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Covance Inc. (NYSE:CVD)

Q4 2008 Earnings Call Transcript

January 29, 2009 9:00 am ET

Executives

Paul Surdez – VP of IR

Bill Klitgaard – SVP and CFO

Joe Herring – Chairman and CEO

Analysts

Randall Stanicky – Goldman Sachs

Jon Wood – Banc of America

Eric Coldwell – Robert W. Baird

Sandy Draper – Raymond James

Greg Bolan – Wachovia

David Windley – Jefferies & Company

John Kreger – William Blair

Todd Van Fleet – First Analysis

Douglas Tsao – Barclays Capital

Ricky Goldwasser – UBS

Operator

Good day, everyone, and welcome to this Covance Fourth Quarter 2008 Investor Conference Call. Today’s 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

Good morning and thank you for joining us for Covance’s fourth quarter 2008 earnings teleconference and webcast. Today, Joe Herring, Covance’s Chairman and CEO, and Bill Klitgaard, Covance’s Chief Financial Officer, will be presenting our fourth quarter financial results. Following our opening comments, we will host a Q&A session. In addition to the press release, 22 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 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 to turn it over to Bill Klitgaard for a review of our financial performance, which begins on page 4 of the slide show.

Bill Klitgaard

Thank you and good morning.

Net revenues for the fourth quarter were $439 million, an increase of 6.7% over the fourth quarter of last year. Full-year net revenues were $1.73 billion, which is up 11.7% over 2007. Excluding the impact of the sale of our centralized ECG business in the fourth quarter of 2007, revenue growth was 7.8% for the fourth quarter and 13.4% for the full year. The impact of foreign exchange on revenue growth was negative 420 basis points for the quarter and positive 100 basis points for the year. A full schedule of foreign exchange impact on revenue can be found in the appendix of the slide presentation.

Operating income in the fourth quarter was $64 million which is up 4.1% from the fourth quarter of last year. And full-year operating income increased 15.3% to $264 million. Foreign exchange rate variances negatively impacted fourth quarter operating income by $3 million and operating income growth by 500 basis points. Operating margin percent in the fourth quarter was 14.5% as compared to 14.8% in the fourth quarter of 2007. Full-year margins were 15.3% which is up 50 basis points year-on-year.

Net income, excluding the gain on sale on all periods, was $46 million in the fourth quarter which is down 2.5% from the fourth quarter of last year. Full-year net income grew to $194 million in 2008 which is up 13% over 2007. And finally EPS, excluding the gain on sale on all periods, was $0.72 in the fourth quarter, the same as the fourth quarter of last year. Full-year EPS was $3.03, up 14.5% over last year.

Note that our December guidance assumed we would have approximately $2 million of foreign exchange transaction losses in the fourth quarter. Actual foreign exchange transaction losses came in around $700,000, or roughly $1.3 million better than we expected due to currency movements in the last half of December. This provided an additional $0.015 of additional upside to our fourth quarter and full-year assumptions.

Now please turn to page five of the slide show. In the fourth quarter of 2008, Early Development delivered 49% of our revenue and Late-Stage 51%. For the full year of 2008, approximately 60% of our revenue came from the US, 13% came from the UK, 12% from Switzerland, 7% from countries within the euro zone, and the remaining 8% was the rest of the world.

Please turn to page six to discuss segment results. In early development, net revenue in the quarter was $214 million representing 3.1% growth over the fourth quarter of 2007. Full-year revenues were $845 million in 2008, an 8.6% increase over 2007. The impact of foreign exchange on revenue growth was negative 520 basis points for the quarter and negative 120 basis points for the year.

Operating income in the quarter was $46 million, a decrease of 11.1% over last year. This decline is attributable to a lower level of new product initiations, and increased project delays in the toxicology, clinical pharmacology and research product areas. Full-year operating income grew 4.8% to $205 million. Operating margin in the fourth quarter was 21.4% as compared to 24.8% in the fourth quarter of last year.

