, the Company
entered into an agreement with Spotlight Health and Bank of America, N.A. to guarantee a $2.0 million revolving line of credit provided to Spotlight Health by Bank of America. This new line of credit was used to refinance existing Spotlight Health
debt that was also guaranteed by the Company. In June 2005, the Company purchased 970,873 shares of Spotlight Healths Series D convertible preferred stock for a purchase price of $1.03 per share. In connection with that transaction, the
parties amended the loan agreement with Bank of America. Spotlight Health also granted Bank of America a first lien security interest on its assets to secure its obligations under the loan agreement. As a result of several unexpected project delays
and cancellations by its customers, Spotlight Health notified the Company in August 2005 that it was unable to continue as a going-concern and is in the liquidation process. During the third quarter of 2005, the Company recorded a charge to earnings
in the amount of $3.8 million relating to its investment in Spotlight Health. This amount includes the Companys investment of $2.2 million and a liability in the amount of $1.6 million based on the outstanding balance as of September 30,
2005 of Spotlight Healths revolving line of credit that is guaranteed by the Company.



In December 2002, the Company purchased 150,000 shares of Oriel Therapeutics, Inc. Series A convertible preferred stock for $150,000. The Company also received, as part of the purchase, a warrant to purchase an equal
number of shares of stock offered by Oriel Therapeutics in its next round of financing at a discount. In April 2003, the Company exercised the warrant for 150,000 shares of Oriel Therapeutics Series B convertible preferred stock for $200,000. At the
same time, the Company also purchased an additional 255,000 shares of Oriels Series B for $500,000. In March 2004, the Company loaned Oriel $900,000 in the form of secured debt convertible into Oriel Therapeutics Series B preferred stock
at $2.00 per share. The loan is secured by a first lien on Oriels assets. In June 2005, the Company loaned Oriel an additional $350,000 and received a warrant to purchase shares offered by Oriel Therapeutics in a future equity financing
transaction. The Company owned approximately 13.5% of Oriel Therapeutics outstanding common stock as of September 30, 2005. Oriel is a privately held company pursuing the development of technology to improve drug delivery in the treatment
of respiratory and pulmonary diseases.



In November 2003, the
Company became a limited partner in A. M. Pappas Life Science Ventures III, LP, a venture capital fund. The Pappas Fund was established for the purpose of making investments in equity securities of privately held companies in the life sciences,
healthcare and technology industries. The Company has committed to invest up to an aggregate of approximately $2.5 million in the Pappas Fund. No capital call can exceed 10% of the Companys aggregate capital commitment. As such, the Company
anticipates that its aggregate investment will be made through a series of future capital calls over the next several years. Capital calls through September 30, 2005 were $320,000. The Companys capital commitment will expire in May 2009.



In March 2005, Takeda Pharmaceutical Company Limited completed
its acquisition of Syrrx, Inc. The Company owned $25.0 million in preferred stock of Syrrx. Takeda paid the Company $25.0 million in April 2005 for this preferred stock. Syrrx is now known as Takeda San Diego, Inc.



In September 2005, the Company became a limited partner in Bay City Capital
Fund IV, a venture capital fund. The Bay City Fund IV was established in July 2004 for the purpose of investing in the life sciences companies. The Company has committed to invest up to a maximum of $10.0 million in the Bay City Fund IV. The Company
accrued an initial investment of $1.3 million as of September 30, 2005. No capital call can exceed 20% of the Companys aggregate capital commitment. Thus, the Company anticipates its remaining investment will be made through a series of
future capital calls over the next several years. The Companys capital commitment will expire in June 2009.



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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS



(unaudited)



7. COMPREHENSIVE INCOME



Comprehensive income consisted of the following:



|                                                                                                                                      |      |                                 |        |      |                                |   |        |   |  |      |        |   |  |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------- | ---- | ------------------------------- | ------ | ---- | ------------------------------ | - | ------ | - |  | ---- | ------ | - |  | - | ------- | -
|(in thousands)                                                                                                                        |      | Three Months EndedSeptember 30, |        |      | Nine Months EndedSeptember 30, |  
|                                                                                                                                      | 2004 |                                 |        | 2005 |                                |   | 2004   |   |  | 2005 |       
|Net income, as reported                                                                                                               |      | $                               | 24,990 |      |                                | $ | 38,381 |   |  | $    | 73,068 |   |  | $ | 97,654  |  
|Other comprehensive income (loss)                                                                                                     |      |                                 |        |      |                                |   |        |   |  |      |        |   |  |   |         |  
|Cumulative translation adjustment                                                                                                     |      |                                 | 1,266  |      |                                |   | (545   | ) |  |      | (55    | ) |  |   | (8,759  | )
|Change in fair value of hedging transaction, net of taxes of ($494), $244, ($447) and $778, respectively                              |      |                                 | 1,096  |      |                                |   | (567   | ) |  |      | 1,030  |   |  |   | (1,785  | )
|Reclassification adjustment for hedging results included in direct costs, net of taxes of $221, ($247), $558 and ($208),
respectively |      |                                 | (515   | )    |                                |   | 574    |   |  |      | (1,300 | ) |  |   | 485     |  
|Unrealized (loss) gain on investments, net of taxes of $0                                                                             |      |                                 | (428   | )    |                                |   | 71     |   |  |      | 41     |   |  |   | (733    | )
|                                                                                                                                      |      |                                 |        |      |                                |   |        |   |  |      |        |   |  |   |         |  
|Total other comprehensive income (loss)                                                                                               |      |                                 | 1,419  |      |                                |   | (467   | ) |  |      | (284   | ) |  |   | (10,792 | )
|                                                                                                                                      |      |                                 |        |      |                                |   |        |   |  |      |        |   |  |   |         |  
|Comprehensive income                                                                                                                  |      | $                               | 26,409 |      |                                | $ | 37,914 |   |  | $    | 72,784 |   |  | $ | 86,862  |  
|                                                                                                                                      |      |                                 |        |      |                                |   |        |   |  |      |        |   |  |   |         |  



Accumulated other
comprehensive income consisted of the following:



|                                              |  |                  |        |   |                   |   |        |  
|--------------------------------------------- |  | ---------------- | ------ | - | ----------------- | - | ------ | -
|(in thousands)                                |  | December 31,2004 |        |   | September 30,2005 |  
|Translation adjustment                        |  | $                | 14,903 |   |                   | $ | 6,144  |  
|Minimum pension liability, net of tax         |  |                  | (5,753 | ) |                   |   | (5,753 | )
|Fair value on hedging transaction, net of tax |  |                  | 413    |   |                   |   | (887   | )
|Unrealized gain on investment, net            |  |                  | 1,616  |   |                   |   | 883    |  
|                                              |  |                  |        |   |                   |   |        |  
|                                              |  | $                | 11,179 |   |                   | $ | 387    |  
|                                              |  |                  |        |   |                   |   |        |  



8. ACCOUNTING FOR DERIVATIVE
INSTRUMENTS AND HEDGING ACTIVITIES



In January 2004, the
Company began entering into foreign exchange forward and option contracts that are designated and qualify as cash flow hedges under SFAS No. 133 Accounting for Derivative Instruments and Hedging Activities. Changes in the fair value
of the effective portion of the outstanding forward and option contracts are recognized in accumulated other comprehensive income, or OCI. These amounts are reclassified from OCI and recognized in earnings when either the forecasted transaction
occurs or it becomes probable that the forecasted transaction will not occur.



Changes in the ineffective portion of a derivative instrument are recognized in earnings in the current period. Effectiveness for forward cash flow hedge contracts is measured by comparing the fair value of the forward contract to the
change in the forward value of the anticipated transaction. The fair market value of the hedged exposure is presumed to be the market value of the hedge instrument when critical terms match. Ineffectiveness in 2004 and 2005 was not significant.



The Company has significant international revenues and
purchase transactions, and related receivables and payables, denominated in non-functional currencies in the Companys foreign subsidiaries. As a result, the Company purchased currency option and forward contracts as cash flow hedges to reduce
or eliminate foreign currency



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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS



(unaudited)



8. ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES (continued)



exposures that can be identified and quantified. Pursuant to its foreign
exchange risk hedging policy, the Company may hedge anticipated and recorded transactions, and the related receivables and payables denominated in non-functional currencies, using forward foreign exchange rate contracts and foreign currency options.
The Companys policy is to only use foreign currency derivatives to minimize the variability in the Companys operating results arising from foreign currency exchange rate movements. The Company does not enter into derivative financial
instruments for speculative or trading purposes. Hedging contracts are measured at fair value using dealer quotes and mature within twelve months from their inception.



The Companys hedging contracts are primarily intended to protect against the impact of changes in the value of the
U.S. dollar against other currencies and its impact on operating results. Accordingly, for forecasted transactions, non-U.S. dollar functional subsidiaries incurring expenses in foreign currencies hedge U.S. dollar revenue contracts. OCI associated
with hedges of foreign currency revenue is reclassified into direct costs upon recognition of the forecasted transaction in the statement of operations. All values reported in OCI at September 30, 2005 will be reclassified to earnings within
twelve months. At September 30, 2005, the face amount of the foreign exchange contracts designated as cash flow hedges was $28.5 million.



The Company also enters into foreign currency forward contracts to hedge against changes in the fair value of monetary assets and liabilities denominated
in a non-functional currency. These derivative instruments are not designated as hedging instruments; therefore, changes in the fair value of these contracts are recognized immediately in other income, net, as an offset to the changes in the fair
value of the monetary assets or liabilities being hedged. At September 30, 2005, the face amount of these contracts was $11.5 million.



At September 30, 2005, the fair value of the Companys foreign currency derivative portfolio was a $3,000 gain recorded as a component of
prepaid expenses and other current assets, and a $1.3 million loss recorded as a component of other accrued expenses.



9. INCOME TAXES



The effective tax rate for the three months and nine months ended September 30, 2005 was 35.8% and 32.8%, respectively. The effective tax rate for
the first nine months of 2005 was positively impacted by a $6.3 million reduction in the valuation allowance provided for the deferred tax asset relating to capital loss carryforwards. This reduction was a result of the utilization of capital loss
carryforwards that previously had a valuation allowance recorded against them, as well as the recognition of capital gains for the SurroMed transaction, a $10.0 million dapoxetine new drug application milestone payment from ALZA Corporation in March
2005 and a $15.0 million up-front payment that Takeda San Diego, Inc. paid the Company under the agreement entered into in July 2005 with respect to the dipeptidyl peptidase IV, or DPP4 program. This reduction in the valuation allowance decreased
the effective tax rate by 4.4%.



The Company records current
and deferred income tax expense related to its foreign operations to the extent those earnings are taxable in a foreign jurisdiction. The American Jobs Creation Act of 2004 introduced a special one-time dividends received deduction on the
repatriation of foreign earnings to a U.S. taxpayer. Prior to 2005, the Company had not previously recorded a U.S. tax liability on these earnings because it intended to permanently reinvest them in its foreign operations. The Company has been
evaluating the impact of this law on its permanent reinvestment position and recorded tax expense of $1.2 million in the third quarter of 2005 relating to an additional expected repatriation of $30.8 million. For the nine months ended
September 30, 2005, the Company recorded tax expense of $1.9 million relating to the total projected repatriation of $53.0 million in foreign earnings. The Company continues to analyze the effect of the new Act on the remaining $23.4 million of
undistributed foreign earnings and expects to complete this analysis by the end of the year. The income tax effect of repatriating the remaining undistributed earnings is not estimable at this time.



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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS



(unaudited)



10. PENSION PLAN



The Company determined pension costs under the provisions of Statement of Financial Accounting Standards No. 87,
Employers Accounting for Pensions, and related disclosures under the provisions of Statement of Financial Accounting Standards No. 132 (Revised 2003), Employers Disclosures about Pensions and other Postretirement
Benefits.



