Covance, Inc. 2009 Guidance Call Transcript

Covance, Inc. (CVD)

2009 Guidance Call

December 18, 2008 9:00 am ET

Executives

Paul Surdez – Vice President of Investor Relations

William Klitgaard – Chief Financial Officer

Joseph L. Herring – Chairman and CEO

Analysts

Randall Stanicky – Goldman Sachs

John Kreger – William Blair

Douglas Tsao – Barclays Capital

Eric Coldwell – Robert W. Baird

Ricky Goldwasser – UBS

John Wood – Banc of America

(Charles Heff – Horizon Financial)

Dave Windley – Jefferies and Company

Todd Van Fleet – First Analysis

Greg Bolan – Wachovia

Presentation

Operator

Good day and welcome to the Covance 2009 guidance conference call. Today’s conference is being recorded. At this time, for opening remarks, I would like to turn the conference over to the Vice President of Investor Relations, Mr. Paul Surdez.

Paul Surdez

Good morning and thank you for joining us for Covance’s 2008 update and 2009 financial guidance teleconference and webcast. Today Joe Herring, Covance’s Chairman and Chief Executive Officer and Bill Klitgaard, Covance’s Chief Financial Officer, will be providing you with our outlook on 2009 and revised targets for 2008. Following our opening comments, we will host a Q&A session. In addition to the press release, 16 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 turn it over to Joe whose comments begin on slide 4 of the slide show.

Joseph Herring

Good morning everyone. Today we’re going to provide an update on fourth quarter business activity and share our initial financial guidance for 2009. As we announced in our press release this morning, during the fourth quarter demand for our toxicology and clinical pharmacology are below our expectations due to a combination of lower new-project initiations and a further increase in project delays from Q4 into 2009. This decrease in near-term demand combined with the unprecedented strengthening of the US dollar has caused us to revise our 2008 financial targets and take a more conservative view of our 2009 outlook.

For 2008, we now expect full-year earnings per share to be $3.02 on low double-digit revenue growth versus our previous expectation of earnings per share of $3.18 on low teens revenue growth. We categorize the difference between these targets as follows: Approximately $0.09 on lower than expected new-project initiations in early development, approximately $0.06 to foreign exchange, and approximately a penny from a combination of below-the-line items including lower interest income and lower equity earnings.

On the business development front, orders for late-stage development continued to be strong. In fact proposal volume and dollar value for Central Labs and Clinical are higher than the third quarter and from a year ago. For consolidated operations, we expect an adjusted net book to bill in the fourth quarter, roughly in line with the third quarter level of 1.2 to 1.

Turning to 2009, our targets reflect three key assumptions. Our first target assumption is that foreign exchange remains at budgets levels throughout 2009 which for our main currencies are $1.50 for the pound, $1.30 for the euro, and $0.85 for the Swiss franc. This assumption presumes a substantial headwind for us. At these rates, foreign exchange translation negatively impacts our year-on-year revenue growth by a little over $100 million and earnings per share by approximately $0.27 versus the results that we would have attained had 2008 average exchange rates continued throughout 2009. This FX volatility continues as US dollar has now weakened substantially just this past week. Bill will provide information which will help you model FX impact on a go-forward basis for Covance, but for now we will continue to use these budget rates I just outlined.

Our second target assumption for 2009 is that our late-stage development segment continues on its current pace including backlog conversion to revenue in line with historical trends and cancellations remain in the normal range as they have throughout 2008.

Our third target assumption relates to the estimated timing of the recovery and early development demand. Our 2009 target range assumes that early development revenue begins to pick up between the second and third quarters with growth increasing to more normal levels toward the end of the year.

Based on the above assumptions we currently expect full-year revenue growth to be in the range of 5% to 10% over 2008 and earnings per share to be in the range of $3.00 and $3.20. Keep in mind that this range includes $0.27 of expected foreign exchange headwind at the budget rates I outlined.

In terms of variability, aside from foreign exchange rates the big screen factor in this assumption is the assumption one would make relative to timing of the recovery in early development demand. To give you a sense of the cone of uncertainty we modeled we looked at scenarios ranging from early development staying relatively flat from current levels throughout all of 2009 to early development demand picking up appreciably towards the end of Q1 and returning to more normal levels of growth beginning in Q2. In the case of flat early development throughout 2009, the resulting earnings per share would be around $2.85.

The faster recovery scenario would be relatively consistent with comments we have been hearing from our clients who push work out of the fourth quarter, and we estimate this scenario would deliver earnings per share closer to $3.35. As you can see from our 2009 target, we believe a view in the middle of this range is more reasonable.

Let me comment on our expected results in the first quarter of 2009. We currently expect year-on-year revenue growth to accelerate from the Q4 level, but for GAAP EPS to come in at roughly $0.05 below Q4 levels. The reason for that difference is three items which we expect to impact reported results by approximately $0.09 in the quarter. Those items include the opening of the Chandler facility, a one-time transition payment from Lilly, and the planned consolidation of some smaller facilities. Let me comment on each of these items.