Full-year operating margins were 24.3% compared to 25.2% last year. Note that we expect operating margins in Early Development to decline further in the first quarter of 2009, likely into the upper teens range. In addition to a slower than expected start in January, this decline is due to three items we outlined in our December 18 call, namely the opening of the Chandler facility, our non-recurring transition candidates from Lilly which we received in the fourth quarter of 2008, and costs associated with the consolidation of two clinical pharmacology facilities.

Turning to Late-Stage development, net revenues in the quarter were $224 million, which is up 10.5% over last year. Full-year net revenues grew 14.9% to $883 million. Excluding the impact of the sale of our centralized ECG business, revenue growth was 12.8% for the fourth quarter, and 18.5% for the full year. The impact of foreign exchange on revenue growth was negative 300 basis point in the quarter and positive 320 basis points for the year.

Operating income for the quarter was $44 million, which is up 35.1% over last year. Full-year operating income was $170 million, which is up 32.8% over last year. Operating margin was 19.6% in the quarter as compared to 19.7% last quarter and 16% last year.

Please turn to page seven to recap the orders and backlog numbers. As we first presented last quarter, we are now including additional data, which further characterizes the impact of dedicated capacity agreements on net orders and book to bill. This should help provide greater transparency. As a reminder, the computation for adjusting that orders starts with reported net orders, subtracts out any orders signed during the quarter for new or expanded dedicated capacity contracts, and adds back as an order the revenue recognized during the quarter from those dedicated capacity agreements.

On this basis, adjusted net orders in the fourth quarter were $567 million and $2.15 billion for the full year, resulting in an adjusted net book to bill of 1.29 for the quarter and 1.24 for the year. Note that we do have – we did have a multi year extension in one of our dedicated capacity contracts in the fourth quarter, which also expanded to include other Covance services. Currently we have dedicated capacity agreements in place with five clients, and those commitments predominantly reside in Early Development. Approximately 38% of our backlog falls within these agreements.

In the fourth quarter, we reclassified approximately $135 million of backlog from regular backlog categories into the dedicated backlog category, reflecting existing Lilly project backlog, which was rolled into and made part of our strategic collaboration. For the full year, total backlog increased $1.65 billion or 62%. Foreign exchange negatively impacted backlog growth by $30 million on a sequential basis and $34 million year on year.

Now please turn to page eight for a review of the cash flow. DSO December 31 was 37 days, near our previous historical level of 36 days, and a four day improvement over September 30 figures of 41 days. Cash at the end of the quarter was $221 million versus $209 million last quarter, and $319 million at the end of 2007. In the fourth quarter, operating cash flow was $113 million and capital expenditures were also $113 million, and that included a $50 million to purchase the Greenfield campus from Lilly.

For the full year, operating cash flow was $286 million and capital expenditures were $319 million, resulting in a $33 million use of cash. As we announced in December, we expect capital spending to decline to approximately $200 million in 2009, and free cash flow to be approximately $90 million, which assumes that we end 2009 with DSOs of 40 days.

Touching on the tax rate, the effective tax rate in the fourth quarter was 28.5%. For 2009, the effective tax rate is expected to be increase slightly to approximately 29%, largely due to changes in the geographic mix of our pretax earnings resulting from a stronger budgeted US dollar. Corporate expenses totaled $26 million in the fourth quarter of 2008 compared to $29 million in the last quarter and $23 million in the fourth quarter of last year. Full-year corporate expenses totaled $112 million as compared to $95 million in the prior year.

We expect corporate expenses to average between 6% and 7% of revenues going forward as we continue to make investments in infrastructure to enhance our ability to manage future growth. And finally a housekeeping note, the equity earnings line of our income statement no longer includes our share of the earnings of Bioimaging Technologies, as our ownership interest has fallen below 20%, and we do not have the ability to exercise significant influence over their operations.

Now I would like to turn the call over to Joe for his comments.

Joe Herring

Thank you, Bill, and good morning, everyone.

Before commenting on results, let me start by thanking Covance employs around the world who delivered on thousands of client projects in 2008. While the global economic downturn in the fourth quarter prevented us from ultimately achieving our revenue and earnings growth in 2008, extraordinary effort of talented Covance employees allowed us to deliver a number of strategic accomplishments this past year, including the signing of a $1.6 billion strategic collocation between Eli Lilly and Covance, the creation of sole-source central lab contracts with two top 10 drug companies, a 40% expansion of molecules in our program management service offering, clinical development selection as a preferred provider for two top 20 drug companies, and more than $19 million of incremental profitability from Six Sigma projects.

