Covalent Group Inc--Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

(Mark One)

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

 

For the quarterly period ended March 31, 2005.

 

¨ 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: 0-21145

 


 

COVALENT GROUP, INC.

(Exact name of registrant as specified in its charter)

 


 

Delaware   56-1668867

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

One Glenhardie Corporate Center, 1275 Drummers Lane, Suite 100, Wayne, Pennsylvania 19087

(Address of principal executive offices) (Zip Code)

 

Registrant’s telephone number, including area code: 610-975-9533

 


 

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 12(b)-2 of the Exchange Act).    Yes  ¨    No  x.

 

As of April 29, 2005, there were 13,499,666 shares of Covalent Group, Inc. common stock outstanding, par value $.001 per share, excluding 152,932 shares in treasury.

 



Table of Contents

COVALENT GROUP, INC.

 

INDEX

 

               Page

PART I.    Financial Information     
     Item 1.    Consolidated Condensed Financial Statements (unaudited)     
          Consolidated condensed balance sheets – March 31, 2005 and December 31, 2004    1
          Consolidated condensed statements of operations – Three months ended March 31, 2005 and 2004    2
          Consolidated condensed statements of cash flows – Three months ended March 31, 2005 and 2004    3
          Notes to consolidated condensed financial statements    4
     Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations    10
     Item 3.    Quantitative and Qualitative Disclosures about Market Risk    17
     Item 4.    Controls and Procedures    18
PART II.    Other Information     
     Item 5.    Other Information    18
     Item 6.    Exhibits    18
SIGNATURES    19


Table of Contents

PART I. FINANCIAL INFORMATION

 

ITEM 1. CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (UNAUDITED)

 

Covalent Group, Inc.

Consolidated Condensed Balance Sheets

 

     March 31,
2005


    December 31,
2004


 

Assets

                

Current Assets

                

Cash and cash equivalents

   $ 5,238,881     $ 3,165,986  

Restricted cash

     147,088       145,612  

Accounts receivable, less allowance of $40,000 at March 31, 2005 and December 31, 2004

     2,810,817       5,209,950  

Prepaid expenses and other

     334,874       158,287  

Prepaid taxes

     1,114,463       1,132,315  

Costs and estimated earnings in excess of related billings on uncompleted contracts

     1,081,183       1,667,947  
    


 


Total Current Assets

     10,727,306       11,480,097  
    


 


Property and Equipment, Net

     1,214,075       1,321,139  

Other Assets

     21,665       21,665  
    


 


Total Assets

   $ 11,963,046     $ 12,822,901  
    


 


Liabilities and Stockholders’ Equity

                

Current Liabilities

                

Accounts payable

   $ 1,240,912     $ 1,101,788  

Accrued expenses

     439,073       392,385  

Obligations under capital leases

     24,335       23,709  

Billings in excess of related costs and estimated earnings on uncompleted contracts

     1,149,774       1,770,275  

Customer advances

     786,482       1,080,469  
    


 


Total Current Liabilities

     3,640,576       4,368,626  
    


 


Long Term Liabilities

                

Obligations under capital leases

     56,985       63,309  

Other liabilities

     552,625       581,710  
    


 


Total Long Term Liabilities

     609,610       645,019  
    


 


Total Liabilities

     4,250,186       5,013,645  
    


 


Stockholders’ Equity

                

Common stock, $.001 par value 25,000,000 shares authorized, 13,499,534 and 13,495,534 shares issued and outstanding respectively

     13,499       13,496  

Additional paid-in capital

     12,024,958       12,017,822  

Accumulated deficit

     (4,031,849 )     (3,933,377 )

Accumulated other comprehensive income

     165,226       170,289  
    


 


Less:

     8,171,834       8,268,230  

Treasury stock, at cost, 152,932 shares

     (458,974 )     (458,974 )
    


 


Total Stockholders’ Equity

     7,712,860       7,809,256  
    


 


Total Liabilities and Stockholders’ Equity

   $ 11,963,046     $ 12,822,901  
    


 


 

See accompanying notes to the consolidated condensed financial statements.

 

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Covalent Group, Inc.

Consolidated Condensed Statements of Operations

 

    

Three months ended

March 31,


 
     2005

    2004

 

Net revenue

   $ 3,213,529     $ 5,282,585  

Reimbursement revenue

     674,272       1,640,133  
    


 


Total Revenue

     3,887,801       6,922,718  
    


 


Operating Expenses

                

Direct

     2,042,768       3,675,580  

Reimbursement out-of-pocket expenses

     674,272       1,640,133  

Selling, general and administrative

     1,146,339       1,323,460  

Depreciation and amortization

     137,525       253,880  
    


 


Total Operating Expenses

     4,000,904       6,893,053  
    


 


Income (Loss) from Operations

     (113,103 )     29,665  

Interest Income

     17,108       757  

Interest Expense

     (2,477 )     (2,828 )
    


 


Net Interest Income (Expense)

     14,631       (2,071 )
    


 


Income (Loss) before Income Taxes

     (98,472 )     27,594  

Income Tax Provision

     —         489  
    


 


Net Income (Loss)

   $ (98,472 )   $ 27,105  
    


 


Net Income (Loss) per Common Share

                

Basic

   $ (0.01 )   $ 0.00  

Diluted

   $ (0.01 )   $ 0.00  

Weighted Average Common and Common Equivalent Shares Outstanding

                

Basic

     13,344,202       13,085,410  

Diluted

     13,344,202       13,229,007  

 

See accompanying notes to the consolidated condensed financial statements.

 

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Covalent Group, Inc.