First, the opening of our Chandler facility will be dilutive in Q1 as we incur expenses of staffing and validating the new facility without any associated revenues. By the end of the first quarter, we expect to have about 80 staff in Chandler, 52 of which will actually be internal Covance transfers which will not be back-filled right away. As you think about Chandler, also note that the second quarter will be slightly more dilutive than the first quarter as the building officially opens, appreciation expense begins, and we continue to increase staffing levels to conduct the studies from our anchor clients that have contractually committed into that facility. As the year progresses and we perform work for other clients in the Chandler facility, we see results improving measurably with Chandler getting to breakeven levels early in the fourth quarter.

Second, in the fourth quarter of 2008, we collected a one-time transition fee from Lilly to help cover the cost of transferring ownership of Greenfield campus and to ensure business continuity for Lilly. By all accounts, the transition has gone very smoothly. Looking forward, operations in Chandler are projected to be profitable in the first quarter of 2009 as well as for the balance of the tenure contract with or without revenue from other clients.

Finally, we are looking to take the opportunity to consolidate a few of our smaller operations during the first quarter, which will increase our productivity and improve operating results in 2009 and beyond. These actions will have some one-time costs associated with them in the first quarter. Excluding these items, we expect the balance of our operations to drive a $ 0.04 sequential increase in EPS in Q1, and we expect revenue growth to accelerate from Q4 levels.

We recognize that our announcement today is not consistent with our expectation 2 months ago. Moving the past the FX component, which further deteriorated and is clearly out of our control, I would like to discuss what has happened to our early development operations over the last 8 weeks to help bridge our performance gap from October to today. Let me break it down into its component parts.

First as we previously reported, delays in clinical pharmacology were the biggest issue in early development in the third quarter. During the quarter, several strategic clients told us they would be pushing projects out of 2008 and into 2009, and they kept their word. To compound this issue, some smaller client made similar decisions later in the fourth quarter, and the net effect was further deterioration in our expected clinical pharmacology results. These delays are virtually impossible to backfill quickly, especially in the current environment.

The next biggest issue in Q3 was European preclinical labs where weaker results came from a substantial reduction in work from a large pharmaceutical client, who pared back their pipeline last spring and became more price sensitive. We believe this large client reduced toxicology volumes across the board in 2008. You should note that outside of this client, we continued to see growth from other Labs Europe clients and new business awards are up year on year and sequentially in the third quarter, and that has continued thus far into the fourth quarter as well.

This brings us to Labs North America which delivered a strong third quarter featuring sequential growth of nearly 6% as we opened up new space in Madison and accepted work from clients that we had turned away earlier in the year. We subsequently experienced two challenges as follows: First as we reported to you in October, we did see some delays in toxicology which accelerated after our call. The pushouts came from large pharmaceutical clients including a few that had already met their minimum commitments in dedicated space contracts. As a side note, our five dedicated space contracts have a minimum commitment to the tune of about $200 million revenue for 2009. Second, the biotech side was harder to read as we do work with hundreds of smaller biotech companies in a year, most of whom we did not know the previous year.

Once these clients complete their projects and move on, they have been historically replaced by other new small companies.

As it turns out in the fourth quarter, the flow of work from new small clients was not sufficient to offset the work that was winding down from existing small clients. The net impact of this churning is much less obvious than the overt actions of a few large clients. Finally the softness in early development is also impacting our research products group. Although we expect demand to pick up between the second and third quarter, we have nonetheless taken a number of steps to adjust expense levels including tighter management of discretionary expenses, managing headcount attrition by only selectively backfilling positions which become available, development of a plan to consolidate a few smaller less productive sites, and a meaningful reduction in planned capital spending.

Because we expect an increase in business flow in toxicology and clinical pharmacology in the coming months, we are not planning on reducing our head count beyond normal attrition as that would come at the expense of pushing early developments to recover out further and potentially hampering our ability to capitalize on the up-tick in demand we expect to see. We feel our ability to absorb costs and maintain revenue generating positions in this environment will give us a clear competitive advantage when early development market recovers with our world class facilities and talent, and as demand improves, we could be in a position to further strengthen our competitive position.

Before I make my closing comments this morning, I would like to turn the call over to Bill Klitgaard for his comments around capital spending and foreign exchange, which begin on page 5 of our slideshow.

Bill Klitgaard

I would like to walk you through our 2009 expectations for working capital, corporate expense, and effective tax rate and then move on to a more detailed discussion around foreign exchange.

Capital expenditures in 2009 are expected to be approximately $200 million, which is down $115 million from the $315 million target for 2008. Our 2009 target for CapEx can be broadly categorized as follows: Toxicology expansions of $60 million as compared to $190 million in 2008, key IT systems projects of $60 million as compared to $65 million in 2008, and all other growth and maintenance spending of $80 million as compared to $60 million in 2008. The largest decline in capital expenditures as you can see is related to the spending on new facilities in early development. More specifically, our Chandler, Arizona facility will be completing in the first quarter of 2009, whereas in 2008, we had a full year of spending on Chandler. The year on year difference for Chandler spending is roughly $70 million. In addition, the $50 million purchase of Lilly’s Greenfield campus is included in our 2008 CapEx, and spending in Greenfield in 2009 will be only a fraction of that amount, roughly a $40 million differential year on year. As we mentioned last quarter, the Greenfield campus provides us with significant growth capacity with favorable economics, and as a result, we are putting on hold for now the plans to build our Manassas property at least the next 18 to 24 months.