Moving on to fourth quarter results, let me start with early development. As we announced in December, fourth quarter demand for toxicology, clinical pharmacology and research products were below our budget due to a combination of lower new product initiations and a further increase in project delays. As a result, Early Development fourth quarter revenue grew 3.1% year-on-year, or 8.3% on a constant currency basis. While analytical chemistry had double digit growth, both toxicology and clinical pharmacology were down year-on-year and sequentially. And Early Development operating margins was 21.4%, down almost 400 basis points from the third quarter.

Due to the rapid Early Development market slowdown in Q4, we continue to get many questions regarding early January activity. Let me start by saying that in my 13 years with Covance, January and February are historically weak order months for toxicology. Budgets have not been approved and clients generally have not been – have not completed their study planning process for the year. With that historical perspective here are a very early report on Q1 activity.

In the first few weeks of the year, global toxicology remained soft, although order activity has improved in the last week. We feel like dedicated capacity agreements and program management strengths are helpful in this environment. In addition, clinical pharmacology and research products have not shown a rebound at this point. The net result is that we currently expect Early Development in Q1 to be somewhat below the levels we anticipated at the time of our December guidance call.

Regarding cost management, our historical experience of a slow January and February activity followed up by strong months has taught us to proceed cautiously before reducing toxicology headcount too early in any given year. Recruiting, training and retraining our highly scientific, operational and regulatory staff is no small task, and our staff is our competitive advantage. So we believe our current strategy of headcount reduction only through attrition, including not backfilling heads that are moving to Chandler, will provide us with needed capacity and a competitive advantage when the market demand returns.

Let me remind you the interim steps we are taking to manage costs. Tight scrutiny of all discretionary spending, managing headcount through attrition, that is only selectively backfilling up of positions, moving staff between sites and business units to improve utilization, consolidation of two clinical pharmacology sites, and a meaningful reduction in planned capital spending.

As we noted in the December, the transition of the Greenfield campus from Eli Lilly to Covance has gone very smoothly with no service interruptions for our anchor client. While we are in the process of finalizing our strategic plan for this important site, we have not yet begin marketing our specialty and non-GLP services to new clients. However, we did establish our Biomarker Center of Excellence in Greenfield.

We also named our business leaders Dr. Tom Turi, who joined us a few months ago from Pfizer, where he most recently served as Senior Director of Translational Biomarkers and Mechanistic Biology. In Chandler, we received our certificate of occupancy on January 15, so we’re right on track for initiating client studies in April. As we previously indicated, the Chandler site will be dilutive in Q1 as we incur expenses of staffing and validating this new facility without any associated revenues.

The second quarter will be slightly more dilutive than that as the building officially opens and depreciation begins, as well as continuing to increase staffing so that we can conduct studies from our anchor client that are contractually committed into that facility. As the year progresses and we perform more work at the site, including work from other clients, we expect results to improve with Chandler getting to breakeven levels in the fourth quarter.

In clinical pharmacology, results continue to be impacted by client delays of study starts. To help offset some of the reduced revenues, we’re consolidating our nine sites in North America into seven sites with the closure of our Boise and San Diego clinics, which are 12 and 36 beds respectively. Following this consolidation, our bed total will remain above 500 globally.

We have a one-time expense in Q1 related to this action, and as mentioned during our December call, the closure of these sites combined with the dilution of Chandler and the non-recurring fourth quarter transition payment in Greenfield, will impact first quarter results relative to 4Q by approximately $0.09 sequentially.

Finally, our program management offering which integrates multiple elements of our Early Development services continues to be an important differentiator for Covance. The number of molecules we are managing under this arrangement grew approximately 40% in 2008 to 355. We provided the data to support the submission of 39 IND packages for our clients in 2008, and we have been increasing our investments in this service with IP support and scientific and regulatory talent.

