Covance Inc. Q3 2008 Earnings Conference Call Transcript

Covance, Inc. (CVD)

Q3 FY08 Earnings Call

October 23, 2008, 9:00 AM ET

Executives

Paul Surdez - VP of IR

William Klitgaard - Corporate Sr. VP and CFO

Joseph Herring - Chairman and CEO

Analysts

Randall Stanicky - Goldman Sachs

Eric Coldwell - Robert W. Baird

John Kreger - William Blair

Douglas Tsao - Barclays Capital

Ricky Goldwasser - UBS

David Windley - Jefferies & Company

Greg Bolan - Wachovia

Todd Van Fleet - First Analysis Securities Corp.

Presentation

Operator

Good day and welcome to this Covance Third Quarter 2008 Investor Conference Call. This call is being recorded. At this time for opening remarks I would like to turn the call over to the Vice President of Investor Relations, Mr. Paul Surdez. Please go ahead, sir.

Paul Surdez - Vice President of Investor Relations

Good morning and thank you for joining us for Covance’s third quarter 2008 earnings teleconference and webcast. Today Joe Herring, Covance’s Chairman and Chief Executive Officer; and Bill Klitgaard, Covance’s Chief Financial Officer, will be presenting our third quarter financial results. Following our opening comments we will host a brief Q&A session. In addition to the press release, 21 slides corresponding to the commentary you are about to hear are available on our website at www.covance.com.

Before we begin the commentary I would like to remind you that statements made during today’s conference call and webcast which are not historical facts might be considered forward-looking statements. Such statements may include comments regarding future financial results and are subject to a number of risks and uncertainties, certain of which are beyond Covance’s control. Actual results could differ materially from such statements due to a variety of factors including the ones outlined in our SEC filings.

Now I would like to turn it over to Bill for a review of our financial performance, which begins on page 4 of the slide show.

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

Thank you, Paul, and good morning, everybody. Net revenues for the third quarter were $440 million, an increase of 11.1% over last year. If you exclude the impact of the sale of our cardiac safety business which occurred in the fourth quarter of last year, revenue growth was 13.3%. Foreign exchange rate movements added approximately 150 basis points to our year-on-year revenue growth for the quarter, primarily relating to the appreciation of the Swiss franc and the euro against the dollar.

Operating income in the third quarter was $70 million, which was up 16.4% from the third quarter of last year. Operating margin was a record 15.9%, up 70 basis points year-on-year and 50 basis points sequentially. Net income was $51 million, which is up 14.6% from the third quarter of last year. EPS is $0.80 per share in the quarter, up 15.9% compared to Q3 of 2007.

In the fourth quarter transaction losses, foreign exchange transaction losses, cost us about $0.01; but we also gained $0.01 on lower tax rate. The good news here is that we now expect our effective tax rate to run at approximately 28.5% going forward.

Now please turn to page 5 of the slide show. In the third quarter of 2008 Early Development delivered 49% of our net revenues and Late-Stage contributed 51%. On a geographic basis, the U.S. accounted for 61% of revenue while the rest of the world accounted for 39% of third quarter revenue.

Now please turn to page 6 to discuss segment results. In Early Development net revenues in the quarter grew 8% year-on-year to $215 million, primarily from the addition of new capacity in North American toxicology. Strong year-on-year growth in North American preclinical laboratories, were partially offset by softness in clinical pharmacology and slower European preclinical laboratory results. Which were also, impacted from a decline in the British pound against the U.S. dollar. Foreign exchange rate movements reduced the year-on-year revenue growth rate in Early Development by approximately 80 basis points in the quarter.

Operating income in the quarter was $55 million, an increase of 5.9% over last year. Third quarter operating margins include the impact of startup costs relating to the recently acquired Greenfield, Indiana campus and our preclinical entry into China. Despite the impact from these items, operating margin was up 10 basis points sequentially at 25.5%.

Turning to Late-Stage Development, net revenue in the quarter was $225 million, which is up 14.4% over the third quarter of last year. Excluding the impact of the sale of cardiac safety, revenue growth was a very strong 18.8%. Foreign exchange movement added 390 basis points year-on-year to revenue growth in this segment in the quarter. Operating income in the quarter was $44 million, which is up an outstanding 28.6% over the third quarter of 2007. And operating margin was again exceptional this quarter, reaching 19.7%, 50 basis points above our previous all-time high achieved last quarter.

Now please turn to slide 7. Net orders in the quarter were a booming $1.78 billion. This figure includes a $1.27 billion in orders related to the 10-year collaboration with Eli Lilly. The difference between the $1.6 billion contract value we announced in August and the Q3 addition to backlog represents a combination of Lilly work that was already in our backlog and will be covered by the new contract, and a portion of services that are subject to contingencies. Those will be counted as orders when the underlying individual projects are awarded.

The company backlog at September 30th grew a spectacular 62% year-on-year to $4.25 billion compared to $2.6 billion at September 30th last year. That figure includes a $100 million negative impact due to movement of foreign exchange rates. Regarding the dedicated capacity agreements and other take-or-pay collaborations, there are three important things I would like to highlight.

First, they represent the most secure part of our backlog. Second, they cause order spikes in quarters when we recognize the win. But third, they reduce orders in future periods since we have already won the work. In order to help clarify the picture, we are including additional data characterizing the impact of these agreements.

On slide 7 we have divided our backlog into two components, backlog supported by dedicated capacity agreements, such as the one we just signed with Eli Lilly, and all other backlog. The dedicated portion of our backlog includes revenue commitments to Covance under take-or-pay arrangements. Currently we have dedicated capacity agreements in place with five clients and those commitments predominantly reside in Early Development.

We are introducing also the metric of adjusted net orders, which will highlight the impact of these dedicated capacity agreements on our net orders and book-to-bills. The computation for net orders starts with reported net orders, subtracts any dedicated capacity agreements signed during the quarter and adds back as an order the revenue recognized underneath those contracts during the quarter. The result is the adjusted net order.

