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

The following discussion of our results of operations and financial condition should be read in conjunction with the financial statements and the related notes. The following discussion includes forward-looking statements. For a discussion of important factors that could cause actual results to differ from results discussed in the forward-looking statements, see "Forward Looking Statements."

As a result of the reverse acquisition that closed on January 25, 2006, Plaza is treated as the accounting acquirer and the results of operations for periods prior to January 25, 2006 reflect only the operations of Plaza.

Overview

We are a validation and compliance consulting service firm in Puerto Rico. The validation and compliance consulting service market in Puerto Rico consists of local validation and compliance consulting firms, United States dedicated validation and compliance consulting firms and large publicly traded and private domestic and foreign engineering and consulting firms. We provide a broad range of compliance and validation consulting services. We market our services to pharmaceutical, chemical, biotechnology and medical devices and allied products companies in Puerto Rico, the United States and Europe through their Puerto Rico operations. Our staff includes more than 150 experienced engineering and life science professionals, and includes former quality assurance managers or directors, and experienced and well-trained professionals with bachelors, masters and doctorate degrees in health sciences and engineering.

Our revenue is derived from time and materials contracts (representing approximately 90% of total revenues), where the clients are charged for the time, materials and expenses incurred on a particular project, and to a lesser extent (approximately 10% of total revenues), from fixed-fee contracts or from "not to exceed" contracts, which generally are short-term contracts, in which the value of the contract to us cannot exceed a stated amount. For time and materials contracts, our revenue is principally a function of the number of its compliance and validation professional employees and the number of hours billed per professional. To the extent that our revenue is based on fixed-fee or "not to exceed" contracts, our ability to operate profitably is dependent upon our ability to estimate accurately the costs that we will incur on a project and to management and monitoring progress. If we underestimate our costs on any contract, we would sustain a loss on the contract.

We believe the most significant factors to achieving future business growth are the ability to (a) continue to provide quality value-added validation and compliance services to our clients in the Puerto Rico marketplace; (b) recruit and retain highly educated and experienced validation and compliance professionals; (c) further expand its products and services to address the expanding compliance needs of the clients; and (d) expand our market presence into the United States, Latin America and Europe in order to respond to the international validation and compliance demands of our clients. Since our business is conducted mainly in Puerto Rico, our business may be affected to the extent that the Puerto Rico’s economic problems affect the decision of our customers and potential customers to locate in Puerto Rico or to continue or expand their existing operations, as well as the continued presence in Puerto Rico of an office of the federal Food and Drug Administration and the continuation of tax benefits available to our customers under the Puerto Rico Internal Revenue Code, which are scheduled to expire at the end of 2007, although there are proposals in the Puerto Rico legislature to extend the existing benefits until a new law is drafted and approved.

Our business has been dependent upon a small number of clients. For the three-month and six-month periods ended April 30, 2007, two customers accounted for approximately 50% of revenues. For the three-month and the six-month periods ended April 30, 2006, one of these two customers, together with another customer accounted for approximately 52% of revenues. In spite of the fact that just a few customers represent a significant source of revenue, our functions are not a continuous process, accordingly, the client base for which our services are typically rendered, on a project-by-project basis, changes regularly. 

 

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However, the loss of or significant reduction in the scope of work performed for any major customer could impair our ability to operate profitably. In particular, we had a contract with one of our largest customers which expired on December 31, 2005. Although this contract was divided in a number of smaller contracts and extended with termination dates varying through December 2006, the level of business has significantly declined from the prior year. In June 2006, this customer announced the closing of one of its two facilities located in Puerto Rico and a reduction of staff in the second facility. The revenues from this major customer were as follows: 

 

		Three months ended April 30,						Six months ended April 30,
		2007			2006			2007			2006
Operating facility		$	235,475		$	236,692		$	421,298		$	634,221
Closed facility			-			551,832			38,739			1,462,923
Total		$	235,475		$	788,524		$	460,037		$	2,097,144

Although our business is affected by seasonal factors such as vacation and holiday work policies, we do not believe that our business is seasonal. However, because our business is based on performing services under contracts that relate to specific projects, there may be a lag between the completion of one project and the commencement of the following project. This lag may cause a decline in revenues and a related decline in gross margin during the affected periods.