Consolidated Condensed Statements of Cash Flows

 

    

Three Months Ended

March 31,


 
     2005

    2004

 

Operating Activities:

                

Net income (loss)

   $ (98,472 )   $ 27,105  

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

                

Depreciation and amortization

     137,525       253,880  

Changes in assets and liabilities;

                

Restricted cash

     (1,476 )     (289,199 )

Accounts receivable

     2,399,133       (2,984,900 )

Prepaid expenses and other

     (176,587 )     (157,767 )

Prepaid Taxes

     17,852       485,252  

Costs and estimated earnings in excess of related billings on uncompleted contracts

     586,764       1,931,359  

Accounts payable

     139,124       387,878  

Accrued expenses

     46,688       1,435,827  

Other Liabilities

     (29,085 )     (29,085 )

Billings in excess of related costs and estimated earnings on uncompleted contracts

     (620,501 )     (249,349 )

Customer advances

     (293,987 )     (434,117 )
    


 


Net Cash Provided by Operating Activities

     2,106,978       376,884  
    


 


Investing Activities:

                

Purchases of property and equipment

     (30,461 )     (972 )
    


 


Net Cash Used In Investing Activities

     (30,461 )     (972 )
    


 


Financing Activities:

                

Repayments under capital leases

     (5,698 )     (8,041 )

Proceeds from exercise of stock options

     7,139       12,997  
    


 


Net Cash Provided By Financing Activities

     1,441       4,956  
    


 


Effect of Exchange Rate Changes on Cash and Cash Equivalents

     (5,063 )     35,434  

Net Increase In Cash and Cash Equivalents

     2,072,895       416,302  

Cash and Cash Equivalents, Beginning of Period

     3,165,986       2,069,687  
    


 


Cash and Cash Equivalents, End of Period

   $ 5,238,881     $ 2,485,989  
    


 


 

See accompanying notes to the consolidated condensed financial statements.

 

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Covalent Group, Inc.

Notes to Consolidated Condensed Financial Statements

(Unaudited)

 

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation

 

The accompanying unaudited financial statements for the three months ended March 31, 2005 and March 31, 2004 have been prepared in accordance with accounting principles generally accepted in the United States of America (“generally accepted accounting principles”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (primarily consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2005 may not necessarily be indicative of the results that may be expected for other quarters or for the year ending December 31, 2005. For further information, refer to the financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2004.

 

Use of Estimates

 

The preparation of consolidated financial statements in conformity with generally accepted accounting principles 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 period. Actual results could differ from those estimates.

 

Consolidation

 

The consolidated financial statements for the three months ended March 31, 2005 and 2004 include our accounts and the accounts of our wholly-owned subsidiaries. Intercompany transactions and balances have been eliminated in consolidation.

 

Restricted Cash

 

We received advance payments from one of our clients as part of a long-term contract, which included a separate restricted cash account to be utilized for payment of investigator fees. As of March 31, 2005 and December 31, 2004 this restricted cash amount was $147 thousand and $146 thousand, respectively. This amount is also included in customer advances in the accompanying balance sheets.

 

Accounts Receivable

 

Accounts receivable consist of customer billings pursuant to contractual terms related to work performed as of March 31, 2005. In general, amounts become billable upon the achievement of milestones or in accordance with predetermined payment schedules set forth in the contracts with our clients. A portion of the balance represents amounts billed subsequent to the balance sheet date. Accounts receivable included $2.1 million and $4.9 million billed to customers as of March 31, 2005 and December 31, 2004, respectively, and $700 thousand and $300 thousand that was billable to clients pursuant to contractual terms and invoiced subsequent to March 31, 2005 and December 31, 2004, respectively.

 

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Revenue Recognition

 

The majority of our net revenue is recognized from fixed-price contracts on a proportional performance basis. To measure the performance, we compare actual direct costs incurred to estimated total contract direct costs, which we believe is the best indicator of the performance of the contract obligations as the costs relate to the labor hours incurred to perform the service. Total direct costs are incurred for each contract and compared to estimated total direct costs for each contract to determine the percentage of the contract that is completed. This percentage is multiplied by the estimated total contract value to determine the amount of net revenue recognized. A formal project review process takes place quarterly although most projects are evaluated on an ongoing basis. Management reviews the estimated total direct costs on each contract to determine if estimated amounts are correct and estimates are adjusted as needed. 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 such determination is made. Because of the inherent uncertainties in estimating direct costs required to complete a project, particularly complex, multi-year studies, it is possible that the estimates used will change and could result in a material change to our estimates. Original estimates might also be changed due to changes in the scope of work. We attempt to negotiate contract amendments with the client to cover these services provided outside the terms of the original contract. There can be no assurance that the client will agree to the proposed amendments, and we ultimately bear the risk of cost overruns. For terminated studies, our contracts frequently entitle us to receive the costs of winding down the terminated project, as well as all fees earned by us up to the time of termination.

 

Costs and estimated earnings in excess of related billings on uncompleted contracts represent net revenue recognized to date that is currently unbillable to the client pursuant to contractual terms. In general, amounts become billable upon the achievement of milestones or in accordance with predetermined payment schedules set forth in the contracts with our clients. Several of our older contracts contain payment schedules that are weighted towards the later stages of the contract. Billings in excess of related costs and estimated earnings on uncompleted contracts represent amounts billed in excess of net revenue recognized at the balance sheet date.

 

Reimbursable Out-of-Pocket Expenses

 

On behalf of our clients, we pay fees to investigators and other out-of-pocket costs for which we are reimbursed at cost, without mark-up or profit. Effective January 1, 2002, in connection with the required implementation of Financial Accounting Standards Board Emerging Issues Task Force Issue No. 01-14 (“EITF 01-14”), “Income Statement Characterization of Reimbursements Received for ‘Out-of-Pocket’ Expenses Incurred,” out-of-pocket costs are now included in Operating Expenses, while the reimbursements received are reported separately as Reimbursement Revenue in the Consolidated Statements of Operations.