The box at the bottom of the slide illustrates the difference between the traditional method of calculating book-to-bill and the adjusted method. So as shown in the slide, adjusted net orders in Q3 are $527 million on this basis; and adjusted book-to-bill is 1.20 to 1. We hope this provides investors with a meaningful and additional information for evaluating our new order flow.

Now please turn to slide 8 for a review of net cash flow. DSO moved up 2 days from Q2 to Q3 and at September 30th was 41 days. But that is a 6-day improvement over Q3 of last year. Now each day of DSO impacts our cash flow by a approximately $5 million. Last December we ended the year with a DSO of 36 days. Our targeted cash flow guidance assumes we are able to exceed that performance this December.

In the third quarter operating cash flow was $87 million and capital expenditures were $63 million, resulting in free cash flow of $24 million. At the beginning of the fourth quarter we spent $50 million to purchase the Greenfield campus; and as a result we now expect full-year capital spending to increase from our previous guidance of $265 million to approximately $315 million. Similarly, we are also adjusting our free cash flow guidance from approximately $25 million of cash generation to a use of approximately $25 million.

At the end of the quarter we had $209 million in cash, which is up $13 million from the end of the second quarter. Corporate expenses were $29 million in the quarter, or 6.6% of revenue. We continue to expect corporate spending to be approximately 6.5% of revenue plus or minus 50 basis points going forward. Finally the recent period of dramatic currency fluctuations has generated many questions from the investment community regarding the impact of FX on our results. Slide 9 provides a graphical representation of previously reported data showing movements of revenue over the past five years... with FX movements on revenue over the past five years.

If you extend that down to EPS, FX had a negative impact on EPS by as much as $0.02 when the dollar strengthened to positively impacting EPS by as much as $0.03 when the dollar was weakening. To put this in a more recent context, since we last talked with you in early August the dollar has appreciated approximately 18% against the pound and the euro and approximately 12% against the Swiss franc. This has moderated the underlying strength of our revenue growth. Note that FX rates at their current level represent a headwind for revenue growth for the next four quarters.

Now I would like to turn the call over to Joe for his comments, which begin on page 10 of the slide show.

Joseph Herring - Chairman and Chief Executive Officer

Thanks, Bill, and good morning, everyone. In the third quarter Covance grew revenues 11% year-on-year, delivered record operating margins of 15.9% and earnings per share of $0.80. A watershed event marked the third quarter for the CRO industry as Eli Lilly awarded Covance a 10-year contract worth a minimum of $1.6 billion for a broad range of drug development services, and later sold their Greenfield campus to us for $50 million. This announcement caught the attention of many of our pharmaceutical clients and sparked numerous conversations on how CROs can help deliver innovative strategic solution to pharma’s increasing productivity challenges in R&D.

In the third quarter we continued strong new business awards in clinical and Central Laboratories drove adjusted net orders of $527 million and an adjusted net book-to-bill of 1.2 to 1. As Bill just described, these order metrics now reflect dedicated capacity contracts. We believe that providing this additional order detail will be helpful to investors.

The diversity of Covance’s backlog and client mix is a unique strength. For example, 36% of our $4 billion backlog represents contractual minimum volume commitments from five clients who have dedicated capacity agreements with Covance. In addition, our overall 2008 client mix by revenue is approximately 80% Top 50 biopharma and funded biotechs, approximately 10% small biotech and specialty pharma, and approximately 10% can be attributed to other sources such as food manufacturers, government agencies, and academia.

Before moving into segment results I would like to make a few comments regarding our views of the global financial crisis and biotech funding. While we did not see a financial impact from these issues during the third quarter, the global economic downturn is creating some signs of delayed decision-making that may impact our business in the coming months. For instance, we are beginning to see some Early Development project starts being pushed into next year. However we are not seeing an uptick in cancellations of Late-Stage clinical trials.

To supplement our Q4 Early Development results, I am pleased to announce we have now converted all existing Early Development work occurring at the Lilly Greenfield site over to Covance, which will add approximately $15 million in revenue in Q4. With regard to biotech funding, we track two pools of funding. The first pool is financing, which has been down substantially in 2008. And the second pool is pharma partnering, which has shown strength in 2008. Pharma partnering investments were strong in Q3 and are off to a good start in Q4 with the pending sale of ImClone to Eli Lilly.

While weak financing is certainly a concern for small biotech segment of our client mix, who rely on these funding grounds. We view the partnering vehicle to be equally good news for our space. Through partnering, novel new compounds survive and move through development with a well-funded owner, while inspiring more biotech innovation, as the payoff is often quicker and more tangible through a pharma partnering exit.

In addition, Covance continues to see the payoff of delivering high-value solutions and services to smaller biotech companies which are later acquired by large pharmaceutical companies. These biotechs often comment on the speed and quality advantages of Covance’s program management service to their new owners, which has recently led to new program management work being awarded from large pharma clients who would previously not consider program management.

Let me now comment on the segment results this quarter, which begins with Early Development on slide 11. Despite the slow financing environment in biotech during the third quarter and throughout 2008, we did not see any hard data indicating weakness from the small biotech portion of our client base. Our weaker than expected third quarter revenue growth of 8% can be attributable to three things.

And they are in order of magnitude, number one, cancellations and longer than usual delays in clinical pharmacology, primarily from several pharmaceutical clients who have made decisions to push noncritical studies into 2009; and I will comment on that more in just a minute. Second was, weaker results in Labs Europe due to a substantial reduction in work from a large pharmaceutical client who has paid [ph] back their pipeline and become more price-sensitive. And third, the strength of the U.S. dollar versus the British pound.

These issues partially offset strong sequential results from toxicology services in North America, which were driven by new rooms we brought online in the second quarter, and the continued benefit of committed strategic client relationships we had added over the past three years. Regarding toxicology expansion, we have clearly demonstrated our ability to bring on new capacity in a responsible and conservative manner. Our model of matching costs with demand as we add new capacity has served us very well over the past six years. And now with the addition of the Greenfield, Indiana, Early Development facilities from Eli Lilly, we now have a quicker, more cost-effective option for accelerating room openings when market needs more supply.