On January 9, 2006, we acquired, for $300,000, from the individual who served as our executive vice president and chief operating officer from February 1, 2006 to March 31, 2006, certain assets of Integrated Validation Service, a United States-based business that performs consulting services for the pharmaceutical and biotech industries. These assets include a client list and the validation compliance service business that was operated by that individual. We also hired nine former employees of the business. This acquisition was made pursuant to our strategy to expand our operations beyond Puerto Rico with a view to lessening our dependence upon a small number of Puerto Rico pharmaceutical companies. We cannot give assurance that any significant revenues will be derived from these operations. Revenues from these operations were as follows:

Period		Amount
Three months ended April 30, 2007		$	342,507
Three months ended April 30, 2006			264,216
Six months ended April 30, 2007			533,221
Six months ended April 30, 2006			356,837

The principal components of our costs of revenue are employee compensation (salaries, wages, taxes and benefits) and expenses relating to the performance of the services. We face increasing labor costs which we seek to pass on to our customers through increases in our rates. However, there is often a delay between the increase in our costs and the increases in our billing rates, which may result in a reduced gross margin during that period. Although we have been successful in the past in being able to increase our billing rates to reflect our increased labor costs, we cannot give any assurance that we will continue to be able to do so.

On January 25, 2006, Pharma-Bio acquired Plaza in a transaction which was accounted for as a reverse acquisition, with Plaza being deemed the accounting acquirer. Pursuant to the acquisition agreement, we paid Elizabeth Plaza, the sole stockholder of Plaza, $10,000,000 plus 1,150,000 shares of Pharma-Bio's common stock. In addition, Ms. Plaza is to receive three installments, each in the amount of $2,750,000, payable on January 25, 2007, 2008 and 2009. In January 2007, Elizabeth Plaza agreed to accept the first installment of $2,750,000 in two payments, one in the amount of $2,500,000 in January 2007 and the second in the amount of $250,000 in February 2007. The second installment due in January 2008, net of imputed interest, is a current liability at April 30, 2007, and is a significant factor in the reduction in the Company's working capital, as discussed under "Liquidity and Capital Resources."

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Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles (“GAAP”) in the United States. We believe the following are the critical accounting policies that impact the financial statements, some of which are based on management’s best estimates available at the time of preparation. Actual experience may differ from these estimates.

 

Cash and cash equivalents - For purposes of the statements of cash flows, cash and cash equivalents include liquid investments with original maturities of three months or less.

 

Revenue Recognition - We recognize revenues from time and material contracts by applying the proportional performance model, whereby revenue is recognized as performance occurs. In the case of fixed-fee or “not to exceed” contracts, which are generally short-term contracts, revenue is recognized similarly, except that certain milestones also have to be reached before revenue is recognized. With respect to fixed-fee contracts, revenue is recognized based on the percentage that services rendered bears to the estimated services to be performed over the contract. If we determine that a fixed-fee or “not to exceed” contract will result in a loss, we recognize the estimated loss in the period in which such determination is made.

  

Bad Debts - Bad debts are accounted for using the direct write-off method whereby an expense is recognized only when a specific account is determined to be uncollectible. The effect of using this method approximates that of the allowance method.

Property and Equipment - Owned property and equipment, and leasehold improvements are stated at cost. Equipment and vehicles under capital leases are stated at the lower of fair market value or net present value of the minimum lease payments at the inception of the leases.

 

Depreciation of owned assets, and amortization of assets under capital leases and leasehold improvements, are provided using the straight-line basis over the shorter of the estimated useful lives of the assets or the lease term. Major renewals and betterments that extend the life of the assets are capitalized, while expenditures for repairs and maintenance are expensed when incurred.

 

We evaluate for impairment our long-lived assets to be held and used, and long-lived assets to be disposed of, whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.

Income Taxes — We elected from our inception until January 25, 2006, to be covered under the provisions of Subchapter N of Subtitle A of the Puerto Rico Internal Revenue Code (the “Puerto Rico Code”), which is similar to Subchapter S of the Internal Revenue Code in that we paid no income taxes since the taxable income was taxed to our stockholder. Under the provisions of the Puerto Rico Code, we paid the Puerto Rico Secretary of Treasury, on behalf of its stockholder, an amount equal to 33% of our taxable income. These payments, and any income tax withheld, are included in the amount of distributions to stockholder in our financial statements.

 

Commencing with the acquisition of Plaza on January 25, 2006, we are taxed based on our taxable income under the applicable provisions of the Puerto Rico Code and the Internal Revenue Code.

The undistributed earnings of our subsidiary, Plaza Consulting Group, Inc., are included in the consolidated financial statements. Since we consider to reinvest Plaza’s current undistributed earnings indefinitely, we do not recognize deferred income taxes on said earnings.