 

As is customary in the industry, we exclude from revenue and expense in the Consolidated Statement of Operations fees paid to investigators and the associated reimbursement since we act as agent on behalf of our clients with regard to investigators. These investigator fees are not reflected in our Net Revenue, Reimbursement Revenue, Reimbursement Out-of-Pocket Expenses, and/or Direct Expenses. The amounts of these investigator fees were $860 thousand and $1.2 million for the three months ended March 31, 2005 and 2004, respectively.

 

Stock Based Compensation

 

We have adopted equity incentive plans that provide for the granting of stock options to employees, directors, advisors and consultants. We account for grants of options to employees and directors under these plans applying the intrinsic value method provided for in Accounting Principles Board (“APB”)

 

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Opinion No. 25 “Accounting for Stock Issued to Employees” and related interpretations. No stock-based compensation expense is reflected in net income as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of the grant. In addition to APB Opinion No. 25, we provide the disclosures required by Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation” and by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” See Note 4.

 

The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” to stock-based employee compensation:

 

     Three months ended
March 31,


 
     2005

    2004

 

Net Income (Loss) - as reported

   $ (98,472 )   $ 27,105  

Deduct: Pro forma stock-based compensation expense determined under the fair value method, net of related tax effects

     (51,799 )     (52,561 )
    


 


Pro forma Net Income (Loss)

   $ (150,271 )   $ (25,456 )
    


 


Net Income (Loss) Per Share

                

Basic - as reported

   $ (0.01 )   $ 0.00  

Basic - pro forma

   $ (0.01 )   $ (0.00 )

Diluted - as reported

   $ (0.01 )   $ 0.00  

Diluted - pro forma

   $ (0.01 )   $ (0.00 )

 

Reclassifications

 

Certain prior year balances have been reclassified to conform to the current year presentation.

 

2. RECENTLY ISSUED ACCOUNTING STANDARDS

 

In December 2004, the FASB issued SFAS No. 123 (R), “Share Based Payment.” Statement No. 123 (R) requires all entities to recognize compensation expense in an amount equal to the fair value of share based payments granted to employees. This statement is effective for the first fiscal year beginning after June 15, 2005. The Company will adopt Statement No. 123 (R) beginning with the first quarter of fiscal 2006. Adoption of the statement will require the Company to record compensation expense relating to the issuance of employee stock options. Currently, the Company follows APB No. 25 which does not require the recognition of compensation expense relating to the issuance of stock options so long as the quoted market price of the Company’s stock at the date of grant is less than or equal to the amount an employee must pay to acquire the stock. The Company is currently evaluating the impact the adoption of this statement will have on its consolidated financial position or results of operations.

 

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3. EARNINGS (LOSS) PER SHARE

 

Earnings (loss) per share are calculated in accordance with SFAS No. 128, “Earnings Per Share.” Basic earnings per share are computed by dividing net income for the period by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed by dividing net income by the weighted average number of common shares plus the dilutive effect of outstanding stock options under the Company’s equity incentive plans. Stock options outstanding that are not included in the table below because of their anti-dilutive effect for the three months ended March 31, 2005 and 2004 were 710,018 and 763,200, respectively.

 

The net income (loss) and weighted average common and common equivalent shares outstanding for purposes of calculating net income (loss) per common share were computed as follows:

 

    

Three Months Ended

March 31,


     2005

    2004

Net Income (Loss)

   $ (98,472 )   $ 27,105

Weighted average number of common shares outstanding used in computing basic earnings per share

     13,344,202       13,085,410

Dilutive effect of stock options outstanding

     —         143,597

Weighted average shares used in computing diluted earnings per share

     13,344,202       13,229,007
    


 

Basic earnings per share

   $ (0.01 )   $ 0.00

Diluted earnings per share

   $ (0.01 )   $ 0.00
    


 

 

4. STOCK-BASED COMPENSATION

 

The Company has adopted equity incentive plans that provide for the granting of stock options to employees, directors, advisors and consultants. We account for grants of options to employees and directors under these plans applying the intrinsic value method provided for in APB Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations. No stock-based compensation expense is reflected in net income as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of the grant. In addition to APB Opinion No. 25, we provide the disclosures required by SFAS No. 123, “Accounting for Stock-Based Compensation” and by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” See Note 1 for disclosure of Pro Forma Net Income and Net Income Per Share.

 

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For purposes of determining the pro forma amounts in Note 1, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions:

 

     Three months ended
March 31,


     2005

  2004

Risk-free interest rate

   4.01% - 4.17%   2.85% - 3.35%

Expected dividend yield

   —     —  

Expected life

   5 years   5 years

Expected volatility

   54%   56%

 

Based upon the above assumptions, the weighted average fair value of the stock options granted for the three months ended March 31, 2005 and 2004 was $1.19 and $1.30, respectively. Because additional option grants are expected to be made, the above pro forma disclosures are not representative of pro forma effects on reported net income for future periods.

 

5. COMPREHENSIVE INCOME

 

A reconciliation of comprehensive income in accordance with SFAS No. 130 “Reporting Comprehensive Income” is as follows:

 

     Three Months Ended
March 31,


     2005

    2004

Net Income (Loss)

   $ (98,472 )   $ 27,105

Foreign currency translation adjustment

     (5,063 )     35,434
    


 

Comprehensive Income (Loss)

   $ (103,535 )   $ 62,539
    


 

 

6. SEGMENT INFORMATION

 

The Company has adopted the provisions of SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information” which establishes standards for reporting business segment information. The Company operates predominantly in one segment in the clinical research industry providing a broad range of clinical research services on a global basis to the pharmaceutical, biotechnology and medical device industries.