Now turning to our Late-Stage Development segment, results continued right on track in Q4. Revenue growth was 10.5% year-on-year and 13.5% on a constant currency basis. The sale of our central lab ECG business negatively impacted year-on-year revenues growth rate – the comparison of revenue growth rate by a further 240 basis points. Operating margins were 19.6%.

Our Late-Stage team delivered record new orders in the fourth quarter, producing a book to bill of 1.67. Trailing 12 month book to bill was over 1.4 for the third consecutive year in Late-Stage. Proposal volume in central labs and clinical in Q4 in terms of both number of proposals and aggregate dollar value were up significantly on a sequential basis as well as from the fourth quarter of last year. In addition, January central lab kit volumes are running ahead of budget and substantially above Q4 levels.

A key assumption for our 2009 EPS target includes Late-Stage backlog conversion to revenue consistent with past experience and that cancellations remain in line with historical levels. Outside of the strengthening of the dollar, we do not see any quantitative leading indicators which give us reason to challenge this assumption. For example, we have not seen a reduction in trial performance or unusual cancellations or project delays in Late-Stage development.

In clinical development, we have added three new preferred provider list in the last 18 months and we’ve enjoyed a greater percentage of work with these large strategic clients. Increased volume from these clients have certainly helped sustain order and revenue flow. In addition in our central lab, where we have a big window into Phase 3 clinical trials, orders have been consistently strong and kit volumes have been accelerating over the last few months.

I would like to focus in even more tightly on central labs for a moment. I’m very happy to announce that our central lab team won sole-source contracts with two top 10 pharmaceutical companies. These strategic contracts make Covance the sole provider of central lab services for these clients for seven years, subject to very limited exceptions. These contracts benefit our clients by reducing the time and effort they spend contracting these studies, and they are becoming increasingly convinced that Covance’s combination of global logistics capabilities, project management expertise, and therapeutic experience make us a partner of choice.

One particular point of pride is that one of these clients moved away from Covance due to price a number of years ago. To replace Covance, they learned that they had to work with multiple vendors. Following a series of mistakes, service gaps, and the additional complexity of multiple data feeds, they decided to designate Covance as their sole source provider. While both of these agreements are very strategic in nature, there are no annual volume commitments. So these are not dedicated capacity contracts for our calculation of adjusted net orders.

Looking forward, our consolidated operations – in our consolidated operations, we continue to expect full-year 2009 revenue growth to be in the range of 5% to 10% over 2008, and earnings per share to be in the range of $3 to $3.20. As a reminder, our targets reflect three key assumptions. Our first assumption is that foreign exchange remains at budgeted levels throughout 2009. This for our main currencies are $1.50 for the British pound, $1.30 for the euro, and $0.85 for the Swiss franc. At yesterday’s rate, this assumption now represents a year-on-year $106 million revenue and a $0.28 EPS headwind.

Our second target assumption is that Early Development revenue begins to pick up between the second and third quarters, with growth increasing to more normal levels towards the end of the year. While January is off to a somewhat slower start versus plan, we feel it’s premature to project from this limited data. We will obviously have a lot more color to share with you in April once client budgets are finalized, leaving the clients to talk about studies at SOT, and our Q1 order results are known. As just discussed, our third target assumption is that Late Stage backlog conversion continues on its current pace. The fourth quarter book to bill of $1.67 and increasing central lab kit volumes gives us comfort with this assumption at this time.

Looking to the first quarter, we believe revenue and EPS should be roughly in line with fourth quarter results before factoring in the $0.09 from the three Early Development items previously described. This is a few cents lower than our prior expectation and takes into account the slower start in early development, partially offset by some upside in Late-Stage.

So I would like to conclude my comments by saying that we recognized today’s economic environment is having an impact on our pharmaceutical client base in terms of lower revenue results and on the funding of our biotech clients, both of which may trickle down to lower R&D spending. When we set our 2009 budget, we estimated overall R&D growth to be about 1% to 3%, and we still feel that this is a likely outcome.

Because CROs remain an actionable and a strategic solution for improving R&D productivity, we believe that the demand for strategic outsourcing will continue to grow. We further believe that Covance’s broad services portfolio, our global footprint and our ability to create win-win strategic partnerships with clients will enable us to earn at least our fair share in this dynamic market over time.