Moving on to free cash flow, which we define as operating cash flow less capital expenditures, for 2009, we expect free cash flow to be approximately $90 million. This compares to anticipated free cash flow of negative $25 million in 2008. You should note that both years include an assumption that DSOs remain at the current level of approximately 40 days.

Turning now to corporate spending, our 2009 target assumes spending of approximately 6.5% of revenue.

Finally, let me comment on our expected effective tax rate for 2009. The strengthening of the US dollar and the impact on translation of foreign earnings into dollars is causing a shift in the geographic mix of our earnings toward the United States, where our effective tax rate is above the company average. As a result, we project a 50 basis point increase in our effective tax rate to 29% for 2009.

Now, I would like to comment on how movements in foreign exchange rates are impacting our results. Please turn to page 6 of the slide deck for a review of the mix of our revenue by major currency and for average exchange rates for 2008 and our budget assumptions for 2009 rates.

For the first 9 months of 2008, approximately 59% of our revenues were domestic, 14% came from the United Kingdom, 13% from Switzerland, 7% from other Euro zone countries and the remainder is derived from a mix of 22 other currencies. As you can see, the exchange rate embedded in our 2007 targets represents a materially strong US dollar than the average exchange rate during 2008. As Joe explained earlier, this stronger US dollar presents the headwind of approximately $100 million in revenue and $0.27 per share versus the result that would have been obtained at the average rates in 2008.

In terms of the 2009 exchange rates we’ve selected, they are consistent with the rates in effect at the end of last and are roughly in line with the average exchange rates over the last few weeks when set the budget. We can’t predict future exchange rate, but with providing you with the current geographic mix of our revenues and our targeted assumptions for the exchange rates, you should have sufficient information to roughly model the impact at varies exchange rates assumptions. For instance, just this week, the US dollar has weakened a fair amount, particularly against the Euro and Swiss Franc which would reduce our foreign exchange headwind by approximately $40 million in revenue and approximately $0.10 per share if last night’s rates stayed in effect for all of 2009.

Now turn to page 7 please. We included this slide in the October deck and have since updated to reflect the estimated revenue impact of the strengthening dollar on our fourth quarter revenues. We expect the year on year translation to negatively impact fourth quarter revenue by approximately $18 million or 450 basis points. On a sequential basis, we estimate there will be a $24 million swing in the year on year impact of foreign exchange rates, from a positive impact of roughly $6 million last quarter to a negative impact of roughly $18 million this quarter. This is approximately three times the movement of the previous highest swing in the last 20 quarters of $8 million, which experienced going from Q2 to Q3 of this year. Again to be clear what I’m outlining here is the swing in the year-on-year impacts from one quarter to another.

Now please turn to slide 8. This slide shows the impact of foreign exchange translation on operating income and earnings per share. Overwhelmingly, the bulk of our overseas business revenue is earned in the same currency in which costs are incurred. As a result the foreign exchange translation impact on operating income is computed by multiplying the foreign exchange impact on revenue by the operating margin for the foreign operation that gave rise to the revenue. From a high level, you can get close to the consolidated operating earning impact by multiplying the revenue impact by our consolidated operative margin rate excluding corporate overhead. That won’t get precisely to the number, but it gets you pretty close. To extend that to EPS, you would need the tax effect on operating income and divide by the weighted average shares outstanding. A quick rule of thumb is that for every million dollar change in operating income, you get about $0.011 impact on EPS. As you can see in the fourth quarter, year-on-year operating income is expected to negatively be impacted by $3.7 million or approximately $0.04 per share.

Now, please turn to slide 9. This shows the impact of foreign exchange transaction gains or loses which are reported below operating income but before taxable income. These result in situations where we have on the balance sheet of any subsidiary assets or liabilities that are denominated in a currency other than the local currency of that subsidiary. Changes in foreign in foreign exchange rate cause a reevaluation of those balances which gives rise to foreign exchange gains and losses. Suffice to say that when you operate more than 25 different currencies, there will be a fair amount of cross currency effect or liability positions that exist at any point in time, and because of the global nature of our operations, there are always cross currency balances outstanding that will match up with offsetting positions elsewhere in the company. We refer to this as internal hedging.

Historically, we’ve been successful in matching up cross currency positions, such that the impact of foreign exchange rate movements has been fairly small, and you can see that on slide 9, but due to unprecedented volatility of currency exchange rates over the past year, matching of asset and liability positions has been difficult to achieve. So before I close, I’d like to remind you and refer you to the several paragraphs of disclosure in the MD&A section of our quarterly and annual filings that outline the nature of these exposures that the company faces regarding foreign exchange.

That concludes my comments. Now, I’d like to hand it back to Joe.

Joseph L. Herring

I hope Bill’s comments help clarify our operating results, the various impacts of foreign exchange on our business, and our short-term outlook. Before I turn it over to questions, I want to emphasize that we believe that the long term growth outlook for our industry and for our company remains positive. Given today’s economic environment, we believe that our pharmaceutical clients have no choice but to invest in R&D and bring new products to the market. To do so, they absolutely must improve their cost structure, make their cost structure more flexible, and increase the speed of the development process. In this hotbed environment, they are likely to embrace strategic outsourcing in a larger and more meaningful manner.

We continue to field calls from clients that are interested in hearing our views on streamlining drug development including calls from some clients who have not seriously considered the strategic use of CROs in the past as well as others who see the need to accelerate the use of more flexible CRO capacity. This increased interest in our services as well as the positive indications on drug development spending from the recent pharma-sponsored R&D days over the last month give us good reason to be optimistic for our future growth, even in this tough economic environment.