The Company has a separate contributory
defined benefit plan for its qualifying U. K. employees employed by the Companys U.K. subsidiaries. This pension plan was closed to new participants as of December 31, 2002. The benefits for the U.K. Plan are based primarily on years of
service and average pay at retirement. Plan assets consist principally of investments managed in a mixed fund.



Pension costs for the U.K. Plan included the following components:



|                                        |      |                                 |      |      |                                |   |      |   |  |      |        |   |  |   |        |  
|--------------------------------------- | ---- | ------------------------------- | ---- | ---- | ------------------------------ | - | ---- | - |  | ---- | ------ | - |  | - | ------ | -
|(in thousands)                          |      | Three Months EndedSeptember 30, |      |      | Nine Months EndedSeptember 30, |  
|                                        | 2004 |                                 |      | 2005 |                                |   | 2004 |   |  | 2005 |       
|Service cost                            |      | $                               | 305  |      |                                | $ | 287  |   |  | $    | 925    |   |  | $ | 890    |  
|Interest cost                           |      |                                 | 429  |      |                                |   | 496  |   |  |      | 1,300  |   |  |   | 1,537  |  
|Expected return on plan assets          |      |                                 | (359 | )    |                                |   | (414 | ) |  |      | (1,088 | ) |  |   | (1,283 | )
|Amortization of transition asset amount |      |                                 | (3   | )    |                                |   | (2   | ) |  |      | (11    | ) |  |   | (5     | )
|Amortization of net loss                |      |                                 | 154  |      |                                |   | 146  |   |  |      | 467    |   |  |   | 453    |  
|                                        |      |                                 |      |      |                                |   |      |   |  |      |        |   |  |   |        |  
|Net periodic pension cost               |      | $                               | 526  |      |                                | $ | 513  |   |  | $    | 1,593  |   |  | $ | 1,592  |  
|                                        |      |                                 |      |      |                                |   |      |   |  |      |        |   |  |   |        |  



For the nine months
ended September 30, 2005, the Company made contributions of $1.3 million, and it anticipates contributing an additional $0.4 million to fund this plan during the remainder of 2005.



11. COMMITMENTS AND CONTINGENCIES



The Company currently maintains insurance for risks associated with the operation of its business, provision of professional services, and ownership of
property. These policies provide coverage for a variety of potential losses, including loss or damage to property, bodily injury, general commercial liability, professional errors and omissions, and medical malpractice. The Companys retentions
and deductibles associated with these insurance policies range from $0.25 million to $1.0 million.



The Company is self-insured for health insurance for employees located within the United States. The Company maintains stop-loss insurance on a
claims made basis for expenses in excess of $0.25 million per member per year. As of December 31, 2004 and September 30, 2005, the Company maintained a reserve of approximately $3.6 million and $4.6 million, respectively,
included in other accrued expenses on the consolidated condensed balance sheets, to cover open claims and estimated claims incurred but not reported.



In April 2000, the Company made an investment in Spotlight Health, Inc. The Company subsequently entered into an agreement to guarantee a $2.0 million
revolving line of credit provided to Spotlight Health by Bank of America. During the third quarter of 2005, the Company determined that its investment in Spotlight Health was impaired. As a result, the Company recorded a charge to earnings in the
amount of $3.8 million consisting of an impairment to its equity investment in Spotlight Health and a liability in the amount of $1.6 million based on the outstanding balance of Spotlight Healths revolving line of credit as of
September 30, 2005 that is guaranteed by the Company. For further details, see Note 6.



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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS



(unaudited)



11. COMMITMENTS AND CONTINGENCIES (continued)



In September 2005, the Company became a limited partner in Bay City Capital
Fund IV, a venture capital fund. The Company has committed to invest up to a maximum of $10.0 million in the Bay City Fund IV. For further details, see Note 6.



In August 2005, the Company amended its September 2004 royalty stream purchase agreement with Accentia. Under the terms of the amended agreement, the
Company agreed to provide specified clinical development services to Accentia in connection with two pivotal Phase III trials for SinuNase® for the treatment of chronic rhinosinusitis. In exchange for providing these services, Accentia
agreed to pay the Company a royalty equal to 14% of the net sales of specified SinuNase products if approved for sale by the FDA.



In February 2005, the Company acquired substantially all of SurroMeds assets related to its biomarker business. As part of this acquisition, the
Company agreed to guarantee repayment of up to $1.5 million under a SurroMed bank loan with a maturity date of December 31, 2006. In accordance with the requirements of FASB Statement No. 5, Accounting for Contingencies, as
clarified by FASB Interpretation No. 45, the Company has recorded a liability in the amount of $150,000 for the estimated fair value of the obligation it has assumed under this guarantee.



In November 2003, the Company entered into an agreement with Syrrx, Inc. to
jointly develop and commercialize human dipeptidyl peptidase IV, or DPP4, inhibitors for the treatment of type 2 diabetes and other major human diseases. The Company expensed a milestone payment of $2.5 million relating to the commencement of the
Phase II studies in the second quarter of 2005. In March 2005, Takeda Pharmaceutical Company Limited acquired 100% of the equity of Syrrx, which is now known as Takeda San Diego, Inc. In July 2005, Takeda San Diego acquired the development and
commercialization rights to all DPP4 inhibitors previously granted to the Company under the collaboration agreement between PPD and Syrrx. Under the new agreement, Takeda San Diego paid the Company a $15.0 million up-front payment in the third
quarter of 2005. The Company will also be entitled to receive potential milestone payments and royalties associated with the future development and commercialization of specified DPP4 inhibitors and will be the sole provider of clinical and
bioanalytical services to Takeda San Diego for Phase II and Phase III trials of DPP4 inhibitors conducted in the U.S. and Europe. As a result of this agreement, the Company will have no further material expense associated with the development and
commercialization of a DPP4 inhibitor.



In April 2003, the
Company made an equity investment in Chemokine Therapeutics Corp. In connection with this investment, Chemokine granted the Company an exclusive option to license a proprietary peptide for a one-time license fee of $1.5 million. The Company is
waiting for the results of certain Phase I studies to determine if it will exercise its option. If the Company chooses to exercise this option, it will be obligated to pay the license fee plus the costs for future development work on the peptide.
Chemokine also granted the Company the right to first negotiate a license to other peptides.



In November 2003, the Company became a limited partner in A. M. Pappas Life Science Ventures III, LP, a venture capital fund. The Company has committed to invest up to an aggregate of approximately $2.5 million in the
Pappas Fund. For further details, see Note 6.



In the fourth
quarter of 2003, the Company acquired from Eli Lilly & Company the patents for the compound dapoxetine for development in the field of genitourinary disorders. This compound is currently licensed to ALZA Corporation, a subsidiary of
Johnson & Johnson, which is developing it for premature ejaculation. Under the terms of the agreement with Lilly, the Company paid Lilly $65.0 million in cash and agreed to pay Lilly a royalty of 5% on annual net sales of dapoxetine in
excess of $800 million. ALZA submitted a new drug application for dapoxetine to the FDA in December 2004. On October 26, 2005, ALZA received a not approvable letter from the FDA on its new drug application. Under the Companys license
agreement with ALZA, the Company is entitled to receive future payments if regulatory milestones are achieved and royalty payments if dapoxetine is approved for



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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS



(unaudited)



11. COMMITMENTS AND CONTINGENCIES (continued)



sale. In its press release issued on October 26, 2005, ALZA stated that it plans to
address the questions raised in the FDA letter and continue the global development program. The Company does not know if or when ALZA will obtain regulatory approval for dapoxetine in the United States or any other country.



In March 2005, the Company signed a new lease for additional space in Austin,
Texas for its Phase II-IV operations. The facility is adjacent to the Companys new Phase I clinic. To induce the Company to enter into the lease for additional space, the landlord placed $5.5 million in an escrow account to be distributed to
the Company to cover the monthly rental on the old facility until the old facility is subleased. If the facility is subleased, the Company will receive an immediate distribution totaling the amount of the sublease income to be received under the
sublease and the escrow account will receive the future sublease rental income and remit the future rental payments due under the original facility lease to the landlord. The Company will continue to be responsible for its obligations under the
original lease and, therefore, subject to the risk of default by a subtenant. The Company will also be responsible to fund the escrow account to the extent the rent payments under the original lease exceed the rent payments under a sublease. The
Company accounts for the $5.5 million to be received from the escrow account as a lease incentive which will be recognized in income over the ten-year term of the new lease. As of September 30, 2005, the escrow account balance was $5.5 million,
$0.4 million of which was included as a component of prepaid expenses and other current assets, and $5.1 million of which was included as a component of other assets.



As of September 30, 2005, the Company had liabilities of $5.8 million in connection with tax positions taken in the
Companys tax returns that include interpretations of applicable income tax laws and regulations. These amounts are based on managements expectation regarding the ultimate tax treatment and outcome of these matters. The Company believes
it is unlikely that the resolution of these matters will have a material adverse effect on the Companys financial position or results of operations.



In January 2005, the Company acquired approximately 7.5 acres of property located in downtown Wilmington, North Carolina, on which the Company is
constructing a new headquarters building. The total purchase price for the land was approximately $2.8 million. In connection with the sale of the property, the seller, Almont Shipping Company, refinanced existing liens on the property with the
proceeds of an $8.0 million loan from Bank of America. This loan will mature in January 2006 and is secured by a lien on substantially all of Almonts assets, including an approximately 30-acre tract of land adjacent to the tract the Company
acquired. This loan is also secured by a guarantee from the Company. In accordance with the requirements of FASB Statement No. 5, Accounting for Contingencies, as clarified by FASB Interpretation No. 45, the Company has
recorded a liability in the amount of $0.8 million for the estimated fair value of the obligation the Company has assumed under this guarantee. Almonts obligation to reimburse the Company in the event the Company is required to pay any sums to
Bank of America under the guarantee is also secured by a lien on substantially all of Almonts assets. As a part of this transaction, Almont granted the Company an option to purchase all or a portion of the adjacent 30-acre tract of land at an
agreed upon price per acre. The option will expire on January 31, 2007.



Under most of the agreements for Development Group services, the Company agrees to indemnify and defend the sponsor against third-party claims based on the Companys negligence or willful misconduct. Any
successful claims could have a material adverse effect on the Companys financial condition, results of operations and future prospects.



The Company is subject to review by taxing authorities in the U.S. and in foreign countries in which the Company does business. In October 2005, the
Company was informed of an audit by the Brazilian authorities. Although the ultimate outcome of these matters is currently not determinable, management of the Company does not believe that the resolution of these matters will have a material effect
upon the Companys financial condition, results of operations or cash flows for an interim or annual period.



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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS



(unaudited)



11. COMMITMENTS AND CONTINGENCIES (continued)



In the normal course of business, the Company is a party to various claims
and legal proceedings. In addition to other pending claims, the Company is currently in litigation with a former client that has sued the Company for breach of contract and tortious acts in conducting a clinical trial. The former client is claiming
that it does not owe the Company the remaining amounts due under the contract and is seeking other damages from the Companys alleged breach of contract and tortious acts. The Company records a reserve for litigation matters when an adverse
outcome is probable and the amount of the potential liability is reasonably estimable. Although the ultimate outcome of these matters is currently not determinable, management of the Company, after consultation with legal counsel, does not believe
that the resolution of these matters will have a material effect upon the Companys financial condition, results of operations or cash flows for an interim or annual period.