 

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Concentration of credit risk — Financial instruments which potentially subject us to concentrations of credit risk consist principally of cash deposits and trade accounts receivable. We maintain our cash deposits in a bank account and an uninsured money market account. While we attempt to limit any financial exposure, our deposit balances in our bank account normally exceed federally insured limits; however, no losses have been experienced on these accounts.

 

Our revenues are concentrated in the pharmaceutical industry in Puerto Rico. Approximately $2.5 million, or 60.3%, of the revenues in the three month period ended April 30, 2007 were generated by four customers. The same customers had an outstanding balance at April 30, 2007 representing 55.1% of the total receivables. Approximately $2.7 million, or 70.3% of revenue, for the three month period ended April 30, 2006, was generated by these four customers. These four customers had outstanding balances at April 30, 2006 representing 78.7% of the total receivables. We assess the financial strength of our clients and, as a consequence, believe that our trade accounts receivable credit risk exposure is limited.

 

Retirement Plan — We adopted a qualified profit sharing plan in January 2002 (amended on November 30, 2003) in accordance with the applicable provisions of the Puerto Rico Code, for employees who meet certain age and service period requirements. We make contributions to this plan as required by the provisions of the plan document, amounting to $14,953 and $11,540 for the three month periods ended April 30, 2007 and 2006, respectively.

Stock Option Plan —During the year ended October 31, 2004, we granted stock options with an exercise price equal to the book value of the common stock as of October 31, 2003, which we deemed to be the fair value of our common stock. The options expired ten years from the date of grant and generally vested over a three-year period. In connection with our acquisition of Plaza, these options were cancelled and we granted the option holders options to purchase an aggregate of 776,186 shares of common stock in respect of the cancelled options and we issued options to purchase an additional 623,814 shares of common stock to employees of Plaza, including those whose options were cancelled. We have subsequently granted options to purchase other 523,724 shares to employees and options to purchase 125,000 shares to independent directors and an independent contractor. However, as of April 30, 2007, there were outstanding options to purchase 1,429,519 shares of common stock. Most of our outstanding options have an exercise price of $0.7344, a term of five years and are exercisable in installments. The average exercise price of such options is $0.75.

Stock-based compensation — Effective November 1, 2006, we adopted the provisions of SFAS No. 123R, “Share-Based Payment” (“SFAS 123R”), and Staff Accounting Bulletin No. 107 (“SAB 107”) using the modified prospective method, which results in the provisions of SFAS 123R being applied to the consolidated financial statements on a prospective basis. Under the modified prospective recognition method, restatement of consolidated income from prior periods is not required, and accordingly, we have not provided such restatements. Under the modified prospective provisions of SFAS 123R, compensation expense is recorded for the unvested portion of previously granted awards that were outstanding on November 1, 2006 and all subsequent awards. SFAS 123R requires that all stock-based compensation expense be recognized in the financial statements based on the fair value of the awards. Stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period, which generally represents the vesting period, and includes an estimate of awards that will be forfeited. We calculate the fair value of stock options using the Black-Scholes option-pricing model at grant date. SFAS 123R also amends SFAS No. 95, “Statement of Cash Flows,” to require that excess tax benefits related to stock-based compensation be reflected as cash flows from financing activities rather than cash flows from operating activities. We do not recognize such cash flow from financing activities since there has been no tax benefit related to the stock-based compensation. 

As required under the new standards, stock option compensation expense is based on the anticipated vesting of the options. Forfeitures estimated when recognizing compensation expense are adjusted when actual forfeitures differ from the estimate.

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Fair value of financial instruments - The carrying value of our financial instruments (excluding obligations under capital leases): cash, accounts receivable, accounts payable and accrued liabilities, are considered reasonable estimates of fair value due to the short period to maturity. We believe, based on current rates, that the fair value of its obligations under capital leases approximates the carrying amount.

 

Use of estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (GAAP), 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 revenue and expenses during the reporting period. Actual results could differ from those estimates.

 

New Accounting Pronouncements

 

In February 2007, the Financial Accounting Standards Board (FASB) issued Statement No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115”. This Statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This Statement is expected to expand the use of fair value measurement, which is consistent with the FASB’s long-term measurement objectives for accounting for financial instruments. This Statement is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007, provided the entity also elects to apply the provisions of FASB Statement No. 157, “Fair Value Measurements”. We do not expect that the application of this standard will have any significant effect on our financial statements.