Thanks you for your time this morning. I would like to turn it back over to the operator for questions and answers.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Our first question today comes from Randall Stanicky from Goldman Sachs.

Randall Stanicky – Goldman Sachs

Okay. Thanks guys for the questions. Just two, first Bill, then Joe, a bigger picture question, but Bill, there’s still $15 million from Lilly recognized in 4Q, and then as you think about the contribution that you have baked into the outlook for 2009, are we still thinking about an incremental $55 million? And then to the extent that you can maybe update us on some of the thoughts around margins, I think you did just over 21% in Early Development this quarter, how do we think about that trend as we move into the back half of the year?

Bill Klitgaard

I think the way we categorize the Lilly project is to talk about the ten years being $160 million a year on average, but it is kind of ramping up throughout the year. So the first few years, or the first year, is going to be a little less than that. The $15 million in Q4, therefore, if you multiply it by four, it would be around $60 million. I think we are looking at something which is greater than that in 2009, but it is going to be ramping up throughout the year. So I don’t we gave – I spoke to that number as I recall for 2009, but it should be ramping up above the…

Joe Herring

Well, Bill, what we said is 2009 looked like $150 million and that we gave them the credit for… so 2009 is $135 million, in minimum commitment, right. And the $15 million in Q4 was only Greenfield. There was obviously other Lilly volume in central lab and clinical and GLP tox and clin pharm that we have, had in Q4, and continue to have in 2009.

Randall Stanicky – Goldman Sachs

From a profitability perspective, does the margins on that business, does that ramp as the revenue comes in? I guess how do we think about the margin as the business comes in relative to what you talked about was low 20s I think for this quarter and the next ramping to sort of mid 20% operating margin range for the back half of 2009?

Bill Klitgaard

I think there is two or three things there going into the overall margins for Early Development. We mentioned in Q1 there is three items. First of all in Q4, we had Q4 08, we had a transition payment from Lilly which won’t repeat in Q1. Secondly we had the closures of two clinical pharmacology units in Q1, and third, we have the opening of the Greenfield facility in Q1. So all those will be pushing margins down. I think we indicated upper teens for Q1 margins in Early Development. But you’re right, it should be trending back towards more normal levels by year-end.

Randall Stanicky – Goldman Sachs

So that still the proper way to think about profitability?

Bill Klitgaard

I think so, yes.

Randall Stanicky – Goldman Sachs

Okay. And then, Joe, just a bigger picture question, the book to bill, 1.67, in late stage was, the 4Q was a lot higher than some of your peers who disclosed their levels of bookings. Is there something else going on here competitively? How do we think about the disconnect between what you guys put out versus what we have seen from some of the other companies in the space?

Joe Herring

Well, first of all, I think it is fair to say the number bounces around for all competitors in the industry, our industry. We, because of the nature of the contract and confidential, we haven’t talked about it all that much. But these preferred provider agreements are with very large clients who went from using 10 or 12 CROs and in two cases we are one of two. And we have executive committee meetings that manage that relationship. We have a lot more view into their portfolio, and it’s just a fast and more efficient process for our clients, and it channels a lot more work into Covance.

So certainly that’s a good guide and we didn’t talk too much about it at the time. We are just letting the performance of those in terms – flow through in terms of book to bill as well as revenue and operating margins over time. We’ve had very strong performances in central lab over the last several years, and while we have two sole-source agreements which by the way, neither one of these are Eli Lilly which were some of the guesses that people had last night, these are the incrementals, so you’d say three of the top 10 that are, close to top 10, are engaged in strategic agreements with Covance.

There are other clients that are inching up the percentage of the volume that they do with Covance central lab, whether or not we end up with a sole source or not. It is just way more convenient to use a company with a global scale and global capabilities of Covance. And keep in mind, central labs only represents 10% of the clinical trial, and so if you get 10%,savings on 10% of the value of the clinical trial, and the data thieves are all over the place, you have to manage five or six suppliers, and they don’t have global reach, and they don’t have – they just don’t – it just gets to be a real hassle.