I will give you a quick review of our projects, which I will mention in chronological order. First, the Greenfield campus. This site was acquired in early October and is already contributing to our fourth quarter results with 100% of the revenue from this location representing new incremental work for the CRO industry. We are extremely pleased that 97% of all eligible Lilly employees signed on with Covance at the beginning of the fourth quarter; and we are looking forward to their direct, positive impact on our results. The early transition of these employees from a large pharma cost center to a revenue-generating CRO business unit has gone extremely well so far.

In Greenfield we have a three part strategy to maximize the utilization of the 600,000 square feet of lab space and highly trained staff. And those three strategies are stabilize, strategize, and grow. First is to stabilize the staff, facilities, and systems following the transition in ownership to ensure business continuity for all Lilly studies. Next is strategize, how we can optimize the transformation of the site to be a world-class CRO facility, which will take some time. We need to better understand the new services to Covance, including a vivo pharmacology, non-GLP toxicology, and nonclinical imaging, and develop plans for how to best position and market these specialty capabilities to other companies. And finally, grow the site by building a strong commercial effort which will bring in work from other clients to Greenfield.

This large campus of laboratory facilities allows Covance significant financial flexibility by providing affordable and high-quality capacity for growing revenues over the next several years without having to build new space. Coupled with the recent capacity expansions in Madison and Harrogate, the Greenfield site provides us with the opportunity to take a more measured view of capacity additions during these times of market uncertainty, yet preserves our ability to ramp capacity more quickly during robust market conditions. The timing of this asset transfer event is working out very well for Covance. Also coming online this quarter is the most recent capacity expansion in Harrogate. This modest capacity expansion delivers an increase in large animal rooms, which are currently in high demand.

Moving back now to North America, the opening of the Chandler facility will occur early in the second quarter of 2009. As you know, the initial build in Chandler is the single largest expansion project in our history, a 288,000 square-foot purpose-built state-of-the-art facility in every respect. Bringing this space online in a measured fashion will be key to launching the facility with the same quality culture as in our other facilities. Our current expectations are to staff less than half the facility by the end of 2009. We have a strong anchor client for the Chandler facility, and we expect it to take most of 2009 to transition their ongoing studies from Madison and into Chandler.

In China we announced that we will pursue our original strategy to build a world-class facility in the region. We plan to build a comprehensive preclinical facility that matches the high-quality facilities and scientific teams our clients have grown to trust in Europe and North America. We will give you further updates once we finalize our land purchase; but suffice to say, this is another new market opportunity for Covance. Finally, regarding the Prince William County, Virginia facility, our construction management teams continue to develop plans and budgets for the facility. And we are also considering the impact of the Greenfield facility, which was not in our plans at the beginning of this year.

I would now like to add a little more color on what we are seeing in clinical pharmacology. As you know, the results in clinical pharmacology tend to be the lumpiest in our portfolio. In addition to the typical volatility we see in first-in-human studies, due to availability of study drug or delays related to FDA comments, we are seeing additional volatility due to the number of projects we conduct that are not on the critical path of an IND filing.

First-in-human studies are clearly on the critical path. But by definition, there is only one first-in-human study per new compound. It is among the dozens or so of follow-on safety studies that occur simultaneously with Phase III trials where we are seeing cancellations or delays into 2009. These follow-on trials, which include drug-drug interactions, food effect, and special population studies, are often required for product registration and labeling use, but can occur at any point during a multi-year Phase III trial. Therefore they are more subject to being delayed than projects in our other service lines. As we are not seeing an uptick in cancellations or delays in Phase III projects, we believe the clinical pharmacology projects currently on hold will need to be initiated pretty soon to meet the registration filings of the larger trials.

Now please turn to slide 12 to discuss Late-Stage. Our Late-Stage team delivered another strong quarter as revenue growth for this segment at 14%; and it is actually 19% when excluding centralized ECG Services from our 2007 base. In addition, Late-Stage achieved exceptional operating margin of 19.7%, a record by 50 basis points over the last quarter. Orders were strong in the segment, keeping the trailing 12-month book-to-bill above 1.4 to 1.

Central Laboratory services again made an outstanding contribution to Covance’s results this quarter. Revenue growth was over 20%. Operating margins were also up significantly from last year. On the business development front, the Central Lab team again delivered very strong new orders. Clinical development revenue growth was over 25% in the third quarter again and operating margins grew very strongly in both year-on-year and sequentially. Clinical orders in the quarter were also very strong.

It is increasingly evident that our investments in talent, training, process improvements, and technology are delivering benefits and helping Covance add a third growth engine to our strong, industry-leading franchise in Early Development and Central Labs. We are extremely proud of the clinical development team for their great progress over the last two years. Their growing list of strategic client relationships, the strong performance against client project metrics, the margin expansion success, and the ever-increasing size of project wins is most impressive and leading to substantial increases in repeat work.

Please turn to slide 13 for our 2008 outlook. For the full year 2008 we are now expecting to deliver low-teens revenue growth and 20% growth in EPS to $3.18 per share, which assumes exchange rates at current levels. We are about to earmark on our annual budget-setting process, which will include an assessment to what extent, if any, these economic factors may have on our 2009 results. Following that, we are hosting a call mid-December, at which time we expect to issue guidance on our expected 2009 results.

Looking to 2009 and beyond, we remain as optimistic as ever about the long-term fundamentals of our industry generally and for Covance in particular. The leading companies in the CRO industry continue to prove the value of strategic outsourcing, including more flexible cost structures for our clients and an expedited drug development timelines. We believe our balanced portfolio of integrated drug development services is a winning hand, and we look forward to playing those cards over and over again in the coming years. Let me close by saying it is a great time to be at Covance, and I really like our chances of capturing at least our fair share of this exciting growth market going forward.

Thank you for your time this morning. Now I’d like to turn the call over to the operator for Q&A session.

Question and Answer

Operator

[Operator Instructions]. We will take our first question from Randall Stanicky with Goldman Sachs.