This ends our prepared comments for this morning, and now I’d like to turn the call over to the operator for our Q&A session.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of Randall Stanicky from Goldman Sachs.

Randall Stanicky – Goldman Sachs

Joe, on the preclinical business, can you help us quantify how much of the near-term impact is a matter of getting projects that are already in backlog started versus the need to go out and win new business to fill that capacity?

Joseph L. Herring

It’s roughly 50:50 in terms of new projects. Again, we talked about this new small client issue. It’s roughly impacted by that equivalent to projects that were awarded but that were pushed out.

Randall Stanicky – Goldman Sachs

Have you adjusted your pricing or cost dynamics in terms of bringing in some of that new business to try to competitively bring some of that over?

Joseph L. Herring

As we’ve said in the past, a high percentage of the pricing for our preclinical services is under contract, and at the margin, we have been more aggressive, but it’s not really a change in pricing policy. Historically as we have brought on new capacity, usually it’s on the heels of turning away clients for 3 to 6 to 9 to 12 months, and we try to give them a reason to come back in now that we have available capacity, so again, there’s no change in the pricing philosophy that we’ve always had.

Randall Stanicky – Goldman Sachs

The question is when does the visibility come back? You have a 90- to 120-day visibility, and what are you hearing from your pharma customers in terms of some of the reason on the budgets? Is that a 1-month or 2-month dynamic, or is there a way to think about when visibility should pick up here?

Joseph L. Herring

It’s unclear, Randall. This is not the time of year that we historically hear very much from our pharmaceutical clients. The week before the Christmas holiday break, they tend to go silent. They don’t have necessarily their budgets for next year. They are not scheduling work, and in my 12 years in the business, usually January and the first two to three weeks of February, the clients are dead silent, and so I don’t know that this is going to clarify for us until the mid to late February timeframe if it stays in lock with historical standards.

Randall Stanicky – Goldman Sachs

Does the guidance implay anything in terms of buyback activity?

William Klitgaard

No.

Randall Stanicky – Goldman Sachs

Is that something you’re thinking about?

Joseph L. Herring

As you know, we have a nice position, but it’s largely stranded in Europe, and it would be very dilutive to bring those dollars back for share buyback, so our hands are pretty much tied at this point.

Operator

Our next question comes from the line of John Kreger from William Blair.

John Kreger – William Blair

Followup to Randall’s question on pricing, if you look across your portfolio of businesses both in the early and later stage, are you seeing any disturbing changes in pricing strategy from your competitors and if so what areas would those be from?

Joseph L. Herring

I’m just trying to think through the pieces in late stage. I really can’t think of a situation where pricing has changed. As we said before, John, this is a very competitive market segment, with a lot of people competing work, and pricing is always a challenge, and that’s the reason why our core strategy is operational and service excellence. We want to have the clients say I want to go back to Covance because I can absolutely count on them, and they may cost a little bit more, but I can sleep easier with that. In the early development businesses again, a large percentage of that is contractually locked in, and I’d say it would be more at the margin, and what competitors are doing, I guess I’ll just leave it for them to comment.

John Kreger – William Blair

You mentioned this pattern of newer smaller clients that you didn’t see quite as much in the fourth quarter. Can you give us a sense about roughly how big a portion of your book that would typically be in a quarter for your tax business?

Joseph L. Herring

Company-wide, it is in the 10-, maybe a little bit more range, and in the preclinical business, it would slightly higher than that just because our late stage portfolio has been increasing market share in late stage, but that’s how we did the analysis which was company wide.

John Kreger – William Blair

Does your budget for 2009 assume any improvement there or that continues in the pattern that you saw in the fourth quarter?

Joseph L. Herring

Well as we said John, the cone of uncertainty, we modeled everything from dead flat 2009 compared to Q4 to recovery coming somewhere in the second or third quarter, and it’s really hard to really cut it that fine and say what percentage of that recovery would be new emerging clients versus some of these studies that have been pushed out. I guess you would say that the more optimistic end of our range would be some of those coming back and the more pessimistic would be that they don’t.

Operator

Our next question comes from Douglas Tsao from Barclays Capital.

Douglas Tsao – Barclays Capital

In terms of the scenarios that you provided Joe, I think you mentioned a 285 number which would assume that early development level stays flat, and then you also threw out the $200 million in terms of the committed minimum. Would that anticipate that in terms for your dedicated space deals that clients would only hit their deal minimums and not exceed, which is what they have done in the past?

Joseph L. Herring

That would be directionally correct. Also keep in mind that 285 is dead flat and it’s also at budgeted rates, which had changes in the last few days, so still a lot of bouncing balls.

Douglas Tsao – Barclays Capital

Given this sort of change in rates, you would think that would probably be closer to $3 or $2.95 range, but I was just thinking about just in terms of the preclinical business and the volumes, we would assume that rather than the 2X that in the past you would see from dedicated space clients that it would run just hitting the guaranteed minimum. That sounds alright?