12. BUSINESS SEGMENT DATA



Revenue by principal business segment is separately stated in the consolidated condensed financial statements. Income (loss) from operations and
identifiable assets by principal business segment were as follows:



|                               |  |                                 |        |                                |      |   |        |  |   |         |   |  |   |        
|------------------------------ |  | ------------------------------- | ------ | ------------------------------ | ---- | - | ------ |  | - | ------- | - |  | - | -------
|                               |  | Three Months EndedSeptember 30, |        | Nine Months EndedSeptember 30,
|(in thousands)                 |  | 2004                            |        |                                | 2005 |   | 2004   |  |   | 2005   
|Income (loss) from operations: |  |                                 |        |                                |      |   |        |  |   |         |   |  |   |        
|Development                    |  | $                               | 41,650 |                                |      | $ | 47,544 |  | $ | 115,094 |   |  | $ | 134,810
|Discovery sciences             |  |                                 | (3,597 | )                              |      |   | 13,233 |  |   | (6,313  | ) |  |   | 7,393  
|                               |  |                                 |        |                                |      |   |        |  |   |         |   |  |   |        
|Total                          |  | $                               | 38,053 |                                |      | $ | 60,777 |  | $ | 108,781 |   |  | $ | 142,203
|                               |  |                                 |        |                                |      |   |        |  |   |         |   |  |   |        



|                     |  |                  |         |                   |   |          
|-------------------- |  | ---------------- | ------- | ----------------- | - | ---------
|                     |  | December 31,2004 |         | September 30,2005
|Identifiable assets: |  |                  |         |                   |   |          
|Development          |  | $                | 879,123 |                   | $ | 1,028,499
|Discovery sciences   |  |                  | 96,078  |                   |   | 91,458   
|                     |  |                  |         |                   |   |          
|Total                |  | $                | 975,201 |                   | $ | 1,119,957
|                     |  |                  |         |                   |   |          



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PHARMACEUTICAL PRODUCT DEVELOPMENT, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS



(unaudited)



13. SUBSEQUENT EVENTS



On October 3, 2005, the Companys Board of Directors approved an annual dividend policy under which it intends to
pay an aggregate annual cash dividend of $0.20 on each outstanding share of common stock. The annual dividend will be payable quarterly at a rate of $0.05 per share. Shareholders of record as of October 17, 2005 will receive the first quarterly
cash dividend payment on November 8, 2005. This dividend will result in a payment of approximately $2.9 million. Additionally, the Company declared a special one-time cash dividend for its shareholders in the amount of $1.00 on each outstanding
share of common stock payable on November 11, 2005 to shareholders of record as of October 17, 2005. This one-time dividend payment will amount to approximately $57.8 million. The Company will fund these dividends from its existing cash
and cash equivalents. The annual cash dividend policy and the payment of future cash dividends are not guaranteed and are subject to the discretion of and continuing determination by the Companys Board of Directors that the policy remains in
the best interests of its shareholders and in compliance with applicable laws.



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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations



The following discussion and analysis is provided to increase understanding of, and should be read in conjunction with, our consolidated condensed
financial statements and accompanying notes. In this discussion, the words PPD, we, our and us refer to Pharmaceutical Product Development, Inc., together with its subsidiaries where appropriate.



Forward-looking Statements



This Form 10-Q contains forward-looking statements within the meaning of the
federal securities laws. These statements relate to future events or our future financial performance. Forward-looking statements include statements concerning plans, objectives, goals, strategies, future events or performances, expectations,
predictions, assumptions and other statements that are not statements of historical facts. In some cases, you can identify forward-looking statements by words such as might, will, should, expect,
plan, anticipate, believe, estimate, predict, intend, potential or continue, or the negative of these terms, or other comparable terminology. These
statements are only predictions. These statements rely on a number of assumptions and estimates that could be inaccurate and that are subject to risks and uncertainties. Actual events or results might differ materially due to a number of factors,
including those listed in Potential Volatility of Quarterly Operating Results and Stock Price below. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future
results, levels of activity, performance or achievements.



Company Overview



We are a leading global contract research organization
providing discovery and development services, market development expertise and compound partnering programs. Our clients and partners include pharmaceutical, biotechnology, medical device, academic and government organizations. Our corporate mission
is to help clients and partners maximize returns on their research and development investments and accelerate the delivery of safe and effective therapeutics to patients.



We have been in the drug development business for more than 19 years. Our development services include preclinical programs
and Phase I to Phase IV clinical development services. We have extensive clinical trial experience across a multitude of therapeutic areas and various parts of the world, including regional, national and global studies. In addition, for drugs that
have received approval for market use, we also offer post-market support services such as product launch services, patient compliance programs, disease registry programs and medical communications programs for consumer and healthcare providers on
product use and adverse events.



With offices in 28 countries
and more than 7,800 professionals worldwide, we have provided services to 45 of the top 50 pharmaceutical companies in the world as ranked by 2004 healthcare research and development spending. We also work with leading biotechnology and medical
device companies and government organizations that sponsor clinical research. We believe that we are one of the worlds largest providers of drug development services to pharmaceutical, biotechnology and medical device companies and government
organizations based on 2004 annual net revenues generated from contract research organizations.



Building on our outsourcing relationship with pharmaceutical and biotechnology clients, we established our discovery services business in 1997. This
business primarily focuses on preclinical evaluations of anticancer and diabetes therapies and compound partnering arrangements associated with the development and commercialization of potential drug products. We have developed a risk-sharing
research and development model to help pharmaceutical and biotechnology clients develop compounds. Through collaborative arrangements based on this model, we assist our clients by sharing the risks and potential rewards of the development and
commercialization of drugs with respect to compounds at various stages of development. In February 2005, we completed the acquisition of a biomarker business. This acquisition expanded our discovery sciences business by adding biomarker discovery
and patient sample analysis capability to the services offered by us.



We believe that our integrated drug discovery and development services offer our clients a way to identify and develop successful drugs more quickly and cost-effectively. We also use our proprietary informatics technology to support our
development services. In addition, because we are positioned globally, we are able to accommodate the multinational drug discovery and development needs of our customers. As a result of having



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these core areas of expertise in discovery and development, we can provide integrated services across the drug development spectrum. For more detailed
information on PPD, see our Annual Report on Form 10-K for the year ended December 31, 2004.



Executive Overview



Because our revenues are dependent on a relatively small number of industries and clients, we closely monitor the market for our drug discovery and development services. For a discussion of the trends affecting our market, see Item 1.
BusinessTrends Affecting the Drug Discovery and Development Industry in our Annual Report on Form 10-K for the year ended December 31, 2004.



While we cannot predict the demand for CRO services for the remainder of 2005, we believe the overall historical market drivers for our industry remain
intact. To continue to grow authorizations for the remainder of 2005 and in 2006, we will continue to focus on delivering timely, high quality services to our clients and on our business development efforts, including increasing the percentage of
successful proposals and the transition of the Senior Vice President of Global Business Development position to recently hired Bill Richardson from Frank Casieri, who will continue in a part-time role to assist with this transition. We currently
conduct a significant amount of government-sponsored research and in July 2005 we were awarded a five-year contract to provide comprehensive research management and support to the National Institute of Allergy and Infectious Disease
(NIAID) Division of AIDS. NIAID is a component of the National Institutes of Health, an agency of the U.S. Department of Health and Human Services. The aggregate value of this contract is $245 million, of which approximately $43 million
is expected to be for subcontractor costs, $25 million for travel costs and other reimbursed out-of-pockets and the remaining $177 million for direct costs that have been added to our backlog. We plan to continue our efforts to win new projects in
this market.



We also believe there are specific opportunities
for continued growth in other areas of our business. Our Latin American and European Phase II through IV units had strong operating and financial performance in the first nine months of 2005 and we believe there are opportunities for further
expansion in these regions. We are also expanding facilities in South Africa, Israel, Germany, Argentina, Taiwan and Singapore, with growth planned in Brazil, Chile, Korea and Thailand. We continue to experience solid demand for our Phase I
services. Our Phase I clinic in Austin, Texas that we recently expanded to 300 beds to enhance our ability to service large, complex studies is now fully operational. Similarly, in the first nine months of 2005, the demand for our bioanalytical and
GMP services continued to increase and we are planning expansions and new services for our GMP laboratory facilities over the next two years. We have continued to invest in scientific equipment in our bioanalytical laboratory and now have 63 liquid
chromatography/mass spectrometry, or LCMS, systems in this laboratory to process fluid samples for preclinical studies. Finally, we also believe the demand for our post-marketing development services should continue to grow.



We review various metrics, including period-to-period growth in backlog, new
authorizations, cancellation rates, revenue, margins and earnings, to evaluate our financial performance. In the third quarter of 2005, we had new authorizations of $645.3 million, an increase of 107.9% over the third quarter of 2004. The
cancellation rate for the third quarter of 2005 was 12% compared to 22% in the full year of 2004. On a net basis, authorizations were up 143.1% in the third quarter of 2005 compared to the same period in 2004. Backlog grew to $1.7 billion as of
September 30, 2005, up 41% over September 30, 2004. Backlog by client type as of September 30, 2005 was 49% pharmaceutical, 33% biotech and 18% government/other. Backlog by client type as of December 31, 2004 was 58%
pharmaceutical, 28% biotech and 14% government/other. This change in the composition of our backlog primarily reflects an increase in new authorizations from both large and small biotech clients and our new contract with NIAID. Net revenue by client
type for the quarter ended September 30, 2005 was 64% pharmaceutical, 28% biotech and 8% government/other. Top therapeutic areas by net revenue for the quarter ended September 30, 2005 were anti-infective/anti-viral, oncology, central
nervous system, endocrine/metabolic and circulatory/cardiovascular. For a detailed discussion of our revenue, margins, earnings and other financial results for the quarter ended September 30, 2005, see Results of Operations  Three
Months Ended September 30, 2005 versus Three Months Ended September 30, 2004 below.



Capital expenditures for the three months ended September 30, 2005 totaled approximately $16.6 million. These capital expenditures included $6.7
million related to land and building costs for our new corporate



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headquarters in Wilmington, North Carolina, $5.0 million for software and computer hardware and $2.6 million for additional scientific equipment for our
Phase I and laboratory units. In addition to investing in our growing business, we continue to implement a number of initiatives to improve the efficiency of our operations.



As of September 30, 2005, we had $335.7 million of cash and cash equivalents and continue to generate cash from
operations. Due to our cash position and free cash flow, our Board of Directors recently declared both a one-time, special dividend and a policy to pay an annual cash dividend. The annual cash dividend policy and the payment of future cash dividends
are not guaranteed and are subject to the discretion of and continuing determination by our Board of Directors that the policy remains in the best interests of our shareholders and in compliance with applicable laws.



In February 2005, we acquired substantially all of the assets of SurroMed,
Inc.s biomarker business. This acquisition expanded our discovery business by adding biomarker discovery and patient sample analysis to the discovery services offered by us. Our preclinical oncology facility had a solid performance in the
third quarter of 2005 and is now offering models to support diabetes drug development. Our Discovery Sciences segment also includes our compound collaboration arrangements. These collaborations allow us to leverage our resources and global drug
development expertise to create new opportunities for growth and to share the risks and potential rewards of drug development with our clients. For a background discussion of our compound partnering arrangements, see Item 1. Business 
Our Services  Our Discovery Sciences Group  Compound Partnering Programs in our Annual Report on Form 10-K for the year ended December 31, 2004.



In the first nine months of 2005, we made significant progress on the dipeptidyl peptidase, or DPP4, collaboration with
Takeda San Diego, Inc. (formerly Syrrx, Inc.). In March 2005, we completed the Phase Ib study in patients for the first DPP4 inhibitor in March 2005 and initiated the Phase II program for that inhibitor in April. We also commenced the Phase I first
in man study for the second DPP4 inhibitor in April 2005. In July 2005, we entered into an agreement under which Takeda San Diego acquired the development and commercialization rights to all DPP4 inhibitors previously granted to us under the
collaboration agreement between PPD and Syrrx. Under the new agreement, Takeda San Diego paid us a $15.0 million up-front payment in the third quarter of 2005. In October 2005, we amended the agreement with Takeda to, among other things, delay the
trigger for the payment of the $15.0 million Phase III development milestone from dosing of the first patient to dosing of the twentieth patient. We will also be entitled to receive other potential milestone payments of up to an aggregate of $70.5
million, sales-based milestones of up to an aggregate of $33.0 million and royalties associated with the future development and commercialization of specified DPP4 inhibitors if regulatory approval is obtained. We will also be the sole provider of
clinical and bioanalytical services to Takeda San Diego for Phase II and Phase III trials of DPP4 inhibitors conducted in the U.S. and Europe. Furthermore, we will not have any responsibility for future expenses associated with the development and
commercialization of a DPP4 inhibitor. As a result, we do not expect to incur significant R&D expense in the Discovery Sciences segment during the remainder of 2005. We do not know if or when Takeda will obtain regulatory approval for DPP4 in
the United States or any other country. As a result, we do not know if we will ever receive any DPP4 milestone payments or royalties contingent upon regulatory approval. For additional information on the agreement with Takeda San Diego and
subsequent amendment to the agreement, see our Current Reports on Form 8-K filed on July 18, 2005 and October 10, 2005.