Randall Stanicky - Goldman Sachs

Great; thanks for taking the question. Joe, can you just expand on some of the delays in clinical pharmacology and maybe give us a sense of a couple things? One, how much exposure to this is the overall business? Then two, as you think about the rest of other non-critical I think you termed it types of services, particularly in maybe the toxicology or preclinical area. Are there other types of work here that could be exposed here as you think about discussions you are having with customers?

Joseph Herring - Chairman and Chief Executive Officer

Well, first of all, Randall, thanks for your question. As you know clinical pharmacology is a smaller percentage of our business. And we have been investing to actually make it a larger percentage of our business because of the strategic contribution it makes to drug development and translational medicine. In terms of the size of that impact, we don’t break out that number separately. But if you think about the past year, Q1 disappointing results for clin pharm, Q2 was booming, made a big contribution, Q3 was not so good. But as I pointed out there are a number of studies that are not on the critical path that can be delayed.

And as pharma companies are looking at the end of the 2008 cycle they are saying, hey, for P&L purposes what can we maybe push into the first quarter. And these types of studies have fallen victim to that. Having said that, it is still the fastest growing segment of drug development. We really like our position, and we are going to continue to invest and grow that business. We also note that the business can turn around as quickly as it goes down. So I see it as a very strategic asset, and we look for a rebound in that service segment.

Randall Stanicky - Goldman Sachs

At this point are there other non-critical types of services that you are seeing a similar dynamic in? Or is it just in the clin pharma?

Joseph Herring - Chairman and Chief Executive Officer

Well I think all large pharma companies... I shouldn’t say all. There are several that have gone on the record in late Q3 as rationalizing their portfolio and maybe picking higher probability projects to fund and slowing some others down. We haven’t seen a huge impact on that on our business. Just the particular clients who have announced that and the type of businesses that they are talking about haven’t really impacted us. On the other hand there are clients who are saying, we have got to accelerate these projects and get new products to the market as soon as possible. And there has been a ramp in spending.

So I think it is easy right now with the headlines we see every day to sort of overcall this. But on the other hand we have got clients who are spending. So let me just make a broader comment, Randall, off of your question, a few reasons why we remain very bullish about the Covance business model. First of all as you well know, there’s $80 billion spent in development every year. And a significant portion of that is to provide data to show the safety and efficacy of new compounds. Covance has the largest footprint in the world, and we think the fastest and most cost-effective footprint. And we are going to leverage and drive that on a go-forward basis.

And with less than $2 billion in revenue and an $80 billion market opportunity, the long-term opportunity looks very good. We crossed over $4 billion in backlog this quarter, which is up 62%. 36% of that backlog is in committed minimum-value contracts, including the largest industry collaboration in history. We have the most diversified portfolio of services. So you see a slump in Phase I in third quarter, per your question. But you saw a booming preclinical toxicology in North America and very strong Central Lab and clinical results. We mirror clients’ R&D organizations. It allows us to integrate, speed development timelines, and be at the table for strategic discussions.

Because of our investments we have modern facilities around the world. We had record operating margins of 15.9% in the third quarter. Our margins have been up nine of the last 12 quarters, greater than 20% revenue growth in clinical and Central Labs. 12 consecutive quarters of trailing book-to-bill of greater than 1.4 to 1, 30 consecutive quarters of expanded EPS. We are maintaining our $3.18 guidance despite approximately $0.08 of FX headwind in the back half of the year. Strong operating cash flow and a healthy balance sheet and today we are seeing more outsourcing and, more importantly, more strategic outsourcing than any time in the history of the industry. So, yes, clin pharm was weak in Q3; but we like our chances.

Randall Stanicky - Goldman Sachs

So Joe, and just to clarify then on those comments on the margins, is it fair to say you are not seeing any pricing pressures then at this point in toxicology?

Joseph Herring - Chairman and Chief Executive Officer

Toxicology pricing and Covance’s approach to toxicology pricing has not changed. We are premium providers that provide a broad set of services; and we are proving more and more to clients that we can speed and reduce the time of drug development. And that is more valuable than a 10% discount on a tox study. Having said that, Randall, as you well know we have been turning away tens of million dollars of tox work over the last few years. Over the past several months as we have brought on new capacity, we know which clients to go after. We know what their price point is, and we give them a chance to come into Covance now as opposed to turning them away in the past. There has been a lot of chatter in the marketplace about that. But it is really around the margin, bringing clients who want to work with Covance and now we have the capacity and the ability to welcome them back into the fold. So the answer is no.

Randall Stanicky - Goldman Sachs

Okay, great. Thanks very much.

Joseph Herring - Chairman and Chief Executive Officer

Thank you, Randall.

Operator

And we will move on to Eric Coldwell.

Eric Coldwell - Robert W. Baird

Thanks and good morning. Two questions around Early Development and then a follow-up. On the Early Development side your operating margin was really very impressive given some of the headwinds that you mentioned, and also given the fact that you had the Lilly startup and the China cost. I just want to know how you did it. What was the major driver that allowed you to beat our margin target and have what is I think generally considered to be at the upper end of your range there?

Joseph Herring - Chairman and Chief Executive Officer

Well if I could pat one team on the back... I am getting a echo.

Paul Surdez - Vice President of Investor Relations

Eric, you might not have hit mute, Eric.

Joseph Herring - Chairman and Chief Executive Officer

If I could pat one team on the back, it would be Labs North America who had a very strong quarter. But I think more on a functional basis we have to look at Six Sigma. We continue to ramp that program and as you look across Early Development, a towering performance by our Six Sigma team. As you know, Six Sigma is all about reducing variation in process. And the benefit of that is higher quality, more accurate deliverables for a client, and ways to increasingly take costs out of the system or further leverage your cost structure as you grow and tens of millions of contributions from Six Sigma this year. Also as you well know, we continue to have mix advantages in that the better we do in our higher-margin businesses the more impact it has on operating margins. And certainly leveraging the fixed cost structure and investment that we have there and continued growth in revenue as we saw, particularly in Labs North America as well as our Muenster facility is just really lighting the skies this year.