Joseph L. Herring

Yes. Each of those comments is directionally correct, and I guess Doug as we look at our business and the relationships with clients including dedicated capacity in Lilly Greenfield, I think we felt the impact of this later than what we are hearing from competitors, and our hope is that it’s a shallower dip and that we recover more quickly, but again we have turned every card that we can think of faced up on the table and let you sort of dial up how you see it or how investors want to company. The cone of uncertainty is wider than it has been historically, and I think you now have most of the inputs that we have.

Douglas Tsao – Barclays Capital

Can you provide a little detail regarding the consolidation of some smaller facilities? Could you give us some details around that?

Joseph L. Herring

Doug, frankly it’s too early in the process to do that, so I would just say that we’ll get back to you, but these are going to be relatively smaller items which I don’t know would really change your outlook all that dramatically.

Douglas Tsao – Barclays Capital

This would be something like along the lines of the Chantilly Lab?

Joseph L. Herring

Stay tuned, Doug.

Operator

(Operator Instructions). Our next question comes from Eric Coldwell from Robert W. Baird.

Eric Coldwell – Robert W. Baird

I was hoping we could get some direction on your expectations for late stage operating margin in 2009 versus early stage. In other words, are you still targeting expanding late stage operating margins next year and having obviously a little bit of pressure in the early stage or is there some kind of a bigger swing there that we should be thinking about?

Joseph L. Herring

Well, the first impact Eric would be FX. Keep that in mind, but net of that, we expect some margin expansion in late stage

Eric Coldwell – Robert W. Baird

Then just strategically longer term, obviously the CapEx is coming down in 2009 as expected, but long term, would you be in the mode now of potentially delaying some of the previously guided expansion plans such as the newer Virginia facility or China for example?

Joseph L. Herring

Yes, Bill did comment that Manassas is on hold for 18 or 24 months, so we won’t be spending there, and China, we are not ready to comment on that yet.

Eric Coldwell – Robert W. Baird

There were some prepared comments that strategic outsourcing and opportunities continue to advance. I’m curious if you can give us any sense of whether current global market environment, etc., is delaying this decisions, expanding those decision by clients or the inquiries by clients, and would those discussions be across the board or are you sensing any shift in terms of clients’ demand, in other words, more strategic outsourcing or interesting relationships in late stage or still very strong opportunities in early stage.

Joseph L. Herring

I would say inquires would be separate from decisions. Decisions have always been incredibly difficult for us to forecast. Pharmaceutical clients tend to make decisions much slower than other businesses that we all would know. Inquires are up substantially and that’s in both in preclinical as well as late stage. Again, I call it sort of a hot bed environment. If I’m a major pharmaceutical company, I’m more desperate for new products than any time in history. I’m trying to accelerate my late stage portfolio. I’m trying to make licensing investments to get new molecules, and I’m trying to drive as hard as I can, but I also look at my shorter term P&L and say I can’t afford to keep building facilities and hiring people around the globe, how I’m going to get this done and I think both Covance and some of our other key competitors offer a very viable opportunity to accelerate development and to add horsepower but in a variable way. They’re calling and some of it is general fact finding, some of them they just want to sit down and talk about the types of relationships we’ve entered and try to understand how that might apply to their model, but in terms of decisions, I wouldn’t want to call it in this economic environment, but what my gut instinct tells me is that it’s probably improving our position to have more strategic relationships not impacting it, and you know in fact if you look at late stage, we haven’t named names or been terribly specific, but we have some pretty substantial new preferred provider agreements with very large pharmaceutical clients who are outsourcing more and consolidating their volume to generally two strategic partners.

Operator

Our next question comes from Ricky Goldwasser from UBS.

Ricky Goldwasser – UBS

Can you break down for us your top-end growth assumptions for early and late-stage, i.e., what percentage of revenue growth is coming from early in ’09 and what percentage is coming from the late-stage business, and also on the operating margin for the early-stage business, do we assume same levels that you reported back in 2002?

Joseph L. Herring

I am not sure I go tall those written down, but let me just comment on Lilly first of all. We shared with you the minimum volume commitment for 2009 was $150 million. We did give them a contractual ability to count fourth quarter revenue as part of the 2009 minimum commitment as a way to motivate them to get started early, so you can model something in the $15 million range for the fourth quarter, so that gives us a minimum volume commitment fro Lilly of $135 million in 2009, and again as we stated before their run rate for 2008 was looking like something in the $80 million range, so for Lilly, I think a good assumption would be about $55 million in incremental revenue. If you ask about early development operating margins, we gave you a number of items including the Lilly Greenfield compare on the transition fee and the Chandler ramp up. Right now we are thinking that early development operating margins in the first quarter will be in the low 20s range, and Bill I think you were going to comment on an earlier question, which I think was late stage revenue growth.

William Klitgaard

I think the way I’d characterize it Joe is that for late state margins, if you look at a full year basis, we are looking for expansion between 2008 and 2009, our early development again on a full-year basis probably had a 100 basis point deterioration from 2008 and 2009. The challenges we are facing right now in Q4 and in the first part of next year are in early development kind of in the 25% run rate, down into the lower 20s and then coming back towards that middle 20% margin rate by second half of the year next year.

Ricky Goldwasser – UBS

In terms of late stage impact on the top line?

Joseph L. Herring

Top line which is the revenue growth and late stage in particular seems to be less impacted by what’s going on right now. We have mid-teens growth rate going on there, and that seems to be continuing. We don’t see as much effect in the late stage part of our business as we do in the early stage part of our business and that includes the FX.