 

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The following table summarizes the distribution of net revenue and contracts with significant clients:

 

    

Three Months Ended

March 31, 2005


  

Three Months Ended

March 31, 2004


     Percentage
of Revenues


    Number of
Contracts


   Percentage
of Revenues


    Number of
Contracts


Client A

   28 %   4    25 %   3

Client B

   18 %   3    18 %   6

Client C

   16 %   1    13 %   2

Client D

   12 %   3    12 %   1

Client E

   12 %   1           
    

 
  

 

Total

   86 %   12    68 %   12
    

 
  

 

 

Client A, B, C, D and E in the table above represent the largest clients for each period, but do not represent the same client for each year shown.

 

The following table summarizes the distribution of net revenues from external clients by geographical area:

 

     2005

   2004

     United States

   Europe

   Total

   United States

   Europe

   Total

Net revenue from external clients

   $ 2,867,794    $ 345,735    $ 3,213,529    $ 4,756,044    $ 526,541    $ 5,282,585

 

7. LINE OF CREDIT

 

We previously maintained a demand line of credit with a bank under which maximum borrowings were the lesser of $2.5 million or 75% of eligible accounts receivable, as defined in the loan agreement, and interest was charged at the LIBOR Market Index Rate plus 2.65%. This line of credit expired on August 15, 2004. The Company does not currently anticipate that it will be able to replace this credit facility based on its recent operating results.

 

8. OTHER LIABILITIES

 

As of January 1, 2003, the Company increased the amount of square feet under lease in the same building by approximately 12,700 to 34,000. The term of the lease was also extended to 2010 and monthly lease payments increased from $50 thousand to $72 thousand. As an incentive for the Company to acquire the additional space, the lessor granted the Company $814 thousand in lease incentives that were used to pay for architectural fees, renovations and improvement costs for the new space. The lease incentives were capitalized as if the Company incurred the costs to make the improvements and are included in Property and Equipment. These assets and the related liability are amortized over the remaining life of the lease at a rate of approximately $116 thousand per year as an additional amortization expense and a reduction in rent expense, respectively. The accounting for these lease incentives has no impact on net income, stockholders’ equity or cash flow.

 

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9. SUPPLEMENTAL CASH FLOW INFORMATION

 

No income tax payments were required for the three months ended March 31, 2005. Cash paid for income taxes for three months ended March 31, 2004 was approximately $8 thousand. Cash paid for interest for the three months ended March 31, 2005 and 2004 was approximately $1 thousand and $3 thousand, respectively. We did not enter into any capital lease obligations during the three months ended March 31, 2005 or March 31, 2004. We did not acquire any property and equipment through lease incentives during the three months ended March 31, 2005 or March 31, 2004.

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

In this discussion, the terms “Company,” “we,” “us” and “our” refer to Covalent Group, Inc. and its consolidated subsidiaries, except where it is made clear otherwise.

 

Forward Looking Statements

 

When used in this Report on Form 10-Q and in other public statements, both oral and written, by the Company and Company officers, the words “estimate,” “project,” “expect,” “intend,” “believe,” “anticipate” and similar expressions are intended to identify forward-looking statements regarding events and trends that may affect our future operating results and financial position. Such statements are subject to risks and uncertainties that could cause our actual results and financial position to differ materially. Such factors include, among others: (i) our success in attracting new business and retaining existing clients and projects; (ii) the size, duration and timing of clinical trials; (iii) the termination, delay or cancellation of clinical trials; (iv) the timing difference between our receipt of contract milestone or scheduled payments and our incurring costs to manage these trials; (v) outsourcing trends in the pharmaceutical, biotechnology and medical device industries; (vi) the ability to maintain profit margins in a competitive marketplace; (vii) our ability to attract and retain qualified personnel; (viii) the sensitivity of our business to general economic conditions; and (ix) other economic, competitive, governmental and technological factors affecting our operations, markets, products, services and prices. We undertake no obligation to publicly release the result of any revision of these forward-looking statements to reflect events or circumstances after the date they are made or to reflect the occurrence of unanticipated events. Please refer to the section entitled “Risk Factors that Might Affect our Business or Stock Price” beginning on page 9 on our annual report on Form 10-K for the fiscal year ended December 31, 2004 for a more complete discussion of factors which could cause our actual results and financial position to change.

 

Company Overview

 

We are a clinical research organization (“CRO”) which we believe is a leader in the design and management of complex clinical trials for the pharmaceutical, biotechnology and medical device industries. Our mission is to provide our clients with high quality, full-service support for their clinical trials. We offer therapeutic expertise, experienced team management and advanced technologies. Our headquarters is in Wayne, Pennsylvania and our International operations are based in Guildford, Surrey, United Kingdom.

 

Our clients consist of many of the largest companies in the pharmaceutical, biotechnology and medical device industries. From protocol design and clinical program development, to proven patient recruitment, to managing the regulatory approval process, we have the resources to directly implement or manage Phase I through Phase IV clinical trials and to deliver clinical programs on time and within budget. We have clinical trial experience across a wide variety of therapeutic areas, such as cardiovascular, endocrinology/metabolism, diabetes,

 

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neurology, oncology, immunology, vaccines, infectious diseases, gastroenterology, dermatology, hepatology, womens’ health and respiratory medicine. We have the capacity and expertise to conduct clinical trials on a global basis.