Eric Coldwell - Robert W. Baird

That’s helpful. Thanks. The second question... and it needs a little bit of a setup. But we have had some pushback last night and this morning that your adjusted net book-to-bill of 1.20 is disappointing. I personally don’t agree with that, given that your average over the last six quarters has been 1.26. I think it would be helpful to have people understand a little better maybe if you could discuss a little better why your book-to-bill of 1.2 or 1.3 or something in that range is equivalent to, say, a clinical-only CRO reporting a number more like 1.4 or 1.5? You know I think a little more discussion around what the traditional book-to-bill should be going forward in the Early Development group, which is half of your revenue, what it should be given that your dedicated contracts are heavily weighted to that segment and therefore not impacting the adjusted net book-to-bill in Early Development? Does that make sense?

Joseph Herring - Chairman and Chief Executive Officer

Yes, sure, Eric and thanks for the question. First of all, our book-to-bill in the third quarter was over 4 to 1. I don’t know how you can take a $1.6 billion order that is going to generate $15 million in orders in the fourth quarter and $150 million minimum guarantee next year and just push that to the side. I just don’t know how you come up with that math. But assuming that you do then what does this math mean? Well, Early Development burns their backlog about every 60 or 90 days. So a book-to-bill of 1.1 is a very good performance. That means you are maintaining your momentum in the business. In fact due to these dedicated capacity agreements Early Development book-to-bill has been running less than 1. It ran less than 1 throughout 2007 because of some big dedicated capacity awards. However they had a record year in revenue growth of 22% last year with a book-to-bill of less than 1 to 1.

So it is an apple-and-orange comparison looking at 50% of our backlog and saying that it should look like some clinical competitor. It is just apples-and-oranges. Late-Stage was greater than 1.4 to 1 in the third quarter and you can compare that to other Late-Stage companies, as well as the trailing 12-month book-to-bill in Late-Stage has been greater than 1.4 to 1. So we don’t have anything to apologize for, for Late-Stage Development. Our Early Development wins were solid; and again, I don’t know how you ignore a $1.6 billion order and push that to the side and somehow look at some sub segment of 4 book-to-bill and find fault.

Eric Coldwell - Robert W. Baird

I agree with that and obviously we are not in a very rational world at the moment. But the final follow-up is around Late-Stage growth. You reported growth in the mid-teens that would’ve been in the high-teens excluding the sale of your cardiac safety business. But yet your two biggest divisions you are saying are growing north of 20% and north of 25%. Help us understand how with clinical development and Central Lab averaging a low to mid-20s growth rate, how the constant dollar organic growth of... or just the organic growth of Late-Stage is below 19%. What is the delta?

Joseph Herring - Chairman and Chief Executive Officer

It is really in the commercialization business. As you know a large portion of that business is dependent on new biotech launches, which there has been a dearth of that really over the last 18 months. And that team has worked very hard to maintain their margins and to scale their business for a difficult situation. But that is where the issue is.

Eric Coldwell - Robert W. Baird

Okay. And so, no other smaller units or divisions, nothing in bioanalytical or elsewhere that would be influencing that?

Joseph Herring - Chairman and Chief Executive Officer

None of those revenues are in Late-Stage Development.

Eric Coldwell - Robert W. Baird

Right. Okay, good. Thanks.

Joseph Herring - Chairman and Chief Executive Officer

Thank you, Eric.

Operator

We will move on with John Kreger with William Blair.

John Kreger - William Blair

Great, thanks. A follow-up question, Joe, to your Lilly comments. I think you guys have probably done more kind of strategic deals with that pharma than anyone else in the industry. What is your vision going forward? Do you think we are going to have a balance between the sort of quarterly bookings project-by-project? Or do you think we will see more of a shift towards more strategic, functional multi-year programs? And from your perspective, are you comfortable with continuing to shift in that direction? Or do you want to keep a balance between the two approaches to winning business?

Joseph Herring - Chairman and Chief Executive Officer

John thanks for your question. I think you have to look at the structure of large pharma clients and what they are staring at right now. I should think anybody in the [inaudible] a major overarching question is... how do we make our fixed cost more variable? How do we prepare ourselves for patent clips that are coming? But at the same time ramp new product development so we have replacement revenues out one, two, three, five years from now. And that is really a conundrum to be in. So I think they start to look at their SG&A, which... I mean what industry can sustain 30% of revenues in SG&A? Not very many, and obviously they are kind of tracking that.

R&D has sort of been a sacred cow, because if you are not developing new products and you can’t talk about your developmental pipeline, how do you drive or maintain the valuation of your company? But I think with the increasing economic challenges they have I think they are having to peer into R&D and start to ask some difficult questions. Then they see here is Eli Lilly taking an absolute sacred cow and I think they have some great facilities and enter into a 10-year... 10 year collaboration with Covance. And I think they are starting to ask questions. How do we do something like that? What did they do? How did they do it? What gave them the confidence to do that? What are the economics of that? And what assets do we have that could be flipped that way?

And trust me, they are calling, they are asking. Now if I were them I would go as fast as I could. Because I would say there is a small handful of global CROs who have quality, global reach, scale, and that might know how to do this. There is not a whole bunch of them. And the ones that are able to tie up our capacity and our hearts and minds the soonest are going to get the best-looking date to the prom. Two or three years from now I think you’re going to sort of be stuck with... wow, that high-quality capacity is gone. And so we are talking to them.

Now historically pharma has moved at a glacial pace, and that has actually been good for the CRO industry. If outsourcing would have gone from 20% to 50% in three years it would have crushed our industry. And the way it is happening now, which is at a good and a brisk pace, has been very helpful. We think that it will accelerate. And these type of agreements take longer than we would like and a lot of different groups have to be involved. But these conversations are happening and I think you’re going to see more of those.

I think maybe your last question, John, is that a good thing? Absolutely. For us to sit here today and have 36% of our backlog in committed contracts is a very good thing. The higher that goes the better. And frankly we are talking with clients... Lilly, three new business lines. We are talking to clients about other business lines that haven’t even been outsourced before. I am not making any commitments here or anything like that, but it is just a very interesting time. And the companies that are prepared and that have made the investment, have the infrastructure, the systems, the global footprint I think are going to benefit.