Operator

Our next question comes from Todd Van Fleet from First Analysis

Todd Van Fleet First Analysis

I wanted to ask you about the early development segment, in particular focusing on page 12 and 13. For the time series that we are looking at here over the course of the next two quarters, you indicate that you expect $0.09 of EPS pressure in Q4 relative to your Q3 call at least in terms of your outlook related to a few different issues and then a further pressure of $0.09 per share in Q1 of next year, so I just want to make sure I understand what’s changing from a time series standpoint since October 22nd, so if we ignore FX and just focus on the three different issues that are impacting the early stage business, the overall reduction in volume is coming into play; secondly, you’ve a new facility coming online in Chandler, and then third, you have the impact from the former Lilly facility in Indiana. I just want to understand in Q4 the majority of the $0.09 impact is the volume issue as opposed to either the Chandler or the Greenfield site issue or related issues, and then moving into Q1, can you help us or at least help me understand little what’s changing incrementally as we go from Q4 to Q1 next year with respect to those three different issues and how you are thinking about the business?

William Klitgaard

Joe did a very good job of I think of bridging that gap, the canyon between expectations from October 22nd for Q4 and what we now expect for Q4, and those relate primarily to demand, particularly pushing out of work from Q4 to 2009 in clinical pharmacology and some softness in toxicology and the downstream effects or upstream maybe in research products. Those are all demand driven, and that’s basically the Q4 story of $0.09. As we go into Q1, we have the opening of the Chandler facility which is going to be at a loss because you have essentially during Q1 people coming on and the cost associated with that with no revenue. You’ve got in Q4 the transition payment that we received from Lilly, we won’t have the same transition payment in Q1. Now, I’ll remind you that as we expect Greenfield to be profitable, but we won’t have that same transition payment, so there will be a difference between Q4 and Q1 on that basis, and as Joe mentioned, we are going to be doing some work to rationalize some of the cost structures of some of the smaller units, which by the way is not Chantilly for our employees who are in Chantilly, so those are the items that hit us in Q1 relative to Q4. I hope that helps.

Todd Van Fleet – First Analysis

Is there anything tat you would have done differently I guess with respect to the Lilly deal in hindsight now given what’s happened over the course of the past couple of months?

William Klitgaard

No. We are thrilled with it.

Opertaor

Our next question comes from David Windley with Jefferies & Company

David Windley – Jefferies & Company

The broader question I have, Joe, is in terms of your dialogue with clients, I know over the years you guys have worked to lift the level of that dialogue substantially, but obviously visibility has declined a little bit here in the short run. What proportion of your clients have completed budget cycles and are giving you a pretty firm view of what their intentions are for 2009 and what proportion of those are you still in a mode of having to guess on what they are going to do in 2009 relative to what they have done in 2008?

Joseph Herring

I would say none.

David Windley – Jefferies & Company

None have completed budget cycles and talk to you about outlook?

Joseph Herring

It’s too early.

David Windley Jefferies & Company

So in late stage, as you are thinking about your backlog there, has there been any discussion about clients rationalizing phase II or phase III programs that under an Obama administration, a new pricing environment, any number of macro factors might cause them to rethink the kind of business case on a clinical compound as no longer viable?

William Klitgaard

No. Cancellations have not changed, push-outs have not changed, and I think they are highly motivated to get new products to market.

Joseph Herring

And I as I mentioned Dave just a minute ago, I think, we see business activity remaining at normal levels, if not strong levels.

David Windley – Jefferies & Company

On CapEx, the other portion that grows in 2009 versus 2008, I missed if you quantified what some of those items are. I guess I’m just curious why CapEx couldn’t down a little bit more, and then as a dovetail to that, any thoughts of levering—I know it’s kind of an unusual question in this environment—but levering in the US to buy back stock given that you can’t repatriate cash efficiently out of Europe?

Joseph Herring

I’ll take the first piece of that, which is the $60 million going to $80 million. It was kind of all other along with maintenance and sustaining, and there are always opportunities for us to invest in other parts of the business, and if you start getting into the $5 million and $10 million pieces of that, we’d he here for several minutes talking about that, so I think what we have always said historically is that maintenance capitals in the 3% to 5% range, it kind of depends on the cycle which things really need to replaced and repaired, and so that number of $60 to $80 million is in that maintenance plus, some sustaining growth for other parts of our business which are not large items.

William Klitgaard

For 2009, a bit of our CapEx is bait. We have $60 million in major IT projects that you can’t stop. We’re halfway through with our new financial systems implementation and it makes no sense to stop that, and the Chandler spillover. There is I think $25 or $30 million that we’ll spend in the first month of January just to complete that project and so just slamming on the brakes does not make sense.

Operator

(Operator Instructions). Next question comes from Greg Bolan from Wachovia

Greg Bolan – Wachovia

Adjusting for the incremental revenues from the Lilly deal and then assumed 2009 constant currency same-store sales growth, it looks to around 9 to 10% at the midpoint. Clearly this is this down somewhat over the past four quarters. Bill, can you tease out your assumption for the contribution of constant currency same-store sales growth by segment in 2009?