So we like our competitive position in central lab, we are increasingly competitive with our clinical development team, and the fact that large companies can look at all the big players in phase 2, 3 clinicals and Covance comes out as strategic partners. It says a lot for the progress of our team in Late-Stage.

Randall Stanicky – Goldman Sachs

Do you think or did you have discussions with the pharma customers, are they talking about shifting business to some of the bigger CROs, are you seeing any change on that front?

Joe Herring

Well I think that has been a trend over the last at least three years, that clients who go on for global regulatory, they’re looking for access to patients in emerging markets, they’re looking for companies with big EDC capabilities, strong informatics, therapeutic depth. I think it is just very obvious, the big market share that all the large CROs are taking from smaller companies. At last count, there were thousand phase 2, 3 CROs in the world, that can’t make sense.

Randall Stanicky – Goldman Sachs

Let me ask just the last question and I’ll hop on this topic, do you see given the pull back in equity prices any strategic rationale at this point for horizontal consolidation in the space?

Joe Herring

No, I think there’s a lot more consideration rather than equity prices.

Randall Stanicky – Goldman Sachs

So no strategic rational or not much?

Joe Herring

No.

Randall Stanicky – Goldman Sachs

Okay, thank you.

Joe Herring

Okay.

Operator

Moving on, our next question will come from Jon Wood from Banc of America.

Jon Wood – Banc of America

Hi good morning. Hi, Joe. Can you give us a sense if you’re willing to talk about your exposure to Wyeth and Pfizer?

Joe Herring

I think the outsourcing profile of both of those companies are pretty well known. The deals that they have done have been very public so people understand those very well. And I think you have seen Covance’s names attached to much of that. You know both of them are – neither of them are top 10 clients for us, so I guess I’ll just leave it at that.

Jon Wood – Banc of America

Okay. And then the two big pharmas you signed with you exclusively on the central lab side, can you give us a sense of how large both these agreements are today, and maybe the potential opportunities from them becoming sole-source?

Joe Herring

I guess there’s two ways to look at it, Jon. One is orders and one is revenue. Orders from these clients – from one client, we have always done kind of 60% or 70% of what we knew. They have made acquisitions and brought in new companies that create new opportunities. So from an order standpoint, we will go from sort of 60% or 70% historically to something pretty close to 100%. And so I think it would be good for central lab orders over the next year. The revenue then is going to ramp over the next three years on that increment.

The other client historically used us a lot, went away on price, and orders men to (inaudible) for a number of years. Over the last one to two years, we have been increasingly winning a higher and higher percentage. I would estimate that over the last year, we won probably 50% to 60%, but that revenue again hasn’t really fallen through. So from an order perspective, it is already maybe in the 60%, 50% to 60% range, but in terms of revenue, as that ramps to near 100% over the next two years, three, maybe four years, then obviously that should have a nice impact on the P&L.

Jon Wood – Banc of America

Okay great. And then one last one quick for Bill, the DSOs clearly continue to tick down here, somewhat counterintuitive, is there a positive mix effect going on from the dedicated agreements becoming a larger part of the revenue, meaning do the dedicated agreements in general have better collection triggers built into them than just the core book?

Bill Klitgaard

I wish that was the case. No, I don’t think so. I think the DSO levels there and the improvement in DSO really has to do with contract terms and how our teams are working with the clients to help explain to them that we’re not a bank, we’re a service provider.

Joe Herring

(inaudible) was a record low in the fourth quarter.

Jon Wood – Banc of America

Okay, great. Thanks a lot.

Joe Herring

Okay, Jon.

Operator

Our next question comes from Eric Coldwell from Robert W. Baird.

Eric Coldwell – Robert W. Baird

Thanks, good morning. First on the preferred provider deals, I’m wondering, Joe, exactly what all those encompass, the three that you announced winning over the last 18 months, can you talk about the list of services you’re providing to those customers?

Joe Herring

Yes. These are phase 2, 3 clinicals is what the MSA contracts are for. Obviously Eric, companies don’t reach that level of commitment with a CRO without spending a whole lot of time. And one of the reasons why I think Covance made this shortlist is not only strong project performance on phase 2, 3 clinical trials, but also the fact that they see the benefit of combining the central lab, the IVR component, as well as our (inaudible). So it is a consolidated offering. So we see it have a positive impact across our Late-Stage service offering.