We also recently modified our royalty stream agreement with Accentia. Under the revised agreement, we agreed to provide specified clinical development
services with respect to Phase III trials for SinuNase® in exchange for a 14% royalty on net sales of specified SinuNase products. SinuNase is a nasal-delivered self-administered amphotericin B suspension for the treatment of chronic
rhinosinusitis.



With regard to our collaboration with ALZA
Corporation on dapoxetine, an investigational compound for the treatment of premature ejaculation, in February 2005 the FDA accepted ALZAs new drug application and we received the $10.0 million payment for this milestone in March 2005.
However, as announced on October 26, 2005, ALZA received a not approvable letter from the FDA on the new drug application. Under our license agreement with ALZA, we are entitled to receive future payments if regulatory milestones are achieved
and royalty payments if dapoxetine is approved for sale. In its press release issued on October 26, 2005, ALZA stated that it plans to address the questions raised in the FDA letter and continue the global development program. We do not know if
or when ALZA will obtain regulatory approval for dapoxetine in the United States or any other country. As a result, we do not know if we will ever receive any future dapoxetine milestone payments or royalties.



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In the first quarter of 2005, we terminated the implitapide program for various reasons and are winding
down our collaboration with Bayer A.G. With regard to our collaboration with Chemokine Therapeutics Corp. on its proprietary peptide for possible use as a blood recovery agent, we are waiting on the results of certain Phase I studies before deciding
whether to exercise our option to license this peptide.



In
addition to our existing collaborations, we continue to evaluate opportunities for new collaborations and investments that we believe will help us achieve our mid- to long-term growth objectives.



Acquisitions



In February 2005, we completed our acquisition of substantially all of the assets of SurroMed, Inc.s biomarker
business. The assets acquired by us consist of equipment, fixtures, leasehold improvements, intellectual property and contracts. The biomarker business supports drug discovery and drug development by identifying biomarkers using biological, chemical
and bioinformatics expertise and technologies. The acquisition expands our business by adding biomarker discovery and patient sample analysis capability to the services offered by us. In exchange for the assets, we surrendered to SurroMed for
cancellation all shares of preferred stock of SurroMed we held. As additional consideration for the acquisition, we assumed approximately $3.4 million of SurroMed liabilities under capital leases and additional operating liabilities and agreed to
guarantee repayment of up to $1.5 million under a SurroMed bank loan. We recognized a pre-tax gain on the exchange of assets of $5.1 million. The biomarker business is now part of the Discovery Sciences segment.



We accounted for this acquisition using the purchase method of accounting,
utilizing appropriate fair value techniques to allocate the purchase price based on the estimated fair values of the assets acquired and liabilities assumed. Accordingly, the estimated fair value of assets acquired and liabilities assumed were
included in our consolidated condensed balance sheet as of the effective date of the acquisition. For further details regarding this acquisition, see Note 2 to the Notes to Consolidated Condensed Financial Statements.



Investments



In January 2004, we purchased 5.0 million shares of Accentia Biopharmaceuticals, Inc. Series E convertible preferred
stock for $5.0 million. At that time, we also received a Class A and Class B warrant, each to purchase up to an additional 5.0 million shares of Series E convertible preferred stock for $1.00 per share. We exercised the Class A
warrant in January 2005 and the Class B warrant in August 2005. On October 28, 2005, Accentia completed its initial public offering of 2.4 million shares of common stock for $8.00 per share. Upon completion of the initial public offering,
our 15 million shares of Series E convertible preferred stock were converted to 4,270,323 shares of common stock. We may sell our Accentia shares beginning 180 days after the date of the initial public offering.



In March 2005, Takeda Pharmaceutical Company Limited completed its
acquisition of Syrrx, Inc. We owned $25.0 million in preferred stock of Syrrx. Takeda paid us $25.0 million in April 2005 for our preferred stock in Syrrx.



In September 2005, we became a limited partner in Bay City Capital Fund IV, a venture capital fund. The Bay City Fund IV was established for the purpose
of investing in life sciences companies. We have committed to invest up to a maximum of $10.0 million in the Bay City Fund IV. We accrued an initial investment in the amount of $1.3 million as of September 30, 2005 and anticipate our remaining
investment will be made through a series of future capital calls over the next several years.



In April 2000, we purchased 1.0 million shares of Spotlight Health Series C convertible preferred stock for $5.0 million. In June 2005, we purchased 970,873 shares of Spotlight Healths Series D convertible
preferred stock at $1.03 per share. As a result of several unexpected project delays and cancellations by its customers, Spotlight Health notified us in August 2005 that it was unable to continue as a going-concern and is in the liquidation process.
During the third quarter of 2005, we recorded a $3.8 million loss relating to our investment in Spotlight Health.



In December 2002, we purchased 150,000 shares of Oriel Therapeutics, Inc. Series A convertible preferred stock for $150,000. We also received, as part of
the purchase, a warrant to purchase an equal number of shares of stock offered by Oriel Therapeutics in its next round of financing at a discount. In April 2003, we exercised the warrant for 150,000 shares of Oriel Therapeutics Series B convertible
preferred stock for $200,000.



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At the same time, we also purchased an additional 255,000 shares of Oriels Series B for $500,000. In March 2004, we
loaned Oriel $900,000 in the form of secured debt that is convertible into Oriel Therapeutics Series B preferred stock at $2.00 per share. The loan is secured by a first lien on Oriels assets. In June 2005, we loaned Oriel an additional
$350,000 and received a warrant to purchase shares offered by Oriel Therapeutics in a future equity financing transaction.



For further details regarding investments, see Note 6 to the Notes to Consolidated Condensed Financial Statements.



New Business Authorizations and Backlog



New business authorizations, which are sales of our services, are added to
backlog when we enter into a contract or letter of intent or receive a verbal commitment. Authorizations can vary significantly from quarter to quarter and contracts generally have terms ranging from several months to several years. We recognize
revenue on these authorizations as services are performed. Our new authorizations for the three months ended September 30, 2004 and 2005 were $310.4 million and $645.3 million, respectively.



Our backlog consists of new business authorizations for which the work has
not started but is anticipated to begin in the near future and contracts in process that have not been completed. As of September 30, 2005, the remaining duration of the contracts in our backlog ranged from one month to 168 months, with an
average duration of 32.2 months. Amounts included in backlog represent potential future revenue and exclude revenue that we have previously recognized. Once work begins on a project included in backlog, net revenue is recognized over the life of the
contract. However, there can be no assurance that our backlog will ever be recognized as revenue. Our backlog as of September 30, 2004 and 2005 was $1.23 billion and $1.73 billion, respectively.



Results of Operations



Revenue Recognition



We record revenue from contracts on a proportional performance basis in our Development Group. To measure performance on a given date, we compare direct
costs incurred through that date to estimated total contract direct costs. We believe this is the best indicator of the performance of the contractual obligations because the costs relate primarily to the amount of labor incurred to perform the
service. Changes to the estimated total contract direct costs result in a cumulative adjustment to the amount of revenue recognized. For time-and-materials contracts in both our Development Group and Discovery Sciences Group, we recognize revenues
as hours are worked, multiplied by the applicable hourly rate. For our Phase I and laboratory businesses, we recognize revenues from unitized contracts as subjects or samples are tested, multiplied by the applicable unit price.



In connection with the management of multi-site clinical trials, we pay, on
behalf of our customers, fees to investigators and test subjects as well as other out-of-pocket costs for items such as travel, printing, meetings and couriers. Our clients reimburse us for these costs. As required by Emerging Issues Task Force
01-14, Income Statement Characterization of Reimbursements Received for Out-of-Pocket Expenses Incurred, amounts paid by us as a principal for out-of-pocket costs are included in direct costs as reimbursable out-of-pocket
expenses and the reimbursements we receive as a principal are reported as reimbursed out-of-pocket revenue. In our statements of operations, we combine amounts paid by us as an agent for out-of-pocket costs with the corresponding reimbursements, or
revenue, we receive as an agent. During the three months ended September 30, 2004 and 2005, fees paid to investigators and other expenses we paid as an agent and the associated reimbursements were approximately $42.7 million and $65.1 million,
respectively.



Most of the contracts for our Development Group
can be terminated by our clients either immediately or after a specified period following notice by the client. These contracts typically require payment to us of expenses to wind down a study, fees earned to date, and in some cases, a termination
fee or some portion of the fees or profit that we could have earned under the contract if it had not been terminated early. Therefore, revenue recognized prior to cancellation does not generally require a significant adjustment upon cancellation. If
we determine that a loss will result from the performance of a fixed-price contract, the entire amount of the estimated loss is charged against income in the period in which the determination is made.



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The Discovery Sciences Group also generates revenue from time to time in the form of milestone payments
in connection with licensing of compounds. We only recognize milestone payments as revenue if the specified milestone is achieved and accepted by the customer, payment is received and continued performance of future research and development services
related to that milestone are not required.



Recording of
Expenses



We generally record our operating expenses among
the following categories:



| |  |  | direct costs;
| | - |  | -------------



| |  |  | research and development;
| | - |  | -------------------------



| |  |  | selling, general and administrative;
| | - |  | ------------------------------------



| |  |  | depreciation and
| | - |  | ----------------



| |  |  | amortization.
| | - |  | -------------



Direct costs consist of amounts necessary to carry out the revenue and earnings process, and include direct labor and related benefit charges, other costs
directly related to contracts, an allocation of facility and information technology costs, and reimbursable out-of-pocket expenses. Direct costs, as a percentage of net revenue, tend to and are expected to fluctuate from one period to another as a
result of changes in labor utilization and the mix of service offerings involved in the hundreds of studies being conducted during any period of time.



Research and development, or R&D, expenses consist primarily of patent expenses, labor and related benefit charges associated with personnel
performing internal research and development work, supplies associated with this work, consulting services and an allocation of facility and information technology costs.



Selling, general and administrative, or SG&A, expenses consist primarily of administrative payroll and related benefit
charges, sales, advertising and promotional expenses, recruiting and relocation expenses, administrative travel, an allocation of facility and information technology costs, and costs related to operational employees performing administrative tasks.



Depreciation consists of depreciation costs recorded on a
straight-line method, based on estimated useful lives of 40 to 50 years for buildings, five years for laboratory equipment, two to five years for software, computers and related equipment, and five to ten years for furniture and equipment, except
for airplanes, which we depreciate over 30 years. We depreciate leasehold improvements over the shorter of the life of the relevant lease or the useful life of the improvement. We depreciate property under capital leases over the life of the lease
or the service life, whichever is shorter.



Amortization
consists of amortization costs recorded on intangible assets on a straight-line method over the life of the intangible assets.