 

The information set forth and discussed below for the three months ended March 31, 2005 and 2004 is derived from the financial statements included elsewhere herein. The financial information set forth and discussed below is unaudited but, in the opinion of management, reflects all adjustments (primarily consisting of normal recurring adjustments) necessary for a fair presentation of such information. The results of our operations for a particular quarter may not be indicative of results expected during the other quarters or for the entire year.

 

Our quarterly results can fluctuate as a result of a number of factors, including our success in attracting new business, the size and duration of clinical trials, the timing of client decisions to conduct new clinical trials or to cancel or delay ongoing trials, and other factors, many of which are beyond our control.

 

Net revenue is derived principally from the design, management and monitoring of clinical research studies. Clinical research service contracts generally have terms ranging from several months to several years. A portion of the contract fee is generally payable upon execution of the contract, with the balance payable in installments over the life of the contract. The majority of our net revenue is recognized from fixed-price contracts on a proportional performance basis. To measure the performance, we compare actual direct costs incurred to estimated total contract direct costs, which we believe is the best indicator of the performance of the contract obligations as the costs relate to the labor hours incurred to perform the service.

 

Contracts generally may be terminated by clients immediately or with short notice. Clinical trials may be terminated or delayed for several reasons, including among others, unexpected results or adverse patient reactions to the drug, inadequate patient enrollment or investigator recruitment, manufacturing problems resulting in shortages of the drug or decisions by the client to de-emphasize or terminate a particular trial or development efforts on a particular drug. Depending on the size of the trial in question, a client’s decision to terminate or delay a trial in which we participate could have a material and adverse effect on our backlog, future revenue and results from operations. Adjustments to contract estimates are made in the period in which the facts that require revisions become known.

 

Our backlog was approximately $14 million as of March 31, 2005 as compared to approximately $11 million as of March 31, 2004. Our backlog consists of anticipated net revenue from signed contracts, letters of intent and certain verbal commitments that either have not started but are anticipated to begin in the near future or are in process and have not yet been completed. Many of our studies and projects are performed over an extended period of time, which may be several years. Amounts included in backlog have not yet been recognized as net revenue in our Consolidated Statements of Operations. Once contracted work begins, net revenue is recognized over the life of the contract on a proportional performance basis. The recognition of net revenue and contract terminations, if any, reduce our backlog while the awarding of new business increases our backlog. For the three months ended March 31, 2005, we obtained approximately $2.7 million of new business awards as compared to approximately $4.8 million for the three months ended March 31, 2004.

 

We believe that our backlog as of any date may not necessarily be a meaningful predictor of future results because backlog can be affected by a number of factors including the size and duration of contracts, many of which are performed over several years. Additionally, contracts relating to our clinical trial business may be subject to early termination by the client or delay for many reasons, as described above. Also, the scope of a contract can change during the course of a study. For these reasons, we might not be able to fully realize our entire backlog as net revenue.

 

The following table sets forth amounts for certain items in our consolidated statements of operations expressed as a percentage of net revenue. The following table excludes revenue and costs related to reimbursable out-of-

 

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pocket expenses because they are not generated by the services we provide, do not yield any gross profit to us, and do not have any impact on our net income. We believe this information is useful to our investors because it presents the net revenue and expenses that are directly attributable to the services we provide to our clients and provides a more accurate picture of our operating results and margins.

 

Percentage of Net Revenue, Excluding Reimbursable Out-of-Pocket Expenses

 

     Three months ended
March 31,


 
     2005

    2004

 

Net revenue

   100.0 %   100.0 %

Operating Expenses

            

Direct

   63.6 %   69.6 %

Selling, general and administrative

   35.7 %   25.0 %

Depreciation and amortization

   4.3 %   4.8 %

Income (Loss) from Operations

   -3.6 %   0.6 %

Net Income (Loss)

   -3.1 %   0.5 %

 

Contractual Obligations and Commitments

 

We did not enter into any capital lease obligations during the three months ended March 31, 2005 or March 31, 2004. We are committed under a number of non-cancelable operating leases, primarily related to office space and other office equipment.

 

Below is a summary of our future payment commitments by year under contractual obligations as of March 31, 2005. Actual amounts paid under these agreements could be higher or lower than the amounts shown below as a result of changes in volume and other variables:

 

     2005

   2006

   2007

   2008

   2009

   Thereafter

   Total

Obligations under capital leases

   $ 23,709    $ 26,314    $ 29,204    $ 7,791    $ —      $ —      $ 87,018

Operating leases

     960,171      921,018      937,259      952,728      969,741      986,754      5,727,671

Employment agreements

     325,000      81,250      —        —        —        —        406,250

Service agreements

     1,418,609      109,840      65,120      55,432      33,479      99,319      1,781,799
    

  

  

  

  

  

  

Total

   $ 2,727,489    $ 1,138,422    $ 1,031,583    $ 1,015,951    $ 1,003,220    $ 1,086,073    $ 8,002,738
    

  

  

  

  

  

  

 

In 2005, we anticipate capital expenditures of approximately $100 thousand - $150 thousand for leasehold improvements, software applications, workstations, personal computer equipment and related assets. A significant portion of our service agreement commitments, which are primarily comprised of investigator payments, are expected to be reimbursed under agreements with clients. There have been no material changes to the above data since December 31, 2004.

 

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Critical Accounting Policies and Estimates

 

The following discussion should be read in conjunction with the consolidated financial statements and notes thereto.

 

Our consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make certain estimates, judgments and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. On an ongoing basis, management evaluates its judgments and estimates. Management bases its judgments and estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. Management considers the following policies to be most critical in understanding the more complex judgments that are involved in preparing our consolidated financial statements and the uncertainties that could affect our results of operations and financial condition.