And one of them was the one we talked about. We talked about one of them in greater detail back in the first quarter of 2008. The other two had been relatively more silent on it because it is not dedicated capacity and committed volume, and we thought it would be better to have the book to bill and revenue flow from those speak more than speculating on what they could be.

Eric Coldwell – Robert W. Baird

That’s fair. And are the two sole source central lab customers also included in those three preferred provider relationships?

Joe Herring

No, they are totally separate.

Eric Coldwell – Robert W. Baird

Oh, that’s great. Second question, clin pharm, obviously you have had some delays in 3Q, and then that work got pushed out into 2009. You had I think three or four big pharmas that you suggested had basically taken a wait-and-see approach on where the budgets were and maybe some other issues. What has been your conversations with those customers to date and do they still expect to bring some of the temporary discretionary work back to Covance at some point this year?

Joe Herring

Well, it is a frustrating situation, Eric, because one of the things that we try really hard to do at Covance is to become strategic partners with large clients who will have high flow and high ability to go from internal capacity to outsource. And these four clients that are using Covance in a very large way and are contractually committed and frankly on a very personal level committed to putting more work with Covance, have placed orders in the third and fourth quarter, continue to place orders in the first quarter, and so it is not an order issue, it is not a competitive issue, it is just that these noncritical path studies and changes in their portfolio and individual dynamics are going on in these companies are preventing them from locking down and starting these studies.

It happened very quickly in the fourth quarter, and as we said in the commentary, it is disappointing but we can’t – we don’t have a lot of visibility into when they are going to start those at this point in time. Some of them, a couple of them are going to start in the first quarter, some of them are pegging for the second quarter, and some of the them are saying, well, any time before the end of the year really works for us, and we will get back to you. So there is not a signal there for us to call it other than sort of flattish.

Eric Coldwell – Robert W. Baird

Great. Last question. With the slowdown activity in toxicology really globally, I don’t think it’s a Covance issue, it is a global issue, some of us have been a believer that perhaps demand for research models would decline at a somewhat lower clip or maybe not quite as fast, but at a pretty sharp clip. What are you seeing with your Covance research products business in terms of demand and unit volume pricing et cetera?

Joe Herring

Overall, it was actually up in the fourth quarter, but recognize that a lot of times clients buying inventory products at the end of the year. So I would say it is an artificial spike, it is more of a seasonal spike. In the first quarter, we see that down by couple of million dollars, maybe $3 million, but again that is sort of been our normal and expected range. In a couple of the critical species, our competitive position is stronger than ever, and I’m not calling anything off of that. It is just that we like where we are, and as demand comes back, I think we’ll be in good shape.

Eric Coldwell – Robert W. Baird

Thank you much.

Operator

Our next question today will come from Sandy Draper from Raymond James.

Sandy Draper – Raymond James

Thank you very much. Just a couple of quick questions, I think for Bill, and then maybe a bigger one for Joe. Bill, just want to make sure I understand, when you’re looking at the first quarter and then 9/10 of incremental costs are charged, is that included in the $3 to $3.20 guidance or is that something that you would expect to exclude?

Bill Klitgaard

It is included.

Sandy Draper – Raymond James

It is included, okay, great. And then second question, obviously the early stages trending a little bit below where you said you are targeted, but you maintained a revenue guidance. Just give us your thoughts there, is that more related to sort of currency and where there is sitting now, is just the strength of the labs and some of the increased visibility there, is there any one or two places do you think that’s sort of absorbing that, or is it more, you’re not going to micromanage that 5% to 10% range?

Bill Klitgaard

I think that’s more the case, too early to call anything permanently for the year. We do see slight weakness in Q1 relative to our expectations that were set at the time of the budget and at the time of the guidance call. It’s early development. We see strength in Late Stage development and on that we are sort of maintaining guidance for the year. We will see how things go, we will update you in April.