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Three Months Ended September 30, 2005 Versus Three Months Ended September 30, 2004



The following table sets forth amounts from our consolidated condensed
financial statements along with the dollar and percentage change for the three months ended September 30, 2005 compared to the three months ended September 30, 2004.



|                                             |  |                                            |         |   |      |   |             |  |   |             |   |  |       |  
|-------------------------------------------- |  | ------------------------------------------ | ------- | - | ---- | - | ----------- |  | - | ----------- | - |  | ----- | -
|                                             |  | Three Months EndedSeptember 30,(unaudited) |         |   |      |   |             | 
|(in thousands, except per share data)        |  | 2005                                       |         |   | 2004 |   | $ Inc (Dec) |  |   | % Inc (Dec) |  
|Net revenue:                                 |  |                                            |         |   |      |   |             |  |   |             |   |  |       |  
|Development                                  |  | $                                          | 235,148 |   |      | $ | 193,233     |  | $ | 41,915      |   |  | 21.7  | %
|Discovery sciences                           |  |                                            | 19,458  |   |      |   | 2,289       |  |   | 17,169      |   |  | 750.1 |  
|Reimbursed out-of-pockets                    |  |                                            | 18,674  |   |      |   | 20,302      |  |   | (1,628      | ) |  | (8.0  | )
|                                             |  |                                            |         |   |      |   |             |  |   |             |   |  |       |  
|Total net revenue                            |  |                                            | 273,280 |   |      |   | 215,824     |  |   | 57,456      |   |  | 26.6  |  
|                                             |  |                                            |         |  
|Direct costs:                                |  |                                            |         |   |      |   |             |  |   |             |   |  |       |  
|Development                                  |  |                                            | 117,414 |   |      |   | 95,038      |  |   | 22,376      |   |  | 23.5  |  
|Discovery sciences                           |  |                                            | 2,064   |   |      |   | 1,367       |  |   | 697         |   |  | 51.0  |  
|Reimbursable out-of-pocket expenses          |  |                                            | 18,674  |   |      |   | 20,302      |  |   | (1,628      | ) |  | (8.0  | )
|                                             |  |                                            |         |   |      |   |             |  |   |             |   |  |       |  
|Total direct costs                           |  |                                            | 138,152 |   |      |   | 116,707     |  |   | 21,445      |   |  | 18.4  |  
|                                             |  |                                            |         |  
|Research and development expenses            |  |                                            | 1,967   |   |      |   | 4,138       |  |   | (2,171      | ) |  | (52.5 | )
|Selling, general and administrative expenses |  |                                            | 61,970  |   |      |   | 49,303      |  |   | 12,667      |   |  | 25.7  |  
|Depreciation                                 |  |                                            | 10,135  |   |      |   | 7,392       |  |   | 2,743       |   |  | 37.1  |  
|Amortization                                 |  |                                            | 279     |   |      |   | 231         |  |   | 48          |   |  | 20.8  |  
|                                             |  |                                            |         |   |      |   |             |  |   |             |   |  |       |  
|Income from operations                       |  |                                            | 60,777  |   |      |   | 38,053      |  |   | 22,724      |   |  | 59.7  |  
|                                             |  |                                            |         |  
|Impairment of investment                     |  |                                            | (3,797  | ) |      |   |            |  |   | (3,797      | ) |  |       |  
|Interest and other income, net               |  |                                            | 2,803   |   |      |   | 994         |  |   | 1,809       |   |  | 182.0 |  
|                                             |  |                                            |         |   |      |   |             |  |   |             |   |  |       |  
|Income before taxes                          |  |                                            | 59,783  |   |      |   | 39,047      |  |   | 20,736      |   |  | 53.1  |  
|Provision for income taxes                   |  |                                            | 21,402  |   |      |   | 14,057      |  |   | 7,345       |   |  | 52.3  |  
|                                             |  |                                            |         |   |      |   |             |  |   |             |   |  |       |  
|Net income                                   |  | $                                          | 38,381  |   |      | $ | 24,990      |  | $ | 13,391      |   |  | 53.6  |  
|                                             |  |                                            |         |   |      |   |             |  |   |             |   |  |       |  
|Net income per diluted share                 |  | $                                          | 0.66    |   |      | $ | 0.44        |  | $ | 0.22        |   |  | 50.0  |  
|                                             |  |                                            |         |   |      |   |             |  |   |             |   |  |       |  



Total net revenue
increased $57.5 million to $273.3 million in the third quarter of 2005. The increase in total net revenue resulted from an increase in both Development and Discovery Sciences revenue. The Development Groups operations generated net revenue of
$235.1 million, which accounted for 86.0% of total net revenue for the third quarter of 2005. The 21.7% increase in the Development Groups net revenue was primarily attributable to an increase in the level of global CRO Phase II through IV
services we provided in the third quarter of 2005 as compared to the third quarter of 2004.



The Discovery Sciences Group generated net revenue of $19.5 million in the third quarter of 2005, an increase of $17.2 million from the third quarter of 2004. The increase in the Discovery Sciences net revenue was
mainly attributable to the $15.0 million up-front payment from Takeda San Diego in connection with the DPP4 agreement that we entered into in July 2005. The remaining increase was due to revenue generated by the biomarker business we acquired from
SurroMed as well as increased revenue generated by our preclinical oncology division.



Total direct costs increased $21.4 million to $138.2 million in the third quarter of 2005 primarily as the result of an increase in the Development Group direct costs. Development Group direct costs increased $22.4
million to $117.4 million in the third quarter of 2005. The primary reason for this increase was an increase in personnel costs of



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$16.5 million. Personnel costs increased due to hiring additional employees in our global CRO Phase II through IV
division. The remaining $5.9 million increase in Development Group direct costs primarily consisted of increased facility costs related to the increase in personnel and increased subcontractor costs to support increased revenue.



Discovery Sciences direct costs increased $0.7 million to $2.1 million in the
third quarter of 2005. The higher costs in the third quarter of 2005 related primarily to additional direct costs of the biomarker business acquired from SurroMed in February 2005.



R&D expenses decreased $2.2 million to $2.0 million in the third quarter of 2005. R&D expenses decreased because
under the new DPP4 agreement with Takeda San Diego that we entered into in July 2005, Takeda San Diego became responsible for development and commercialization costs of the DPP4 inhibitors. Thus, we do not expect to incur significant R&D expense
during the remainder of 2005.



SG&A expenses increased
$12.7 million to $62.0 million in the third quarter of 2005. As a percentage of total net revenue, SG&A expenses decreased slightly to 22.7% in the third quarter of 2005 compared to 22.8% in the third quarter of 2004. The increase in SG&A
expenses in absolute dollars includes additional personnel costs of $8.2 million. The increase in personnel costs related to training costs for new personnel, higher levels of operations infrastructure to manage direct personnel and changes in
utilization levels. The increase in SG&A costs also includes an increase of $1.3 million in recruiting costs to hire additional personnel and $1.0 million in travel costs for training initiatives for new and existing operations personnel, as
well as higher administrative travel and an increase of $0.8 million in facility costs related to the increase in personnel.



Depreciation increased $2.7 million to $10.1 million in the third quarter of 2005. The increase was related to the property and equipment we acquired to
accommodate our growth. Our property, plant and equipment, net balance increased $77.2 million from September 30, 2004 to September 30, 2005. Capital expenditures were $16.6 million in the third quarter of 2005. Capital expenditures
included $6.7 million related to land and building costs for our new corporate headquarters in Wilmington, North Carolina. Capital expenditures also included $5.0 million for software and computer hardware and $2.6 million for additional scientific
equipment for our Phase I and laboratory units.



Income from
operations increased $22.7 million to $60.8 million in the third quarter of 2005. As a percentage of net revenue, income from operations increased to 22.2% of net revenue in the third quarter of 2005 from 17.6% in the third quarter of 2004. Income
from operations in the third quarter of 2005 included a $15.0 million up-front payment from Takeda San Diego in connection with the DPP4 agreement as well as a decrease in R&D expenses of $2.2 million compared to the third quarter of 2004.



During the third quarter of 2005, we recorded a charge to
earnings of $3.8 million relating to our investment in Spotlight Health, Inc. The write-down of Spotlight Health consisted of our equity investment of $2.2 million and a liability of $1.6 million based on the outstanding balance as of
September 30, 2005 of Spotlight Healths revolving line of credit that we guaranteed.



Our provision for income taxes increased $7.3 million to $21.4 million in the third quarter of 2005 primarily due to an increase in pre-tax income.
Additionally, we recorded tax expense of $1.2 million in the third quarter of 2005 on expected repatriation of foreign earnings of $30.8 million. Our effective income tax rate for the third quarter of 2005 was 35.8% compared to 36.0% for the third
quarter of 2004.



Net income of $38.4 million in the third
quarter of 2005 represents an increase of $13.4 million from $25.0 million in the third quarter of 2004. Net income per diluted share was $0.66 for the third quarter of 2005 and $0.44 for the third quarter of 2004.



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Nine Months Ended September 30, 2005 Versus Nine Months Ended September 30, 2004



The following table sets forth amounts from our consolidated condensed
financial statements along with the dollar and percentage change for the nine months ended September 30, 2005 compared to the nine months ended September 30, 2004.



|                                             |  |                                           |         |   |      |   |         |             |  |   |             |   |  |        |  
|-------------------------------------------- |  | ----------------------------------------- | ------- | - | ---- | - | ------- | ----------- |  | - | ----------- | - |  | ------ | -
|                                             |  | Nine Months EndedSeptember 30,(unaudited) |         |   |      |   |         |             | 
|(in thousands, except per share data)        |  | 2005                                      |         |   | 2004 |   |         | $ Inc (Dec) |  |   | % Inc (Dec) |  
|Net revenue:                                 |  |                                           |         |   |      |   |         |             |  |   |             |   |  |        |  
|Development                                  |  | $                                         | 672,931 |   |      | $ | 551,125 |             |  | $ | 121,806     |   |  | 22.1   | %
|Discovery sciences                           |  |                                           | 35,954  |   |      |   | 11,870  |             |  |   | 24,084      |   |  | 202.9  |  
|Reimbursed out-of-pockets                    |  |                                           | 53,591  |   |      |   | 48,645  |             |  |   | 4,946       |   |  | 10.2   |  
|                                             |  |                                           |         |   |      |   |         |             |  |   |             |   |  |        |  
|Total net revenue                            |  |                                           | 762,476 |   |      |   | 611,640 |             |  |   | 150,836     |   |  | 24.7   |  
|                                             |  |                                           |         |  
|Direct costs:                                |  |                                           |         |   |      |   |         |             |  |   |             |   |  |        |  
|Development                                  |  |                                           | 338,531 |   |      |   | 274,082 |             |  |   | 64,449      |   |  | 23.5   |  
|Discovery sciences                           |  |                                           | 5,821   |   |      |   | 4,215   |             |  |   | 1,606       |   |  | 38.1   |  
|Reimbursable out-of-pocket expenses          |  |                                           | 53,591  |   |      |   | 48,645  |             |  |   | 4,946       |   |  | 10.2   |  
|                                             |  |                                           |         |   |      |   |         |             |  |   |             |   |  |        |  
|Total direct costs                           |  |                                           | 397,943 |   |      |   | 326,942 |             |  |   | 71,001      |   |  | 21.7   |  
|                                             |  |                                           |         |  
|Research and development expenses            |  |                                           | 22,233  |   |      |   | 9,062   |             |  |   | 13,171      |   |  | 145.3  |  
|Selling, general and administrative expenses |  |                                           | 176,389 |   |      |   | 142,271 |             |  |   | 34,118      |   |  | 24.0   |  
|Depreciation                                 |  |                                           | 28,006  |   |      |   | 20,992  |             |  |   | 7,014       |   |  | 33.4   |  
|Amortization                                 |  |                                           | 846     |   |      |   | 973     |             |  |   | (127        | ) |  | (13.1  | )
|Gain on exchange of assets                   |  |                                           | (5,144  | ) |      |   |        |             |  |   | (5,144      | ) |  |        |  
|Restructuring charges                        |  |                                           |        |   |      |   | 2,619   |             |  |   | (2,619      | ) |  | (100.0 | )
|                                             |  |                                           |         |   |      |   |         |             |  |   |             |   |  |        |  
|Income from operations                       |  |                                           | 142,203 |   |      |   | 108,781 |             |  |   | 33,422      |   |  | 30.7   |  
|                                             |  |                                           |         |  
|Impairment of investment                     |  |                                           | (3,797  | ) |      |   | (2,000  | )           |  |   | (1,797      | ) |  | (89.9  | )
|Interest and other income, net               |  |                                           | 6,875   |   |      |   | 2,699   |             |  |   | 4,176       |   |  | 154.7  |  
|                                             |  |                                           |         |   |      |   |         |             |  |   |             |   |  |        |  
|Income before taxes                          |  |                                           | 145,281 |   |      |   | 109,480 |             |  |   | 35,801      |   |  | 32.7   |  
|Provision for income taxes                   |  |                                           | 47,627  |   |      |   | 36,412  |             |  |   | 11,215      |   |  | 30.8   |  
|                                             |  |                                           |         |   |      |   |         |             |  |   |             |   |  |        |  
|Net income                                   |  | $                                         | 97,654  |   |      | $ | 73,068  |             |  | $ | 24,586      |   |  | 33.6   |  
|                                             |  |                                           |         |   |      |   |         |             |  |   |             |   |  |        |  
|Net income per diluted share                 |  | $                                         | 1.68    |   |      | $ | 1.29    |             |  | $ | 0.39        |   |  | 30.2   |  
|                                             |  |                                           |         |   |      |   |         |             |  |   |             |   |  |        |  