William Klitgaard

I guess the way we build our budget was to look at the different factors, which is what’s unusual or what’s normal, and then the unusual things that are coming through here are, we have the Greenfield site, which is only in for one quarter of 2009 versus the full year next year. We have the Chandler facility coming up which we mentioned is going to be impacting our earnings in the first part of the year, so we try to look at that, and we looked at the foreign exchange, and then what we are left with is something in the 10 to 15% growth rate if you extract all of that 10 to 15 percent topline growth and bottomline growth which is pretty solid in the 10% range. The growth in ’09 is down due to demand in early development a little bit, but as we said, there is a wide cone of uncertainty about how deep and pronounced that will be. So we are trying to give you all the pieces that we know about. Hopefully, we’ve given you enough in terms of foreign exchange part and you can model that out and make assumptions about the rest of it.

Greg Bolan – Wachovia

I appreciate all the detail. Lastly, Bill, on the fourth quarter, the total assumed FX impact is $0.04 from translation and $0.02 from below the line, correct?

William Klitgaard

That is correct.

Operator

Our next question comes from John Wood from Banc of America.

John Wood – Banc of America

Joe, early development cost structure looks to be about $620 million or so in ’08. Can you give us a sense of the fixed versus variable components there? I assume most of the variable component is labor, and just any detail you’d be willing to offer on how fast you can adjust that? Is it a half year or is it more like a year, just some parameters around the labor component there?

Joseph L. Herring

Let me just try to provide a little bit of information regarding our cost structure. I don’t know that I can tie it exactly to your question, but a very substantial portion of our cost structure, depending on business of course, are employee costs—payroll, fringes, travel, training, and you could argue that those are variable costs, but in the short-term obviously they are fixed costs, particularly with high science and people very experienced in the regulatory processes of drug development. In the short term, it feels more fixed, but should there be a substantial and persistent downturn, then obviously we could make some decisions there. Just for rough modeling, it ranges from 40% of our total cost structure in central labs to 60% of our cost structure in our preclinical labs to 80% of our cost structure in clinical, so those would be helpful. The second component part is really what I would call other direct costs or the non-employee variable costs, and that ranges from 3% in clinical, because obviously a huge percentage of their cost structure, 80%, is labor related. These variable costs in preclinical run about 25%, and in central labs, they run 56%, so very different depending on which business you’re looking at. The true fixed cost of our business, you think about things like rent, depreciation, taxes, and utilities, run about 15%, and so again it looks a little bit different by segment. You could argue that employee costs are fixed in the short term, variable in the medium to longer term, and then each business has a little bit different complexion as it relates to these other variable costs. I hope that’s helpful, John.

Operator

We’ll take a followup question from Douglas Tsao with Barclays Capital.

Douglas Tsao – Barclays Capital

You indicated that you pulled revenues ahead from the Eli Lilly contract into the fourth quarter of around $15 million.

William Klitgaard

We gave them an incentive to kick the contract off early, ahead of Jan 1^st, and the incentive was anything they did in the fourth quarter, we would apply that to their contract minimum commitment in 2009, and obviously if they get off to an earlier start, it’s not like they’re going to do work in the fourth quarter and then cancel and do nothing in the first quarter, so it was more of an incentive for a running start to January as opposed to waiting till January to implement contract and then you have to do this and you have to do that, so it was in everybody’s best interest to get a running start and in fact we did.

Douglas Tsao – Barclays Capital

This was always planned?

William Klitgaard

Yes, it was part of the contract.

Operator

We’ll take our next question from Charles Heff from Horizon Financial.

(Charles Heff – Horizon Financial)

I have a followup to the labor expense side. Regarding under-funded pension expense, I see that at the end of ’07 you had about $38 million of under-funded pension and was wondering where that stood today and what type of pension expenses you have budgeted for 2009?

William Klitgaard

With respect to the pension plan, we have a pension plan in Europe, and there are two factors at work right now. Obviously with equity returns being down, there has been some erosion in the asset base for that, but with interest rates spiking up, the present value equation is actually better, so the net of those two things is actually a slightly better funded status right now. Those pension plans were closed in the late ‘90s. These are residual obligations, but there are no current pension plans per se.

Operator

We have a followup question from Dave Windley from Jefferies and Company.

Dave Windley – Jefferies and Company

You kind of detailed this, but if we were to look at the fourth quarter, the transition payment from Lilly, if we take that out, what would the non-FX portion of the delta be?

William Klitgaard

We are not providing that level of detail, Dave.

Dave Windley – Jefferies and Company

That’s a reconciling item from 4Q to 1Q, so I was trying to get to a base.

William Klitgaard

We’re given you a reconciliation for both fourth quarter and first quarter and as much detail as we feel comfortable with.

Dave Windley – Jefferies and Company

On the 2009 biotech contribution, is it possible, Joe, to talk a little bit about what your assumptions are in terms of how they contribute to revenue in 2009 as somewhat of an indicator about how much they come back in your assumption?

Joseph L. Herring

Well, that’s the reason why we’ve given a cone of uncertainty. The low end of the range says not much; the high end of the range says more.

Dave Windley – Jefferies and Company

Given that this is something that where the news has become apparent relatively recently, in terms of the worst case scenario, what gives you confidence that we don’t have lower from here first?

Joseph L. Herring

Generally speaking, we believe in this environment that good molecules will find a home, and if there’s a good receptor binding, if there are good structure reactions, good things happening with the molecule that gives you a sense that it could be a drug, somebody is going to fund it. It may be dislocated from a timing standpoint, but ultimately, they are going to be funded, and biotech is a huge percentage of the innovation in the industry right now, but keep in mind it’s a relatively small percentage of our revenue, and we have tried to be as conservative as we think is reasonable.