 

Revenue Recognition

 

The majority of our net revenue is recognized from fixed-price contracts on a proportional performance basis. To measure the performance, we compare actual direct costs incurred to estimated total contract direct costs, which we believe is the best indicator of the performance of the contract obligations as the costs relate to the labor hours incurred to perform the service. Total direct costs are incurred for each contract and compared to estimated total direct costs for each contract to determine the percentage of the contract that is completed. This percentage is multiplied by the estimated total contract value to determine the amount of net revenue recognized. A formal project review process takes place quarterly although most projects are evaluated on an ongoing basis. Management reviews the estimated total direct costs on each contract to determine if estimated amounts are correct, and estimates are adjusted as needed. 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 such determination is made. Because of the inherent uncertainties in estimating direct costs required to complete a project, particularly complex, multi-year studies, it is possible that the estimates used will change and could result in a material change to our estimates. Original estimates might also be changed due to changes in the scope of work. We attempt to negotiate contract amendments with the client to cover these services provided outside the terms of the original contract. There can be no assurance that the client will agree to the proposed amendments, and we ultimately bear the risk of cost overruns. For terminated studies, our contracts frequently entitle us to receive the costs of winding down the terminated project, as well as all fees earned by us up to the time of termination.

 

Costs and estimated earnings in excess of related billings on uncompleted contracts represent net revenue recognized to date that is currently unbillable to the client pursuant to contractual terms. In general, amounts become billable upon the achievement of milestones or in accordance with predetermined payment schedules set forth in the contracts with our clients. Several of our older contracts contain payment schedules that are weighted towards the later stages of the contract. Billings in excess of related costs and estimated earnings on uncompleted contracts represent amounts billed in excess of net revenue recognized at the balance sheet date.

 

Reimbursable Out-of-Pocket Expenses

 

On behalf of our clients, we pay fees to investigators and other out-of-pocket costs for which we are reimbursed at cost, without mark-up or profit. Effective January 1, 2002, in connection with the required implementation of Financial Accounting Standards Board Emerging Issues Task Force Issue No. 01-14 (“EITF 01-14”), “Income Statement Characterization of Reimbursements Received for ‘Out-of-Pocket’ Expenses Incurred,” out-of-pocket costs are now included in Operating Expenses, while the reimbursements received are reported separately as Reimbursement Revenue in the Consolidated Statements of Operations.

 

As is customary in the industry, we exclude from revenue and expense in the Consolidated Statement of

 

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Operations fees paid to investigators and the associated reimbursement since we act as agent on behalf of our clients with regard to investigators. These investigator fees are not reflected in our Net Revenue, Reimbursement Revenue, Reimbursement Out-of-Pocket Expenses, and/or Direct Expenses. The amounts of these investigator fees were $860 thousand and $1.2 million for the three months ended March 31, 2005 and 2004, respectively.

 

Concentration of Credit Risk

 

Our accounts receivable and costs and estimated earnings in excess of related billings on uncompleted contracts are concentrated with a small number of companies within the pharmaceutical, biotechnology and medical device industries. The significant majority of this exposure is to large, well established firms. Credit losses have historically been minimal. As of March 31, 2005, the total of accounts receivable and costs and estimated earnings in excess of related billings on uncompleted contracts was $3.9 million. Of this amount, the exposure to our three largest clients was 66% of the total, with the three largest clients representing 41%, 19%, and 6% of total exposure, respectively. As of March 31, 2004, the total of accounts receivable and costs and estimated earnings in excess of related billings on uncompleted contracts was $15.5 million. Of this amount, the exposure to our three largest clients was 61% of the total, with the three largest clients representing 27%, 19%, and 15% of total exposure, respectively.

 

Operating Expenses

 

Direct expenses include amounts incurred during the period that are directly related to the management or completion of a clinical trial or related project and generally include direct labor and related benefit charges, other direct costs and certain allocated expenses. Direct costs as a percentage of net revenues tend to fluctuate from one period to another as a result of changes in the mix of services provided and the various studies conducted during any time period. Selling, general and administrative expenses include the salaries, wages and benefits of all administrative, finance and business development personnel, and all other support expenses not directly related to specific contracts.

 

Stock-Based Compensation

 

The Company has adopted equity incentive plans that provide for the granting of stock options to employees, directors, advisors and consultants. We account for grants of options to employees and directors under these plans applying the intrinsic value method provided for in Accounting Principles Board (“APB”) Opinion No. 25 “Accounting for Stock Issued to Employees” and related interpretations. No stock-based compensation expense is reflected in net income as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of the grant. In addition to APB Opinion No. 25, we provide the disclosures required by Statement of Financial Accounting Standards (“SFAS”), No. 123 “Accounting for Stock-Based Compensation” and by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.”

 

Results of Operations

 

Three Months Ended March 31, 2005 Compared With Three Months Ended March 31, 2004

 

Net revenue for the three months ended March 31, 2005 decreased 39% to $3.2 million as compared to $5.3 million for the three months ended March 31, 2004. The decrease of $2.1 million reflects a lower than anticipated level of new business awards as well as the completion of several projects that were active during the first quarter of 2004. New business awards and changes of scope for the three months ended March 31, 2005 were $2.7 million as compared to $4.8 million for the three months ended March 31, 2004. For the three months ended March 31, 2005, net revenue from our largest clients amounted to 86% of our net revenue, with

 

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the largest clients representing 28%, 18%, 16%, 12% and 12% of net revenue. For the three months ended March 31, 2004, net revenue from our largest clients amounted to 68% of our net revenue, with the largest clients representing 25%, 18%, 13%, and 12% of net revenue.