Can anybody predict what is going to happen to the equity markets in the next month? They certainly didn’t predict it well in the last month or exchange rates turning out like that. But what we are really dependent on is really slide 15, the ISO curve chart that shows that $80 billion, a bunch of that has got to be outsourced. If R&D spending even goes flat there is a great economic case for this industry and for our company. I think we are very well positioned to be at that table and to bring innovative solutions for our clients.

John Kreger - William Blair

Thanks, Joe. And that is very helpful. Just two very quick follow-ups. You outlined the sort of a three-step process to the Greenfield facility. Can you give us a sense about how quickly you start to sell some of that capacity to clients other than Lilly? Is that a year away or longer? And similarly, how far out in the future are you now thinking that you might have online capacity in China that you can actually sell?

Joseph Herring - Chairman and Chief Executive Officer

With regarding the Lilly space I don’t want to stick my neck out too far. I probably wouldn’t model much in the first half of next year. I think we would probably start talking about that maybe in the third or fourth quarter of next year. There is a bunch of Lilly work out there that we now have in our hands that we want to make sure that goes extremely well. I am personally and we as an organization are committed to make sure that the transition and business continuity for Lilly is absolutely job one. But we do have I think a really good shorter-term opportunity... medium-term opportunity, with respect to program management clients. That business is absolutely booming for us. And if we have additional space that we can start that study, that would be a good thing. I think that is probably the first and best use of that excess capacity.

We are going to need to bring that site back up to GLP compliance, which is going to take us a good six to eight months, including some IT investments. Then we will be good to go from there. So I think I would model it in a modest fashion as we look at 2009. But there is a whole bunch more work in this Lilly agreement that is going to flow to Covance. There is a couple of the areas that are actually progressing better than we projected, even as we signed the order.

Then finally your question about China, China is not a short-term and I think it is a modest mid-term opportunity. I mean we were excited about the potential opportunity we had; but it doesn’t really change our outlook. We see major multi-national companies wanting non-GLP and small non-critical path studies on molecules that they have discovery work being done in China. They are going to want to have that in animal models starting mid-to-late 2009 and into 2010. It would be great if we had a facility online that fast to take care of that. But I know in my direct conversations with two of the largest pharmaceutical companies in the world, when I look at the volume that they anticipate in the back half of 2009, you are talking about $300,000 or $400,000 per client. And we don’t need some massive investment to handle that. What they are saying is as that grows then that business will grow.

So I think it is going to be more modest. We think by the time any company is going to have a big footprint in reputable GLP space in China, I think there is going to be a large equilibration in labor rates, and I think you’re not going to see some big shift from U.S. and Europe into China. So we believe that if we get space on in the 2011 time frame to supplement what we already have there in terms of chemistry, biochemistry Phase III and in our Central Lab, I think we will do fine in China.

John Kreger - William Blair

Thanks very much.

Joseph Herring - Chairman and Chief Executive Officer

Okay. John.

Operator

And moving on to Doug Tsao with Barclays Capital.

Douglas Tsao - Barclays Capital

Hi, good morning. Joe, in terms of the transformative deals, to your point, you want the execution on the Lilly deal to go well. To the extent that you are adding capacity there, how much does it potentially slow down your thinking? I mean how many deals can you take on? Because I suspect some of these deals might require you to take on or involve more facilities. So would you want to potentially sort of from your own perspective delay them, because you don’t want to... you are already bringing on capacity both at Greenfield as well as Chandler?

Joseph Herring - Chairman and Chief Executive Officer

Well, Doug, we will have to sort of take each one of these as they come. Frankly there are a number of large pharma clients who have toxicology facilities that we would not want to take on. They are either buried deeply within a campus, not easily separable and sellable on the outside. There are a number who have very, very tired facilities that, if you run the economic model, fix versus replace. I think you come out on the replacement side. A number of them have multiple tox facilities; each and every one is sort of subscale. So I don’t think that there is going to be a whole lot more of the Lilly-type deals. But I do think that there will be probably several more.

The good news is it’s not really adding capacity to the industry; it is really transferring maybe an underused facility from the client’s side, which is current industry capacity, and flipping it to a CRO model, which allows you to bring in work from other clients. And so I think rather than the CRO industry just continuing to add new capacity, which makes the total capacity of industry grow. It is more of a transformation of current capacity into something that is more effective and more efficient.

I also don’t want to limit our comments on strategic deals to toxicology capacity. I think there is going to be opportunities in clinical pharmacology. I think that there are opportunities in early clinical translational medicine type of opportunities. I think there are CRA and data management opportunities. Again I think the obvious ones now are ones that we have sort of been a part of and pinpoint [ph] to; but I certainly would not limit it to that in my thinking, certainly in a longer-term model for the industry or for Covance.

Douglas Tsao - Barclays Capital

Okay. And then Joe, sort of also following up on your earlier comments that you think some clients are perhaps pushing some clinical pharmacology as well as perhaps some preclinical work into ‘09 due to budget constraints, do you think that there is perhaps a little bit more emphasis on late-stage development right now? And perhaps they feel a little bit less urgency for some of the early work right now, just because there is a great... if you look at some different numbers there seems to be a backlog of molecules that have just gone through Phase I or are sort of sitting in Phase II. And so that perhaps is easing the pressure to replenish the early-stage pipeline. Perhaps later either next year, early in the year or perhaps maybe a little later in the year they will press ahead to replenish the early pipeline.

Joseph Herring - Chairman and Chief Executive Officer

I don’t think there is enough data to really make that call. I can give you some anecdotal examples of clients who are doing what you suggest. And I can give you anecdotal examples from clients who say we have a new platform molecule right now that we feel very good about and it is going to generate several projects, and we need to expedite that work and get it going as fast as we possibly can. So how you balance those and make some sort of a jump-ball call I think is difficult to do right now, Doug, to be fair.

Douglas Tsao - Barclays Capital

Okay. Then just one quick follow-up question. The operating margin in Late-Stage was obviously a record. If I did my math right, it seems like the Central Lab was down a little bit sequentially. So was there a lot of the incremental profit coming from the clinical development business sort of continuing its ramp in terms of profitability? Or was there some improved profitability from the Central Labs as well?