Dave Windley – Jefferies and Company

As part of your whetting of opportunities, have you developed any opinions on what percentage of the 300+ biotechs actually have good molecules?

Joseph L. Herring

We’ve spent a fair amount of time staring at that list and doing research, and we’ve been focused on is how much cash they have, how many of them are facing a sunset or the implications from an AR standpoint and from a new business standpoint, and frankly it’s thousands of companies. We have a found a significant meaningful database that’s helping us do that, but to look at each compound within each one of those companies, I think that is virtually an impossible task. There are lead compounds and backup compounds, and guessing which one of those are going to show activity and be meaningful is almost impossible.

Dave Windley – Jefferies and Company

I don’t think I put the qualifier of public companies on my comment, but yes, there are lots of them. Thanks a lot.

Operator

We have a followup question from Todd Van Fleet from First Analysis.

Todd Van Fleet – First Analysis

I’m trying to get a better handle on the potential operating leverage related to the Greenfield facility moving forward assuming changes are increases in volume levels. At this point, you’ve told us that profitable or will be profitable in Q1 at Greenfield. I’m going to just assume that that’s because you have the minimum contractual payments because that facility I guess is still utilized maybe at half capacity or half utilized at this stage, if that’s fair. So I am wondering as volumes increase and throughput increases at that facility, do you necessarily get improvements in the way of margin or just in terms of raw dollars operating margin that comes out of that facility? Does the dollar amount of operating profit increase as volume increases or are you capped until the minimum is satisfied, and then only once you get above the minimum in terms of there is sufficient volume to go above the minimum, can you help us understand that a little bit better?

Joseph L. Herring

I think you’re tripping up a little bit. It’s not like it’s anything related to the contractual volume. It’s really the cost structure of that business. We own it at 100%. The volume commitment is an annual commitment, and so if they start slow and ramp throughout the year, they can get to the commitment. Obviously if they ramp up faster, that’s a good guy, but it doesn’t change the contractual commitment, but again, with our current forecast and study starts for the first quarter, we anticipate it being profitable in the first quarter and profitable throughout the year. It will be less than our early development average for some period of time, but the opportunity for this to be a very profitable facility with or without extra clients is pretty obvious to us at this point in time, and if bring in other clients and develop some of these new product lines that we are working on, then it’s even better than that. I hope, Todd, that answers your question.

Todd Van Fleet – First Analysis

I’m just trying to understand in the Q1 assumption regarding the contribution to Greenfield from Lilly, does it assume that they satisfy their minimum, because it sounds like, Joe, that they could go for three quarters without satisfying their minimum on a run rate basis, and then you could have a huge payment in Q4 related to the minimum that would be a big windfall from an earnings standpoint, so I’m wondering what Q1 assumes with respect to their satisfaction of their minimum on a run rate basis.

Joseph L. Herring

Theoretically your case could happen, but what I’m trying to tell you is that the first quarter volume based on study starts that we have booked in feels similar to fourth quarter, and they are continuing to look for work that they can take out of competitors. Their pipeline or most any form of pipeline is inconsistent with no volume for three quarters and then mammoth volume in the fourth quarter. I’ve never seen anything quite like that, so I wouldn’t forecast that. I think you’re thinking this is sort of harshly black or white. They are on a good ramp. They have a strong pipeline. They have if anything more work today in their minds than they did when we signed the contract. They’ve made some acquisitions and the R&D day that they had and the comments we’re having with them is that they have a very strong pipeline

William Klitgaard

Todd, I don’t know if this will help you, but from a budgetary standpoint, in terms of the guidance we gave you, we’re assuming that volumes ramp up fairly consistently throughout the year, and with increasing volume, you have increasing profit and profit margins, so it’s going to be lower than our early development margins early in the year, but it will be ramping up through the year.

Joseph L. Herring

They’ve actually given their management organization golden objectives to exceed the minimum. We’ve got people at many levels at Lilly that are very committed to this and looking for ways to expand the relationship.

Operator

We have a followup question from Greg Bolan from Wachovia.

Greg Bolan – Wachovia

With regards to pricing for preclinical work within North America, Joe, would it be fair to say that you are being more aggressive or less aggressive for booking studies in January than you have been in the fourth quarter?

Joseph L. Herring

Greg, I’ve answered that question twice. What I’m saying generally is our pricing philosophy has not changed. Most of our preclinical work is under contract from a pricing standpoint. When we have additional capacity coming on, historically what we’ve done is get a little more aggressive to try to bring clients back in that we’ve had to turn away, and frankly, we’re having success doing that. We also have our dedicated capacity clients that want to make sure they hit their minimum, and they are pulling in work I think more aggressively compared to what they have done in the past, but again, it’s to the contractual pricing that they already have, so I just don’t see a sea of change.

Operator

Mr. Surdez, We have no further questions in the queue at this time. I’ll turn the call back over to you for any additional or closing remarks.

Paul Surdez

Thank you everyone for participating in today’s call. We wish you safe and happy holidays. I’ll be available for the next few days before Christmas if you’d like to follow up with any questions, and again, thanks for your time today.

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