 

Reimbursement revenue consisted of reimbursable out-of-pocket expenses incurred on behalf of our clients. Reimbursements are made at cost, without mark-up or profit, and therefore have no impact on net income.

 

Direct expenses include compensation and other expenses directly related to conducting clinical studies. These costs decreased by approximately $1.6 million to $2.0 million for the three months ended March 31, 2005 from $3.7 million for the three months ended March 31, 2004. The decrease in direct expenses resulted principally from a decline in personnel costs associated with lower project requirements and cost control initiatives. Direct expenses as a percentage of net revenue were 64% for the three months ended March 31, 2005 as compared to 70% for the three months ended March 31, 2004. The improvement in the gross margin was principally due to greater cost efficiencies in managing the clinical studies.

 

Selling, general, and administrative expenses included the salaries, wages and benefits of all administrative, financial and business development personnel and all other support expenses not directly related to specific contracts. Selling, general and administrative expenses for the three months ended March 31, 2005 were $1.1 million, or 36% of net revenue, as compared to $1.3 million, or 25% of net revenue, for the three months ended March 31, 2004. The decrease of $177 thousand resulted principally from a decline in personnel costs and other cost control initiatives. The increase in the ratio was principally due to the lower level of net revenue reported for the quarter and for $76 thousand of compliance costs related to the Sarbanes-Oxley Act of 2002 incurred in the first quarter of 2005.

 

Depreciation and amortization expense decreased to $138 thousand for the three months ended March 31, 2005 from $254 thousand for the three months ended March 31, 2004, primarily as a result of assets that were fully depreciated prior to the first quarter of 2005 combined with lower capital expenditures during 2004.

 

Income from operations decreased by $142 thousand to a loss of $113 thousand primarily for the reasons noted in the preceding paragraphs.

 

Net interest income for the three months ended March 31, 2005 was $15 thousand compared to net interest expense of $2 thousand for the three months ended March 31, 2004 due to an increase in the amount of cash on hand.

 

The effective income tax rate for the three months ended March 31, 2005 and 2004 was 0% and 2%, respectively. No tax provision was required in the first quarter of 2005 due to the net loss incurred.

 

Net income for the three months ended March 31, 2004 of $27 thousand, or $0.00 per diluted share, decreased to a net loss of $98 thousand, or $(0.01) per diluted share, for the three months ended March 31, 2005, for the reasons noted above.

 

Liquidity and Capital Resources

 

Our primary cash needs are for the payment of salaries and fringe benefits, hiring and recruiting expenses, business development costs, acquisition-related costs, capital expenditures, and facilities–related expenses. Our principal source of cash is from contracts with clients. If we are unable to generate new contracts with existing and new clients and/or if the level of contract cancellations increases, revenues and cash flow will be adversely affected. Absent a material adverse change in the level of the Company’s new business bookings or contract cancellations, we believe that our existing capital resources together with cash flow from operations will be sufficient to meet our foreseeable cash needs for the next twelve months. However, if we significantly expand our business through acquisitions and/or continue to incur a loss from operations we may need to raise additional funds through the sale of debt or equity securities in order to keep operating our business.

 

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Our contracts usually require a portion of the contract amount to be paid at the time the contract is initiated. Additional payments are generally made upon completion of negotiated performance milestones, or on a regularly scheduled basis, throughout the life of the contract. Accordingly, cash receipts do not necessarily correspond to costs incurred and revenue recognized. For terminated studies, our contracts frequently entitle us to receive the costs of winding down the terminated project, as well as all fees earned by us up to the time of termination. Some contracts also entitle us to an early termination fee, usually in the form of a predetermined fee or percentage of revenue expected to be earned for completion of the project.

 

Net revenue is recognized on a proportional performance basis. We typically receive a low volume of large-dollar receipts. As a result, the number of days net revenue outstanding in accounts receivable, costs and estimated earnings in excess of related billings, customer advances, and billings in excess of related costs will fluctuate due to the timing and size of billings and cash receipts. At March 31, 2005, the net days revenue outstanding was 56 days compared to 192 days at December 31, 2004. Compared to December 31, 2004, accounts receivable decreased $2.4 million to $2.8 million at March 31, 2005, primarily due to receipt of previously billed milestone payments. Of the accounts receivable balance at March 31, 2005, less than 5% of the total was over 60 days past invoice date.

 

Compared to December 31, 2004, costs and estimated earnings in excess of related billings on uncompleted contracts decreased $587 thousand to $1.1 million at March 31, 2005. The decrease primarily represents the billing of milestones in accordance with the payment schedules contained in the contracts with our clients. The balance at March 31, 2005 primarily consisted of 2 clinical trials, which individually constituted 66%, and 13% of the balance. These clinical trials are expected to be completed during 2005. The decrease in the liability account billings in excess of related costs and estimated earnings on uncompleted contracts of $621 thousand to $1.2 million of March 31, 2005 from $1.8 million as of December 31, 2004, resulted from continued progress on several contracts with billing schedules weighted toward the earlier phases of the study. The decrease in customer advances of $294 thousand to $786 thousand as of March 31, 2005 from $1.1 million as of December 31, 2004, resulted primarily from the net utilization of customer advances in order to make payments to clinical trial investigators.

 

Our net cash provided by operating activities was $2.1 million for the three months ended March 31, 2005, compared with net cash provided by operating activities of $377 thousand for the three months ended March 31, 2004. Net cash used by investing activities, consisting principally of purchases of property, equipment and leasehold improvements, was $30 thousand for the three months ended March 31, 2005, compared with net cash used by investing activities of $1 thousand for the three months ended March 31, 2004. The difference was related to purchases of personal computer equipment. Net cash provided by financing activities was $1 thousand for the three months ended March 31, 2005, compared with net cash provided by financing activities of $5 thousand for the three months ended March 31, 2004. The difference was related to the realization of less proceeds from the exercise of stock options.