 

In September 2006, the FASB published Statement No. 157 “Fair Value Measurement”. This Statement defines fair value, establishes a framework for measuring fair value in accordance with GAAP, and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. However, for some entities, the application of this Statement will change current practice. The changes to current practice resulting from the application of this Statement relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Earlier application is encouraged, provided that the reporting entity has not yet issued financial statements for that fiscal year, including financial statements for an interim period within that fiscal year. The provisions of this Statement should be applied prospectively as of the beginning of the fiscal year in which this Statement is initially applied, except for certain exceptions stated in the Statement. The implementation of this Statement will have no significant effect on our financial statements.

 

In June 2006, the FASB issued Interpretation No. 48 “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”). This Interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes”. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This Interpretation is effective for fiscal years beginning after December 15, 2006. Earlier application of the provisions of this Interpretation is encouraged if the enterprise has not yet issued financial statements, including interim financial statements, in the period this Interpretation is adopted. We do not expect that the application of this standard will have any significant effect on our results of operations or financial condition.

 

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Other recently issued FASB Statements or Interpretations, SEC Staff Accounting Bulletins, and AICPA Emerging Issue Task Force Consensuses have either been implemented or are not applicable to the Company.

Results of Operations

The following table sets forth our statements of operations for the three months ended April 30, 2007 and 2006, in dollars (dollars in thousands) and as a percentage of revenue:

 

		Three months ended April 30,												Six months ended April 30,
		2007						2006						2007						2006
Revenue		$	4,181			100.0	%	$	3,805			100.0	%	$	7,799			100.0	%	$	7,209			100.0	%
Cost of revenue			2,362			56.5	%		2,233			58.7	%		4,530			58.1	%		4,266			59.2	%
Gross profit			1,819			43.5	%		1,572			41.3	%		3,269			41.9	%		2,943			40.8	%
Selling, general and administrative costs			830			19.9	%		567			14.9	%		1,566			20.1	%		1,020			14.1	%
Interest expense			85			2.0	%		131			3.4	%		214			2.7	%		134			1.9	%
Income before income taxes			904			21.6	%		874			23.0	%		1,489			19.1	%		1,789			24.8	%
Income tax expense1			386			9.2	%		399			10.5	%		642			8.2	%		420			5.8
Net income1		$	518			12.4	%	$	475			12.5	%	$	847			10.9	%	$	1,369			19.0	%

(1)

Plaza was treated as an N Corporation under the Puerto Rico Internal Revenue Code, which is similar to an S Corporation under the United States Internal Revenue Code, prior to the reverse acquisition. As a result, Plaza did not pay any income tax through January 25, 2006. Since January 25, 2006, the Company has been subject to income tax in Puerto Rico. If Plaza had not been treated as an N Corporation during the six-month period ended April 30, 2006, the Company income before income taxes would have been taxed at a 41.5% rate, the income tax expense and the net income would have amounted to approximately $1,011,000 (14.0%).

Revenues. Revenues for the quarter ended April 30, 2007 (the “April 2007 quarter”) were $4.2 million, an increase of approximately $0.4 million, or 9.9%, compared to the revenues for the quarter ended April 30, 2006 (the “April 2006 quarter”). We increased our revenue notwithstanding a decline in revenue of approximately $0.6 million from a major customer following the completion of a contract with that customer. This customer significantly reduced the scope of its operations by closing one of its two facilities in Puerto Rico and reduced personnel at the second. This decrease in revenue from this customer was offset mainly by an increase of approximately $.7 million from one customer that generated revenues of $0.3 million in the April 2006 quarter.

There was an increase in revenue of $0.6, or 8.2%, in the six-month period ended April 30, 2007 (the “April 2007 period”) from the comparable six-month period of the prior year (the “April 2006 period”). Although there was a decline in revenue from the customer referred to in the preceding paragraph of approximately $1.6 million in the April 2007 period from the April 2006 period , there was an increase in revenue of approximately $1.7 from two other customers that generated $4.1 million in the April 2007 period as compared with $2.4 for the April 2006 period.

Cost of Revenues; Gross Margin. The gross margin increased from 41.3% to 43.5% during the April 2007 quarter as compared to the April 2006 quarter and from 40.8% in the April 2006 period to 41.9% in the April 2007 period. The increase in gross margin for both the April 2007 quarter and the April 2007 period was attributable to a higher proportion of independent contractors to employees, which resulted in savings in our cost of services.