Total net revenue
increased $150.8 million to $762.5 million in the first nine months of 2005. The increase in total net revenue resulted from an increase in our Development Group revenue, the $15.0 million up-front payment from Takeda San Diego in connection with
our DPP4 agreement and the $10.0 million milestone payment from ALZA related to the filing of the new drug application, or NDA, for dapoxetine in the first nine months of 2005. The Development Groups operations generated net revenue of $672.9
million, which accounted for 88.3% of total net revenue for the first nine months of 2005. The 22.1% increase in the Development Groups net revenue was primarily attributable to an increase in the level of global CRO Phase II through IV
services we provided in the first nine months of 2005 as compared to the first nine months of 2004. Net revenue for the Development Group also increased by approximately $1.6 million due to the effect of the U.S. dollar weakening relative to the
euro and British pound in the first nine months of 2005.



The
Discovery Sciences Group generated net revenue of $36.0 million in the first nine months of 2005, an increase of $24.1 million from the first nine months of 2004. The increase in the Discovery Sciences net revenue was mainly attributable to the
$15.0 million up-front payment from Takeda San Diego in connection with the DPP4



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agreement and the $10.0 million milestone payment related to the filing of the dapoxetine NDA. Revenue generated by our
biomarker business that we acquired from SurroMed contributed to the remaining increase in Discovery Sciences revenue. In 2004, we received a $5.0 million payment from ALZA in connection with an amendment to the dapoxetine out-license agreement.



Total direct costs increased $71.0 million to $397.9 million
in the first nine months of 2005 primarily as the result of an increase in the Development Group direct costs. Development Group direct costs increased $64.4 million to $338.5 million in the first nine months of 2005. The primary reason for this
increase was an increase in personnel costs of $44.5 million. Personnel costs increased due to hiring additional employees in our global CRO Phase II through IV division and increased costs in our foreign operations due to the weakening of the U.S.
dollar. The remaining $19.9 million of this increase in Development Group direct costs primarily consisted of increased facility costs related to the increase in personnel and increased subcontractor costs to support increased revenue.



Discovery Sciences direct costs increased $1.6 million to $5.8 million in
the first nine months of 2005. The higher costs in the first nine months of 2005 related primarily to additional direct costs of the biomarker business acquired from SurroMed in February 2005.



R&D expenses increased $13.2 million to $22.2 million in the first nine
months of 2005. R&D expenses increased primarily as a result of increased spending in connection with the DPP4 program prior to entering into the arrangement with Takeda San Diego, which included a $2.5 million milestone payment by us as a
result of the commencement of the Phase II studies in April 2005. Based on the new DPP4 agreement with Takeda San Diego entered into in July 2005, Takeda San Diego is responsible for future development and commercialization costs of the DPP4
inhibitors. Thus, we do not expect to incur significant R&D expense during the remainder of 2005.



SG&A expenses increased $34.1 million to $176.4 million in the first nine months of 2005. As a percentage of total net revenue, SG&A expenses
decreased to 23.1% in the first nine months of 2005 compared to 23.3% in the first nine months of 2004. The increase in SG&A expenses in absolute dollars includes additional personnel costs of $21.3 million. The increase in personnel costs
related to training costs for new personnel, higher levels of operations infrastructure to manage direct personnel and changes in utilization levels. The increase in SG&A costs also includes an increase of $3.6 million in travel costs due to
training initiatives for new and existing operations personnel and increased administrative travel. In addition, SG&A costs include $3.4 million in recruiting costs to hire additional personnel and an increase of $2.2 million in facility costs
related to the increase in personnel.



Depreciation increased
$7.0 million to $28.0 million in the first nine months of 2005. The increase was related to property and equipment we acquired to accommodate our growth. Capital expenditures were $89.1 million in the first nine months of 2005. Capital expenditures
included $30.5 million for our new corporate airplane, $8.6 million related to leasehold improvements to the new clinic in Austin, Texas and $13.6 million for our new corporate headquarters facility in Wilmington, North Carolina. The majority of the
remaining capital expenditures included spending on land and building costs, software, computer hardware, and additional scientific equipment for our Phase I and laboratory units.



Income from operations increased $33.4 million to $142.2 million in the first nine months of 2005. As a percentage of net
revenue, income from operations increased to 18.7% of net revenue in the first nine months of 2005 from 17.8% in the first nine months of 2004. Income from operations in the first nine months of 2005 included a $15.0 million up-front payment from
Takeda San Diego in connection with the DPP4 agreement, a $10.0 million milestone payment related to the filing of the dapoxetine NDA and a $5.1 million gain on exchange of assets associated with the acquisition of SurroMeds biomarker
business. Income from operations in the first nine months of 2005 was negatively impacted by the increase in R&D expenses of $13.2 million compared to the first nine months of 2004. Income from operations in the first nine months of 2005 was
also negatively impacted by approximately $3.4 million due to the weakening of the U.S. dollar relative to the euro, British pound and Brazilian real. Although these currency movements increased net revenue in the aggregate, the negative impact on
income from operations is attributable to dollar-denominated contracts for services rendered in countries other than the United States. In these cases, revenue is not impacted by the weakening of the U.S. dollar, but the costs associated with
performing these contracts, which are paid in local currency, are negatively impacted when translated into U.S. dollars. Income from operations in the first nine months of 2004 was negatively impacted by the $2.6 million restructuring charge
associated with exiting our chemistry facility in Research Triangle Park, North Carolina.



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During the first nine months of 2005, we recorded a charge to earnings of $3.8 million relating to our
investment in Spotlight Health, Inc. The write-down of Spotlight Health consisted of our investment of $2.2 million and a liability of $1.6 million based on the outstanding balance as of September 30, 2005 of Spotlight Healths revolving
line of credit that we guaranteed. During the first nine months of 2004, we recorded charges to earnings for other than temporary declines in the fair market value of our investment in Chemokine Therapeutics Corp. of $2.0 million. Our investment in
Chemokine was deemed to be impaired as a result of issuances of shares to new investors at a lower valuation than our original investment.



Our provision for income taxes increased $11.2 million to $47.6 million in the first nine months of 2005. Our effective income tax rate for the first nine
months of 2005 was 32.8% compared to 33.3% for the first nine months of 2004. The effective tax rate for the 2005 period was positively impacted by a $6.3 million reduction in our valuation allowance provided for the deferred tax asset relating to a
capital loss carryforward. This reduction was a result of the utilization of capital loss carryforwards that previously had a valuation allowance recorded against them as well as the recognition of capital gains for the SurroMed transaction, the
$10.0 million dapoxetine NDA milestone payment and the $15.0 million Takeda San Diego DPP4 up-front payment. This reduction in the valuation allowance decreased the effective tax rate by 4.4%. During the first nine months of 2004, our effective tax
rate was positively impacted by the $3.7 million tax benefit which we recorded as a result of the utilization of capital loss carryforwards that previously had a valuation allowance recorded against them. The remaining difference in our effective
rates for the first nine months of 2005 compared to the first nine months of 2004 is due to the tax on the planned repatriation of foreign earnings of $1.9 million and the change in the geographic distribution of our pretax earnings among locations
with varying tax rates.



Net income of $97.7 million in the
first nine months of 2005 represents an increase of $24.6 million from $73.1 million in the first nine months of 2004. Net income per diluted share of $1.68 in the first nine months of 2005 represents a 30.2% increase from net income per diluted
share of $1.29 in the first nine months of 2004. Net income per diluted share for the first quarter of 2005 included $0.07 per share, net of tax, for the gain on exchange of assets associated with the acquisition of SurroMeds biomarker
business.



Liquidity and Capital Resources



As of September 30, 2005, we had $335.7 million of cash and cash
equivalents. Our expected primary cash needs on both a short- and long-term basis are for capital expenditures, including our new corporate headquarters, expansion of services, possible acquisitions, geographic expansion, dividends, working capital
and other general corporate purposes. We have historically funded our operations and growth, including acquisitions, with cash flow from operations, leasing arrangements, borrowings and sales of our stock. We hold our cash and cash equivalents in
financial instruments that are rated A or better by Standard & Poors or Moodys, and earn interest at market rates.



In the first nine months of 2005, our operating activities provided $142.0 million in cash as compared to $114.1 million for the same period last year.
The increase in cash flow from operations is primarily due to a $24.6 million increase in net income, a $6.9 million increase in depreciation and amortization and a non-cash increase in provision for deferred income taxes of $10.3 million. These
increases were partially offset by a non-cash gain on exchange of assets of $5.1 million and a decrease in the change in operating assets and liabilities of $7.7 million. The change in operating assets and liabilities of $12.1 million in the first
nine months of 2005 primarily consisted of an increase in current income taxes of $23.3 million due to additional pre-tax income and the timing of tax payments and an increase in deferred rent of $11.2 million as a result of the additional facility
leases with up-front lease incentives. These items were partially offset by an increase in receivables and unbilled services of $9.3 million, a decrease in unearned income of $5.8 million and an increase in prepaid expenses and other current assets
of $9.6 million due partially to an increase in receivables for tenant improvements.



In the first nine months of 2005, we generated $33.3 million in cash from investing activities. The net cash provided by purchases, maturities and sales of available-for-sale investments of $105.0 million, proceeds
from sale of the Syrrx investment of $25.0 million and proceeds from the sale of property and equipment of $3.9 million were partially offset by capital expenditures of $89.1 million and purchases of investments of $11.6 million. We expect our
capital expenditures for the remainder of 2005 to be $30.0 million to $35.0 million. This estimate includes fourth quarter 2005 construction costs of approximately $23.0 million for the new corporate headquarters building in Wilmington, North
Carolina. We expect the majority of the remaining anticipated capital expenditures to be for equipment for our Phase I and laboratory units and information technology enhancement and expansion.



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In the first nine months of 2005, our financing activities provided $22.9 million in cash, as net
proceeds from stock option exercises and purchases under our employee stock purchase plan totaling $24.5 million were partially offset by $1.6 million in repayments of capital lease obligations and long term debt.



Working capital as of September 30, 2005 was $339.6 million, compared to
$257.1 million at December 31, 2004. The increase in working capital was due primarily to an increase in cash and short-term investments of $86.3 million, which included the proceeds from the sale of investment of Syrrx for $25.0 million, a
decrease in unearned income of $7.5 million, an increase in prepaid expenses and other current assets of $6.3 million and an increase in accounts receivable and unbilled services of $4.1 million partially offset by an increase in other accrued
expenses of $12.1 million and an increase of accrued income taxes of $5.6 million due to the increase in pretax income.The number of days revenue outstanding in accounts receivable and unbilled services, net of unearned income, also
known as DSO, was 32.8 and 41.2 days for the nine months ended September 30, 2005 and September 30, 2004, respectively. We calculate DSO by dividing accounts receivable and unbilled services less unearned income by average daily gross
revenue for the period presented. Over the past three years, our year-to-date DSO has fluctuated between 32.2 days and 42.2 days. We expect DSO will fluctuate in the future depending on the mix of contracts performed within a quarter, the level of
investigator advances and unearned income and our success in collecting receivables.