 

As a result of these cash flows, our cash and cash equivalents balance at March 31, 2005 was $5.2 million as compared to $3.2 million at December 31, 2004, an increase of $3.0 million.

 

We previously maintained a demand line of credit with a bank under which maximum borrowings were the lesser of $2.5 million or 75% of eligible accounts receivable, as defined in the loan agreement, and interest was charged at the LIBOR Market Index Rate plus 2.65%. This line of credit expired on August 15, 2004. The Company does not currently anticipate it will be able to obtain a new credit facility based on its recent operating results.

 

We purchased equipment of $31 thousand during the three months ended March 31, 2005. We anticipate capital expenditures of approximately $70 - $120 thousand during the remainder of 2005, primarily for leasehold improvements, software applications, workstations, personal computer equipment and related assets.

 

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Recently Issued Accounting Standards

 

In December 2004, the FASB issued SFAS No. 123 (R), “Share Based Payment.” Statement No. 123 (R) requires all entities to recognize compensation expense in an amount equal to the fair value of share based payments granted to employees. This statement is effective for the first fiscal year beginning after June 15, 2005. The Company will adopt Statement No. 123 (R) beginning with the first quarter of fiscal 2006. Adoption of the statement will require the Company to record compensation expense relating to the issuance of employee stock options. Currently, the Company follows APB No. 25 which does not require the recognition of compensation expense relating to the issuance of stock options so long as the quoted market price of the Company’s stock at the date of grant is less than or equal to the amount an employee must pay to acquire the stock. The Company is currently evaluating the impact the adoption of this statement will have on its consolidated financial position or results of operations.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Market Risk

 

The fair value of cash and cash equivalents, restricted cash, accounts receivable, costs and estimated earnings in excess of related billings on uncompleted contracts, accounts payable, accrued expenses and billings in excess of related costs and estimated earnings on uncompleted contracts are not materially different than their carrying amounts as reported at March 31, 2005 and March 31, 2004.

 

As of March 31, 2005, the Company was not a counterparty to any forward foreign exchange contracts or any other transaction involving a derivative financial instrument.

 

Foreign Currency Exchange Risk

 

The Company is exposed to foreign currency exchange risk through its international operations. For the three months ended March 31, 2005, approximately 11% of our net revenues were derived from contracts denominated in other than U.S. Dollars. Our financial statements are denominated in U.S. Dollars. As a result, factors associated with international operations, including changes in foreign currency exchange rates, could affect our results of operations and financial condition. Contracts entered into in the United States are denominated in U.S. Dollars. Contracts entered into by our international subsidiary are generally denominated in pounds sterling, Euros or U.S. Dollars. To date, we have not engaged in any derivative or contractual hedging activities related to our foreign exchange exposures. We believe that these exposures are limited by virtue of their small size relative to our operations as well as the partial natural hedge afforded by our local currency expenditures to service these local currency contracts.

 

Assets and liabilities of the Company’s international operations are translated into U.S. Dollars at exchange rates in effect on the balance sheet date. Revenue and expense items are translated at average exchange rates in effect during the quarter. Gains or losses from translating foreign currency financial statements are recorded in other comprehensive income. The cumulative translation adjustment included in other comprehensive income for the three months ended March 31, 2005 and March 31, 2004 was $(5) thousand and $35 thousand, respectively.

 

Inflation

 

We believe that the effects of inflation generally do not have a material adverse impact on our operations or financial condition.

 

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ITEM 4. CONTROLS AND PROCEDURES

 

Our management, including our principal executive officer and principal financial officer, has evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2004. Our disclosure controls and procedures are designed to provide reasonable assurance that the information required to be disclosed in this annual report on Form 10-K has been appropriately recorded, processed, summarized and reported. Based on that evaluation, our principal executive and principal financial officers have concluded that our disclosure controls and procedures are effective at the reasonable assurance level. Our management, including our principal executive and principal financial officers, has evaluated any changes in our internal control over financial reporting that occurred during the year ended December 31, 2004, and has concluded that there was no change that occurred during the year ended December 31, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. The Company conducts periodic evaluations of its controls to enhance, where necessary, its procedures and controls. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. (a) An evaluation was performed under the supervision and with the participation of the Company’s management, including its Chief Executive Officer, and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures, as such term is defined under Rule 13a- 15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of March 31, 2004. Based upon that evaluation, the Company’s management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act, is recorded, processed, summarized and reported as specified in the Securities and Exchange Commission rules and forms.

 

PART II. OTHER INFORMATION

 

ITEM 5. OTHER INFORMATION

 

None.

 

ITEM 6. EXHIBITS

 

  (a) Exhibits

 

31.1    Certification of Chief Executive Officer required by Rule 13a-14(a) or Rule 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2    Certification of Principal Accounting Officer required by Rule 13a-14(a) or Rule 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1    Certification pursuant to 18 U.S.C. § 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2    Certification pursuant to 18 U.S.C. § 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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SIGNATURES

 

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

 

    COVALENT GROUP, INC.
Dated: May 16, 2005   By:  

/s/ Kenneth M. Borow, M.D.


        Kenneth M. Borow, M.D.
        President and Chief Executive Officer
Dated: May 16, 2005   By:  

/s/ Lawrence R. Hoffman


        Lawrence R. Hoffman
       

Executive Vice President, General Counsel,

Secretary and Chief Financial Officer

 

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