Joseph Herring - Chairman and Chief Executive Officer

Well, we had sort of the seasonal slump in kits that we predict every year, so it was sort of flattish, but against strong year-on-year growth. But we had good margin expansion on both sides of our Late-Stage business.

Douglas Tsao - Barclays Capital

Okay. Thank you very much, Joe.

Joseph Herring - Chairman and Chief Executive Officer

Thank you, Doug.

Operator

And we move on to Ricky Goldwasser with UBS.

Ricky Goldwasser - UBS

Good morning. Thank you very much for quantifying for us the exposure in the topline from smaller biotech specialty customers. But can you just give us a little bit even more clarity of the state of what is also the exposure from these clients to the bottom line? Then also I know you talked about SG&A as an area where you are going to... to anyway find some cost-cutting opportunities for the fourth quarter. Can you give us some more color as to how are you going to lower costs? Also, when we think about SG&A on an absolute dollar basis in the fourth quarter and taking into account the Lilly-related headcount, should the dollar number be up or down from what you reported in the third quarter? Thank you.

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

Ricky, it is Bill Klitgaard. I think the biotech exposure I would quantify it this way. Right now it is 10% of our business. There is existing backlog that we are going to run out with these clients. And I guess your assumption would have to be... suppose these clients don’t renew new business opportunities? Of course we would try and fill in with other clients. But the revenue that we have on current backlog would still burn off. So it would take some time to be felt in terms of revenue and OM. I am not aware of a real material difference at the OM level between those clients and other clients.

So I think you could just do it proportionate to revenue impact, and then you’d have to model that. Secondly, with respect to SG&A, I think for any company of our size there is lots of opportunities to spend or not spend in a quarter depending upon activities you have. And in times like these is when you start to pull back and ration those things and look at them in a more prudent light. And that is exactly what we are going to do in Q4.

Joseph Herring - Chairman and Chief Executive Officer

Yes, I would also like to say, Ricky, we commented regarding the third quarter we had not seen an impact on that. And sitting here in the fourth quarter in October whatever it is, 23rd, we haven’t seen an impact. Just because biotech funding is down for a couple of quarters doesn’t mean that these companies go out of business. They may reprioritize their portfolio. Again, we talked about pharma partnering. Pharma partnering is up. Based on our relationship with Lilly, they bring in ImClone Systems. I kind of like our chances of maybe successfully competing for that work where maybe we didn’t have an opportunity at that in the past. So I think saying, hey, 10% of the portfolio is at risk is a pretty radical assumption. Again sitting here today we haven’t seen it. If you look at big pharma companies, they are looking to biotech as the innovative new drugs that they want to develop. It is hard to find a large pharma company that is not targeting biotech acquisitions to help fill in their pipeline for the future. So I wouldn’t sound the death knell.

Ricky Goldwasser - UBS

I understood. And then just on the SG&A question, kind of really when you think about the Lilly-related headcount, I don’t think that we saw all of it in the third quarter. So if you can just quantify to us how we should think about it into the fourth quarter?

Joseph Herring - Chairman and Chief Executive Officer

Ricky, we didn’t see any Lilly employees at Covance in the third quarter. We closed the transaction on October 3rd and we transitioned about 260 employees. We added 235 employees organically net during the third quarter. And 260 new employees in the fourth quarter right out of the chutes with the Lilly transition and we expect employee headcount to be up in the fourth quarter.

Ricky Goldwasser - UBS

Okay, thank you. That’s helpful.

Joseph Herring - Chairman and Chief Executive Officer

Thank you, Ricky.

Operator

And we will move on to Dave Windley with Jefferies & Company.

David Windley - Jefferies & Company

Hi, good morning. Thanks for taking the questions. Joe, as I am looking at Early Development trend and growth, you commented about the factors impacting the third quarter. You also commented I think to one of the earlier questions that clin pharm was soft in the first quarter as well. If you look at... say compare first quarter of this year to third quarter of this year, what is the difference, apart from clin pharm, that causes that... it is about almost 5% difference in growth rate? I mean I know part of it is going to be FX. But I guess I am trying to get a sense for... is North American toxicology stronger than it was earlier in the year, about the same, or is it not quite as strong as early in the year?

Joseph Herring - Chairman and Chief Executive Officer

Keep in mind that in total Early Development continues to grow. It is just a moderation of the growth. We said that there were three issues in order of importance. One, first, was clin pharm; and I think we characterized that as best we can. Second of all we talked about Labs Europe; and most of the Labs Europe issue is an FX related. Okay. Obviously the strength of the dollar against the pound is stunning. And then we mentioned that there is one client, a large client for the facility that has really slowed down their portfolio and become much more price-sensitive. And we haven’t done well with that client. But that would be below certainly the impact of FX.

David Windley - Jefferies & Company

Okay, so on the European business with your opening Harrogate, I think that is specifically for large animal, and you said there is good demand for large animal. You are you losing this other client. On the whole, do you think there is enough demand in Europe to keep your European tox operation at high levels of utilization? Or do we need to be cautioned a little bit there?

Joseph Herring - Chairman and Chief Executive Officer

Outside of FX and this one client, orders are booming in Labs Europe. I think they are up 20, 25%. We are doing very well from a competitive position. We are not seeing anything that is overly concerning, bar these two items. I think the FX has definitely been a headwind, and so that is it.

David Windley - Jefferies & Company

When you look in North America, switching over to here, and you mentioned... you talked about Chandler coming online and moving a key client out of Madison into Chandler. Can we fill the Madison space that will be vacated? And then as part of that you also talked about Virginia. As part of your consideration of Virginia, is selling that building one of the options there?

Joseph Herring - Chairman and Chief Executive Officer

Okay. Well first of all, moving this anchor client out to Chandler will create room capacity in Labs North America, specifically there in Madison. I think that is the easiest facility fill on the planet. So we feel pretty good about our chances there. It is the heart and soul of where program management sits. We have a world-class Phase I clinic right across the street, as well as very strong chemistry capabilities. So we actually feel very good about that. Regarding the Vienna campus, you know, ultimately selling that piece of property has been a part of our plans all along. But that won’t happen until we have a replacement facility and have a full transition plan for all studies that are in the Vienna facility into the new facilities. So that will be something that is hard to call right now.