In July 2005, we renewed our $50.0 million revolving credit facility with Bank of America, N. A. Indebtedness under the facility is unsecured and subject to traditional covenants relating to financial ratios and
restrictions on certain types of transactions, although not payment of dividends. Borrowings under this credit facility are available to provide working capital and for general corporate purposes. As of September 30, 2005, no amounts were
outstanding under this credit facility. However, the aggregate amount we are able to borrow has been reduced by $0.8 million due to outstanding letters of credit issued under this facility. This credit facility is currently scheduled to expire in
June 2006, at which time any outstanding balance would be due.



On October 3, 2005, our Board of Directors approved an annual dividend policy under which we intend to pay an aggregate annual cash dividend of $0.20 on each outstanding share of common stock. The annual dividend will be payable
quarterly at a rate of $0.05 per share. Shareholders of record as of October 17, 2005 will receive the first quarterly cash dividend payment on November 8, 2005. This dividend will result in a payment of approximately $2.9 million.
Additionally, we will pay a special one-time cash dividend for our shareholders in the amount of $1.00 on each outstanding share of common stock payable on November 11, 2005 to shareholders of record as of October 17, 2005. This one-time,
special dividend payment will amount to approximately $57.8 million. We will fund these dividends from our existing cash and cash equivalents. The annual cash dividend policy and the payment of future cash dividends are not guaranteed and are
subject to the discretion of and continuing determination by our Board of Directors that the policy remains in the best interests of our shareholders and in compliance with applicable laws.



In April 2000, we purchased 1.0 million shares of Spotlight Health
Series C convertible preferred stock for $5.0 million. In July 2003, we entered into an agreement with Spotlight Health and Bank of America, N.A. to guarantee a $2.0 million revolving line of credit provided to Spotlight Health by Bank of America.
This new line of credit was used to refinance existing Spotlight Health debt that was also guaranteed by us. In June 2005, we purchased 970,873 shares of Spotlight Healths Series D convertible preferred stock for a purchase price of $1.03 per
share. In connection with that transaction, the parties amended the loan agreement with Bank of America. Spotlight Health also granted Bank of America a first lien security interest on its assets to secure its obligations under the loan agreement.
As a result of several unexpected project delays and cancellations by its customers, Spotlight Health notified us in August 2005 that it was unable to continue as a going-concern and is in the liquidation process. During the third quarter of 2005,
we recorded a charge to earnings in the amount of $3.8 million relating to our investment in Spotlight Health. This amount includes our equity investment of $2.2 million and a liability in the amount of $1.6 million based on the outstanding balance
as of September 30, 2005 of Spotlight Healths revolving line of credit that we guaranteed.



In January 2004, we purchased 5.0 million shares of Accentia Biopharmaceuticals, Inc. Series E convertible preferred stock for $5.0 million. At that
time, we also received a Class A and Class B warrant, each to purchase up to an additional 5.0 million shares of Series E convertible preferred stock for $1.00 per share. We exercised the Class A warrant in January 2005 and the Class
B warrant in August 2005. We owned approximately 17.5% of the outstanding capital stock of Accentia as of September 30, 2005. Accentia is a privately held, specialty biopharmaceutical company that focuses on commercializing targeted
therapeutics in the respiratory, oncology and critical care areas. In February 2005, Accentia filed a registration statement with the SEC for its proposed initial public offering of common stock. On October 28, 2005, Accentia completed its
initial public offering of 2.4 million shares of common stock for $8.00 per



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share. Upon completion of the initial public offering, our 15 million shares of Series E convertible preferred stock were converted into 4,270,323
shares of common stock. We may sell our Accentia shares beginning 180 days from the date of the initial public offering.



In August 2005, we amended our September 2004 royalty stream purchase agreement with Accentia. Under the terms of the amended agreement, we agreed to
provide specified clinical development services to Accentia in connection with two pivotal Phase III trials for SinuNase for the treatment of chronic rhinosinusitis. In exchange for providing these services, Accentia agreed to pay us a royalty equal
to 14% of the net sales of specified SinuNase products if approved for sale by the FDA.



In February 2005, we acquired substantially all of SurroMeds assets related to its biomarker business. As part of this acquisition, we agreed to guarantee repayment of up to $1.5 million under a SurroMed bank
loan with a maturity date of December 31, 2006. In accordance with the requirements of FASB Statement No. 5, Accounting for Contingencies, as clarified by FASB Interpretation No. 45, we have recorded a liability in the
amount of $150,000 for the estimated fair value of the obligation assumed under this guarantee.



In November 2003, we entered into a collaboration agreement with Syrrx to jointly develop and commercialize human dipeptidyl peptidase IV, or DPP4,
inhibitors for the treatment of type 2 diabetes and other major human diseases. In September 2004, we filed an investigational new drug application for one DPP4 inhibitor and the Phase I clinical study for that inhibitor commenced in late October
2004. In the fourth quarter of 2004, we paid Syrrx a milestone payment of $2.5 million as a result of the commencement of the Phase I studies. These studies were completed in March 2005. We began the Phase II program in April and paid a milestone
payment of $2.5 million in the second quarter. In March 2005, Takeda Pharmaceutical Company Limited acquired 100% of the equity of Syrrx, which is now known as Takeda San Diego, Inc. We owned $25.0 million in preferred stock of Syrrx, for which
Takeda paid us $25.0 million in April 2005. In July 2005, Takeda San Diego acquired the development and commercialization rights to all DPP4 inhibitors previously granted to us under the collaboration agreement between PPD and Syrrx. Under the new
agreement, Takeda San Diego paid us a $15.0 million up-front payment in the third quarter of 2005. In October 2005, we amended the agreement to modify the first development milestone on which payment is made to us. We will also be entitled to
receive other potential milestone payments of up to an aggregate of $70.5 million, sales-based milestones of up to an aggregate of $33.0 million and royalties associated with the future development and commercialization of specified DPP4 inhibitors.
As a result of this agreement, we will have no further material expense associated with the development and commercialization of a DPP4 inhibitor.



In November 2003, we became a limited partner in A. M. Pappas Life Science Ventures III, LP, a venture capital fund. The Pappas Fund was established for
the purpose of making investments in equity securities of privately-held companies in the life sciences, healthcare and technology industries. We are committed to invest up to an aggregate of approximately $2.5 million in the Pappas Fund. No capital
call can exceed 10% of our aggregate capital commitment. As such, we anticipate that our aggregate investment will be made through a series of future capital calls over the next several years. Capital calls through September 30, 2005 were
$320,000. Our capital commitment will expire in May 2009.



In
September 2005, we became a limited partner in Bay City Capital Fund IV, a venture capital fund. The Bay City Fund IV was established for the purpose of investing in companies in the life sciences industry. We have committed to invest up to a
maximum of $10.0 million in the Bay City Fund IV. We accrued an initial investment in the amount of $1.3 million as of September 30, 2005 and anticipate our remaining investment will be made through a series of future capital calls over the
next several years. Our capital commitment will expire in June 2009.



In January 2005, we acquired approximately 7.5 acres of property located in downtown Wilmington, North Carolina, on which we are constructing a new headquarters building. The new facility will be approximately 400,000 square feet and is
expected to be completed in 2006 or early 2007. We plan to begin consolidating our Wilmington operations into the new building at that time. We expect the total cost for the construction and up-fit of the new building to be $80.0 million to $100.0
million. In addition, we are constructing a parking deck to serve this new facility with an expected cost of approximately $20.0 million. The purchase price for the land was approximately $2.8 million. In connection with the sale of the property,
the seller, Almont Shipping Company, refinanced existing liens on the property with the proceeds of an $8.0 million loan from Bank of America. This loan will mature in January 2006 and is secured by a lien on substantially all of Almonts
assets, including an approximately 30-acre tract of land adjacent to the tract we acquired. This loan is also secured by a guarantee from us. In accordance with the



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requirements of FASB Statement No. 5, Accounting for Contingencies, as clarified by FASB Interpretation No. 45, we have recorded a
liability in the amount of $0.8 million for the estimated fair value of the obligation we have assumed under this guarantee. Almonts obligation to reimburse us in the event we are required to pay any sums to Bank of America under the guarantee
is also secured by a lien on substantially all of Almonts assets. As a part of this transaction, Almont granted us an option to purchase all or a portion of the adjacent 30-acre tract of land at an agreed upon price per acre. The option will
expire on January 31, 2007.



In March 2005, we signed a
new lease for additional space in Austin, Texas for our Phase II-IV operations. The facility is adjacent to our new Phase I clinic. To induce us to enter into the lease for additional space, the landlord placed $5.5 million in an escrow account to
be distributed to us to cover the monthly rental on the old facility until the old facility is subleased. If the facility is subleased, we will receive an immediate distribution totaling the amount of the sublease income to be received under the
sublease and the escrow account will receive the future sublease rental income and remit the future rental payments due under the original facility lease to the landlord. We will continue to be responsible for our obligations under the original
lease and, therefore, subject to the risk of default by a subtenant. We will also be responsible to fund the escrow account to the extent the rent payments under the original lease exceed the rent payments under a sublease. We account for the $5.5
million to be received from the escrow account as a lease incentive which will be recognized in income over the 10-year term of the new lease. As of September 30, 2005, the escrow account balance was $5.5 million, $0.4 million of which was
included as a component of prepaid expenses and other current assets, and $5.1 million of which was included as a component of other assets.



The American Jobs Creation Act of 2004 introduced a one-time dividends received deduction on the repatriation of foreign earnings to a U.S. taxpayer.
Prior to 2005, we had not previously recorded a U. S. tax liability on these earnings because we intended to permanently reinvest them in our foreign operations. We have been evaluating the impact of this law on our permanent reinvestment position
and recorded tax expense of $1.2 million in the third quarter relating to an expected repatriation of $30.8 million. For the nine months ended September 30, 2005, we recorded tax expense of $1.9 million relating to the total projected
repatriation of $53.0 million in foreign earnings. We continue to analyze the effect of the new Act on the remaining $23.4 million of undistributed foreign earnings and expect to complete this analysis by the end of the year. The income tax effect
of repatriating the remaining undistributed earnings is not estimable at this time.



As of September 30, 2005, we had liabilities of $5.8 million in connection with tax positions taken in our tax returns that include interpretations of applicable income tax laws and regulations. These amounts are
based on managements expectation regarding the ultimate tax treatment and outcome of these matters. We believe it is unlikely that the resolution of these matters will have a material adverse effect on our financial position or results of
operations.



Under most of our agreements for Development Group
services, we agree to indemnify and defend the sponsor against third party claims based on our negligence or willful misconduct. Any successful claims could have a material adverse effect on our financial condition, results of operations and future
prospects.



We expect to continue expanding our operations
through internal growth and strategic acquisitions and investments, and to pay dividends under our recently announced dividend policy. We expect these activities will be funded from existing cash, cash flow from operations and, if necessary or
appropriate, borrowings under our existing or future credit facilities. We believe that these sources of liquidity will be sufficient to fund our operations and dividends for at least the next 12 months. From time to time, we evaluate potential
acquisitions, investments and other growth opportunities that might require additional external financing, and we might seek funds from public or private issuances of equity or debt securities. In any event, our sources of liquidity and ability to
pay dividends could be affected by our dependence on a small number of industries and clients, compliance with regulations, international risks, personal injury, environmental or intellectual property claims, as well as other factors described below
under Potential Volatility of Quarterly Operating Results and Stock Price and Quantitative and Qualitative Disclosures about Market Risk. In addition, see Contractual Obligations and Commercial Commitments and
Critical Accounting Policies and Estimates in our Annual Report on Form 10-K for the year ended December 31, 2004.