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Selling, General and Administrative Expenses. Selling, general and administrative expenses were approximately $830,000 during the April 2007 quarter, an increase of $263,000, or 46.4%, from the selling, general and administrative expenses of $567,000 in the April 2006 quarter. The selling, general and administrative expenses for the April 2007 period increased by $546,000 as compared with said expenses for the April 2006 period. Such increases resulted from expenses related to an expansion of our executive staff, an increase in the monthly lease payments of our main office and to expenses of an office we opened in Pennsylvania in early January 2006. Prior to January 2006, our chief executive officer, Elizabeth Plaza, was our sole stockholder and she did not receive any salary prior to January 2006.

Interest Expense. Since January 25, 2006 and up to January 2007, we recognized approximately $125,000 quarterly reflecting imputed interest expense incurred in connection with the long-term obligations to Ms. Plaza which originated as a result of the reverse acquisition. Because of the payment of the first installment of these obligations, the quarterly imputed interest expense on the obligations to Ms. Plaza decreased to approximately $82,000.

Income Tax Expense. The income tax expense for the April 2007 quarter was $386,000, a decrease of approximately $13,000 as compared to the income tax expense for the April 2006 quarter. The decrease resulted primarily from a decrease of certain nondeductible expenses for tax return purposes.

The increase of $222,000 in the income tax expense for the April 2007 period as compared to the expense of $420,000 for the April 2006 period resulted primarily from a change in our tax status. We became a regular corporation taxpayer effective January 25, 2006. Prior to that date, we did not pay taxes pursuant to the provisions of Subchapter N of Subtitle A of the Puerto Rico Internal Revenue Code, which is similar to Subchapter S of the United States Internal Revenue Code in that our taxable income was taxed to the stockholder.

 

Net Income. As a result of the increase in the selling, general and administrative expenses and the income tax expense, which was partially offset by an increase in gross profit, our:

·	net income for the April 2007 quarter increased to approximately $518,000, or $0.03 per share (basic) and $0.02 (diluted), an increase of approximately $43,000, or 9%, from net income of $475,000, or $0.14 per share (basic) and $0.02 per share (diluted), for the April 2006 quarter.

·

net income for the April 2007 period decreased to approximately $848,000, or $0.04 per share (basic and diluted), a decline of approximately $522,000, or 38.1%, from net income of $1,369,000, or $0.53 per share (basic) and $0.10 per share (diluted), for the April 2006 period. The basic and diluted income per share amounts were also affected by the securities issued in connection with the private placement that was completed contemporaneously with the reverse acquisition. At that time, the Company issued shares of series A preferred stock which were convertible into 15,998,800 shares of common stock. The series A preferred stock was automatically converted into the 15,998,800 shares on April 25, 2006, when the Company increased its authorized capital stock. As a result, the shares of common stock that were issued upon conversion of the series A preferred stock are included in determining diluted earnings per share from January 25, 2006 until April 24, 2006 and in determining basic earnings per share thereafter.

Liquidity and Capital Resources

Liquidity is a measure of our ability to meet potential cash requirements, including planned capital expenditures. At April 30, 2007, we had working capital of approximately $3.1 million, a decrease of $1.5 million from the working capital of $4.6 at October 31, 2006. Although we generated approximately $3.8 million from operations during the April 2007 period, this increase was offset by a payment of $2.75 million made to Elizabeth Plaza in connection with the acquisition of Plaza. At April 30, 2007, we have a $2.6 million short term and a $2.5 million long term obligations, both net of imputed interest, to Ms. Plaza for two payments of $2.75 million each due in January 2008 and 2009, respectively.

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Our primary cash needs consist of payments of compensation to professional employees, overhead expenses and payments due to Ms. Plaza pursuant to the terms of the acquisition of Plaza. In addition, since January 25, 2006, we have been subject to income tax in Puerto Rico. Our taxable income in Puerto Rico is taxed at rates ranging from 39% to 41.5% of taxable income.

Management believes that based on current levels of operations and anticipated growth, cash flows from operations, high quality customer receivables will be sufficient to fund anticipated expenses and satisfy other possible long-term contractual commitments, including our obligations to pay Ms. Plaza pursuant to the agreement relating to the acquisition of Plaza, for the next twelve months.

We are pursuing possible opportunities of expanding our operations beyond Puerto Rico. To the extent that we are able to expand our operations, either by acquisition or by the establishment of operations in a new country, we will incur additional overhead, and there may be a delay between the period we commence operations and our generation of cash flow from operations.

While uncertainties relating to competition, the industries and geographical regions served by the Company and other regulatory matters exist within the consulting services industry, management is not aware of any trends or events likely to have a material adverse effect on liquidity or its financial statements.

Forward Looking Statements