David Windley - Jefferies & Company

Joe, I asked that question incorrectly. I apologize. The Prince William County facility is what I really meant. You kind of intimated that you would take a harder look at the timing and pace of build out of that facility. And I guess I wondered if not going forward with that build out could be part of the plan or could be part of the consideration. Sorry.

Joseph Herring - Chairman and Chief Executive Officer

Yes, obviously looking at the timing makes a lot of sense. We have new input and new data compared to the last time we made a comment on that. So, but if you are asking... are we selling this Prince William? Absolutely not.

David Windley - Jefferies & Company

Okay, okay. Then finally and I will jump out, on Late-Stage development you made a lot of progress on margin there. Is that a sustainable level? And beyond this quarter is there still plenty of Six Sigma projects on the board that will continue to drive margin in Late-Stage in 2009?

Joseph Herring - Chairman and Chief Executive Officer

Yes, we did see extraordinary in Q3 segment, I think that was quite a vault. I think the margin expansion story continues to be very good. Certainly Six Sigma is a contribution. But with the revenue growth and we are sort of bumping ahead of what you would consider a critical mass in clinical development, where we can start to drive margin expansion. And some of the new client relationships that we are developing and the throughput we are getting from some very large projects from those are all contributing. As well as some of the IT investments that we have continued to talk about that are starting to roll into that business and will continue to roll into that business over the next 18 to 24 months. That we think will give us additional operating leverage from where we are today.

David Windley - Jefferies & Company

Okay, great. Thank you.

Joseph Herring - Chairman and Chief Executive Officer

Okay.

Paul Surdez - Vice President of Investor Relations

Operator, it is Paul. We are running up against time. I would like to get everyone in the queue in. So everyone in the queue, if you could keep your questions probably to one, and if you have follow-ups I will be available after the call.

Operator

[Operator Instructions]. Then we will move on to Greg Bolan with Wachovia.

Greg Bolan - Wachovia

Thanks for taking the question, gentlemen. I understand this is a small yet important business for Covance, but can you dive into the competitive landscape for the research products business? Specifically as it relates to North America and ex-U.S. geographies like Europe, for example, and then across maybe the products like primates, please.

Joseph Herring - Chairman and Chief Executive Officer

Greg, I think you are asking a very... a question that would require an expansive answer to really dive into the competitive landscape. And I would like to maybe ask you to connect with Paul after the call to talk about that. But having said that, we have had a very strong franchise there, the growth has moderated somewhat compared to historical times, but it is still a growing business. It is very profitable, and we are a premium provider. Our footprint there is predominantly in North America. Overwhelmingly I would say in North America. But there are growth opportunities for that business that we feel good about in the future and we will continue to look for those.

Paul Surdez - Vice President of Investor Relations

Greg, since we are going to talk about that after the call feel free to ask one more.

Greg Bolan - Wachovia

Okay, thanks. And then as I look at EPS guidance of $3.18 I realize continued volatility in currency rates could prevent you from making that number. But beyond that can you talk about other risks that you believe could soften guidance? And then spell out the tools you are employing to kind of mitigate those risks.

Joseph Herring - Chairman and Chief Executive Officer

Well, how much time do you have? I mean you read the headlines every day. But again I think we walk back to... what are the real drivers of this business? Are we sitting here worried about energy prices? No, we are probably not. Inflation, deflation? No, probably not. You know what we are... credit markets? Could care less. Personally, but certainly not as a business. What we are focused on is that $80 billion market opportunity and us being less than a $2 billion company. And we have got clients who are willing to talk to us about how to outsource more, not less. So I think FX is probably the biggest risk factor, and we have been very transparent with that in giving you additional slides to help you see historical. Maybe, Greg, you are a better predictor than I am in the future. I didn’t think we would be where we are today. But FX could be a tailwind between now and year-end, you know who knows.

Greg Bolan - Wachovia

Okay, thanks. Great detail.

Joseph Herring - Chairman and Chief Executive Officer

Yes.

Operator

And we will move on to Todd Van Fleet with First Analysis Securities Corporation

Todd Van Fleet - First Analysis Securities Corp.

Hi, guys, thanks. Bill, real quickly. Maintenance CapEx, if you could give us that figure on an annualized basis. And then your tax rate, any additional commentary you can provide on why you are seeing the tax rate drift down?

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

Maintenance CapEx is always a tough thing to try and calibrate. I think we have looked at it as maybe being 3% of revenue, something in that range historically. But honestly it kind of depends on the sense of what is wearing out. So it is not a very good answer for you. It also depends on the business model. Obviously the CapEx for Late-Stage is substantially lower than CapEx in Early Stage. And there is almost no maintenance CapEx there in many respects, except for refreshing of our PCs and things like that. On the tax rate really this reflects kind of an ongoing effort by our tax department to put in tax planning strategies. And some favorability in terms of where the mix of revenue and where the profit comes from. But by and large it is the effort of our VP of Tax, Fred Wojtowicz, and I want to give him some credit here for driving that.

Todd Van Fleet - First Analysis Securities Corp.

Do you have more tax credit than in the U.S.? Is that why you are seeing... because I would think that as the dollar rises, maybe you would see a higher tax rate. But...

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

No, on a blended basis it’s a lower tax rate overseas than U.S.

Joseph Herring - Chairman and Chief Executive Officer

And revenues overseas are growing substantially faster than U.S.

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

Right.

Todd Van Fleet - First Analysis Securities Corp.

Okay. Thank you.

Operator

There are no further questions at this time.

Paul Surdez - Vice President of Investor Relations

Thank you, operator; and thank you, everyone, for participating on today’s call. I will be available immediately following this call so feel free to call me if you have follow-ups. We look forward to speaking with you and seeing you during the fourth quarter.

Operator

Ladies and gentlemen, this concludes today’s conference call. Thank you for your participation and have a wonderful day. .

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