Critical Accounting Policies and Estimates



There were no material changes to our critical accounting policies and estimates in the first nine months of 2005. For detailed information on our
critical accounting policies and estimates, see our Annual Report on Form 10-K for the year ended December 31, 2004.



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Recently Issued Accounting Standards



For information about recently issued accounting standards, see Recent Accounting Pronouncements in Note 1 to
the Notes to our Consolidated Condensed Financial Statements in Item 1.



Income Taxes



Because we conduct operations on
a global basis, our effective tax rate has and will continue to depend upon the geographic distribution of our pretax earnings among locations with varying tax rates. Our profits are also impacted by changes in the tax rates of the various taxing
jurisdictions. In particular, as the geographic mix of our pre-tax earnings among various tax jurisdictions changes, our effective tax rate might vary from period to period.



Inflation



Our long-term contracts, those in excess of one year, generally include an inflation or cost of living adjustment or factor for the portion of the
services to be performed beyond one year from the contract date. As a result, we expect that inflation generally will not have a material adverse effect on our operations or financial condition.



Potential Volatility of Quarterly Operating Results and Stock Price



Our quarterly and annual operating results have fluctuated in the past, and
we expect that they will continue to fluctuate in the future. Factors that could cause these fluctuations to occur include:



| |  |  | the timing and level of new business authorizations;
| | - |  | ----------------------------------------------------



| |  |  | the timing of the initiation, progress or cancellation of significant projects;
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| |  |  | the timing and amount of costs associated with R&D and compound partnering collaborations;
| | - |  | ------------------------------------------------------------------------------------------



| |  |  | the timing of our Discovery Sciences Group milestone payments or other revenue;
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| |  |  | the timing of the opening of new offices;
| | - |  | -----------------------------------------



| |  |  | the timing of other internal expansion costs;
| | - |  | ---------------------------------------------



| |  |  | exchange rate fluctuations between periods;
| | - |  | -------------------------------------------



| |  |  | our dependence on a small number of industries and clients;
| | - |  | -----------------------------------------------------------



| |  |  | the mix of products and services sold in a particular period;
| | - |  | -------------------------------------------------------------



| |  |  | pricing pressure in the market for our services;
| | - |  | ------------------------------------------------



| |  |  | our ability to recruit and retain experienced personnel;
| | - |  | --------------------------------------------------------



| |  |  | rapid technological change;
| | - |  | ---------------------------



| |  |  | the timing and amount of start-up costs incurred in connection with the introduction of new products and services;
| | - |  | ------------------------------------------------------------------------------------------------------------------



| |  |  | the timing and extent of new government regulations;
| | - |  | ----------------------------------------------------



| |  |  | intellectual property risks;
| | - |  | ----------------------------



| |  |  | impairment of investments or intangible assets; and
| | - |  | ---------------------------------------------------



| |  |  | the timing and amount of costs associated with integrating acquisitions.
| | - |  | ------------------------------------------------------------------------



Delays and terminations of trials are often the result of actions taken by our customers or regulatory authorities, and are not typically controllable by
us. Because a large percentage of our operating costs are relatively fixed while revenue is subject to fluctuation, variations in the timing and progress of large contracts can materially affect our quarterly operating results. For these reasons, we
believe that comparisons of our quarterly financial results are not necessarily meaningful and should not be relied upon as an indication of future performance.



Fluctuations in quarterly results, actual or anticipated changes in our dividend policy or factors beyond our control could affect the market price of
our common stock. These factors include changes in earnings estimates by analysts, market conditions in our industry, disclosures by product development partners and actions by regulatory authorities with respect to potential drug candidates,
changes in pharmaceutical, biotechnology and medical device industries and government sponsored clinical research, general economic conditions, and differences in assumptions



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used as compared to actual results. Any effect on our common stock could be unrelated to our longer-term operating performance. For more detail, see
Factors that Might Affect our Business or Stock Price in our Annual Report on Form 10-K for the year ended December 31, 2004.



Item 3. Quantitative and Qualitative Disclosures about Market Risk



We are exposed to foreign currency risk by virtue of our international operations. Approximately 27.2% and 26.9% of our total net revenue for the three
months ended September 30, 2004 and 2005, respectively, were derived from operations outside the United States. Funds generated by each subsidiary are generally reinvested in the country where they are earned, although we are currently
analyzing the effect of the one-time dividends received deduction of the American Jobs Creation Act of 2004 on undistributed foreign earnings and expect to repatriate significant foreign earnings this year. Our operations in the United Kingdom
generated approximately 43.6% of our net revenue from international operations during the three months ended September 30, 2005. Accordingly, we are exposed to adverse movements in the pound sterling and other foreign currencies.



The vast majority of our contracts are entered into by our U. S. or U. K.
subsidiaries. The contracts entered into by the U. S. subsidiaries are almost always denominated in U.S. dollars. Contracts entered into by our U. K. subsidiaries are generally denominated in pounds sterling, U.S. dollars or euros, but the majority
of these contracts are in U.S. dollars. Although an increase in exchange rates for the pound sterling or euro relative to the U.S. dollar would increase net revenue from contracts denominated in these currencies, the negative impact on income from
operations is attributable to dollar-denominated contracts for services rendered in countries other than the United States. In these cases, revenue is not impacted by the weakening of the U.S. dollar, but the costs associated with performing these
contracts, which are paid in local currency, are negatively impacted when translated into U.S. dollars. In January 2004, we began engaging in hedging activities in an effort to manage our potential foreign exchange exposure.



We also have currency risk resulting from the passage of time between the
invoicing of customers under contracts and the ultimate collection of customer payments against those invoices. If a contract is denominated in a currency other than the subsidiarys local currency, we recognize a receivable at the time of
invoicing for the local currency equivalent of the foreign currency invoice amount. Changes in exchange rates from the time the invoice is prepared until payment from the customer is received will result in our receiving either more or less in local
currency than the local currency equivalent of the invoice amount at the time the invoice was prepared and the receivable established. We recognize this difference as a foreign currency transaction gain or loss, as applicable, and report it in other
income, net. We do not expect that a 10% increase or decrease in exchange rates would have a material effect on our financial statements.



Our strategy for management of currency risk relies primarily on conducting our operations in a countrys currency, making intercompany foreign
currency denominated loans and from time to time, using currency derivatives, primarily forward exchange contracts. As of September 30, 2005, we had open foreign exchange derivative contracts with a face amount totaling $40.0 million to buy the
local currencies of our foreign subsidiaries. The estimated fair value of the foreign currency derivative portfolio was a $3,000 gain recorded as a component of prepaid expenses and other current assets and a $1.3 million loss recorded as a
component of other accrued expenses. The potential loss resulting from a hypothetical weakening of the U.S. dollar relative to the pound sterling and euro of 10% would have been approximately $1.9 million for the quarter ended September 30,
2005 based on third quarter 2005 revenues and the costs related to our foreign operations. Our foreign currency hedging activities would partially offset these potential losses. We do not expect that a 10% change in exchange rates in the future
would have a material effect on our financial statements.



Changes in exchange rates between the applicable foreign currency and the U.S. dollar will affect the translation of foreign subsidiaries financial results into U.S. dollars for purposes of reporting our consolidated financial
results. The process by which we translate each foreign subsidiarys financial results to U.S. dollars is as follows:



| |  |  | we translate income statement accounts at average exchange rates for the period;
| | - |  | --------------------------------------------------------------------------------



| |  |  | we translate balance sheet assets and liability accounts at end of period exchange rates; and
| | - |  | ---------------------------------------------------------------------------------------------



| |  |  | we translate equity accounts at historical exchange rates.
| | - |  | ----------------------------------------------------------



Translation of the balance sheet in this manner affects shareholders equity through the cumulative translation adjustment account. This account
exists only in the foreign subsidiarys U.S. dollar balance sheet and is necessary to



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keep the foreign balance sheet, stated in U.S. dollars, in balance. Translation adjustments are reported with accumulated other comprehensive income (loss)
as a separate component of shareholders equity. To date, cumulative translation adjustments have not been material to our consolidated financial position. However, future translation adjustments could materially and adversely affect our
financial position.



Currently, there are no material exchange
controls on the payment of dividends or otherwise prohibiting the transfer of funds out of or from within any country in which we conduct operations. Although we perform services for clients located in a number of foreign jurisdictions, we have not
experienced any difficulties in receiving funds remitted from foreign countries. However, new or modified exchange control restrictions could have an adverse effect on our financial condition.



We are exposed to changes in interest rates on our cash equivalents and
amounts outstanding under notes payable and lines of credit. We invest our cash and cash equivalents in financial instruments with interest rates based on financial market conditions. We do not expect that a 10% change in interest rates in the
future would have a material effect on our financial statements.



Item 4. Controls and Procedures



Disclosure Controls and Procedures



Disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) are designed only to provide reasonable assurance that information to be disclosed in our Exchange Act Reports is recorded, processed,
summarized and reported within the time periods specified in the SECs rules and forms. As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management,
including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b). Based upon that evaluation, our Chief Executive Officer and Chief Financial
Officer have concluded that our disclosure controls and procedures are effective to provide the reasonable assurance discussed above.



Internal Control Over Financial Reporting



There were no changes in internal control over financial reporting during the third quarter of 2005 that materially
affected, or are reasonably likely to materially affect, the Companys internal control over financial reporting.



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Part II. OTHER INFORMATION



Item 6. Exhibits



|(a) | Exhibits
|--- | --------



|       |  |                                                                                                                                                    
|------ |  | ---------------------------------------------------------------------------------------------------------------------------------------------------
|       | 
|10.220 |  | Lease Agreement dated August 31, 2004 by and between Evan A. Stein, M.D., Ph.D. and Medical Research Laboratories International LLC                
|       | 
|10.221 |  | Lease Agreement dated April 30, 2001 by and between Greenway Properties, Inc. and PPD Development, LP                                              
|       | 
|10.222 |  | First Amendment dated August 15, 2001, to Lease Agreement, dated April 30, 2001, by and between Greenway Properties, Inc. and PPD Development, LP  
|       | 
|10.223 |  | Second Amendment dated August 25, 2003, to Lease Agreement, dated April 30, 2001, by and between Greenway Properties, Inc. and PPD Development, LP 
|       | 
|10.224 |  | Third Amendment dated March 22, 2004, to Lease Agreement, dated April 30, 2001, by and between Greenway Properties, Inc. and PPD Development, LP   
|       | 
|10.225 |  | Fourth Amendment dated May 17, 2004, to Lease Agreement, dated April 30, 2001, by and between Greenway Properties, Inc. and PPD Development, LP    
|       | 
|10.226 |  | Fifth Amendment dated December 14, 2004, to Lease Agreement, dated April 30, 2001, by and between Greenway Properties, Inc. and PPD Development, LP
|       | 
|10.227 |  | Sixth Amendment dated June 3, 2005, to Lease Agreement, dated April 30, 2001, by and between Greenway Properties, Inc. and PPD Development, LP     
|       | 
|10.228 |  | Seventh Amendment dated July 29, 2005, to Lease Agreement, dated April 30, 2001, by and between Greenway Properties, Inc. and PPD Development, LP  
|       | 
|31.1   |  | Certification of the Chief Executive Officer pursuant to Rule 13a-14(a)                                                                            
|       | 
|31.2   |  | Certification of the Chief Financial Officer pursuant to Rule 13a-14(a)                                                                            
|       | 
|32.1   |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of The Sarbanes-Oxley Act of 2002  Chief Executive Officer   
|       | 
|32.2   |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of The Sarbanes-Oxley Act of 2002  Chief Financial Officer   



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SIGNATURES



In accordance with the
requirements of the Securities Exchange Act of 1934, the registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.



PHARMACEUTICAL PRODUCT DEVELOPMENT, INC.(Registrant)By

/s/ Fredric N. EshelmanChief Executive Officer(Principal Executive Officer)By

/s/ Linda BaddourChief Financial Officer(Principal Financial and Accounting Officer)




Date: November 7, 2005



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