Sandy Draper – Raymond James

Okay. Thanks. And Joe, just, not looking for any specific names, I would love to get your thoughts on the likelihood of what your hear of additional pharma merges, and if you have a sense that the Pfizer Wyeth transaction may create a ripple effect and other pharma have to respond, or do you have any perspective on that? Thanks.

Joe Herring

Thanks, Sandy. We’ll first of all, I think if you go down sort of the top 10 or 15, there are some pretty large reasons why we don’t think companies will be involved in mergers. There are a couple that are fiercely independent and have poison pills and legislation working their behalf. I don’t think that is going to happen. There are a couple with really nasty change in control provisions, where if an acquired company takes over, one or few molecules actually go to another company, so that sort of wipes that out.

We’ve got a couple with massive patent expiries coming in terms of the impact on the company, buying the company right now, probably doesn’t make a lot of sense. We have got some biotech companies with very high P/Es, even in today’s market, which makes them sort of a natural hedge there. And so you work down through that list, and you go what is possible here, we have been talking to our bankers, we have been talking to our clients, and just looking at this ourselves. And our view is there’s maybe one more that could happen and the one that is most likely, not a big impact on Covance. Maybe there’s two, but there is more likely none. So I’m not a pharma analyst, nor is anybody at Covance a pharma analyst, but these companies are very important to us. And your question is very, very relevant. I just don’t see this as the tipping point, and Wyeth Pfizer is the beginning of some big industry consolidation.

Sandy Draper – Raymond James

Great, thanks for the perspective.

Joe Herring

Sure.

Operator

Moving on, our next question is from Greg Bolan from Wachovia.

Greg Bolan – Wachovia

Good morning, gentlemen. For Early Development, 4Q revenue was flat sequentially, yet margins declined sharply. I understand the headwind and the impact that had on margins, but can you help me understand any of the dynamics that might have caused such a severe decline in the operating margin?

Joe Herring

Well, it is largely related to clin pharm delays, maybe talk about weakness in some of the tox areas, particularly in Europe. We talked about some of the downstream impacts in other parts of our business. We continue to maintain our headcount just through attrition, just a combination of items.

Greg Bolan – Wachovia

I just expected a more I guess kind of tandem moment in revenue margin. So revenues being flat sequentially and actually up year over year, on top of the fact you obviously received a transition payment from Eli Lilly in the fourth quarter, I expected somewhat better margins in the quarter, and I was just basically trying to understand those dynamics.

Joe Herring

Yes. Well, I think we talked about this – I thought everyone understood, but without Greenfield, revenue was down about $15 million, right? So you have revenue coming in from Greenfield that was very helpful; but without that, there was a revenue decline.

Greg Bolan – Wachovia

Right. Okay, understood. And then more of high-level question, obviously multiple factors driving the delays in program decision on the Early Development side of things. Joe, as you speak to the folks at big pharma, have you run into any greater angst amongst executives, is there planning R&D budgets in the face of new administration and the associated changes in key positions like for instance a new FDA Commissioner?

Joe Herring

Yes, I think it is really too early at this point in time to know exactly what the administration is going to do and what the impact is. I think the bigger issue facing the suite of pharmaceutical companies are patent expiries and R&D productivity. And so I think it is less related to the new administration. While that is important, I think that is an unknown. So what is in their face, and it’s been in their face for the last several years is really expiries and low R&D productivity.

Unfortunately the CRO industry can be part of a strategic solution. I'm not going to say that pharmaceutical companies are; for example, Covance we can go from first in animal to first in human in 16, 17, 18 weeks at a fraction of their internal cost structure, why not more that. And if you want to make your cost structure more flexible, why not utilize CROs more broadly, so – but related to administration, I just think it is a little too early.

Greg Bolan – Wachovia

All right. Great, thanks.

Operator

(Operator instructions) Our next question today is from David Windley from Jefferies & Company.

David Windley – Jefferies & Company

Hi, good morning, gentlemen. Bill on – going back – I want to go back to the DSO question. Over the last couple of years, maybe three years, we have heard off and on from the industry that clients were paying less upfront, looking at payment terms, delaying payment terms within contract timing. You mentioned that we are not a bank comment, I wondered if you could provide a little more color on, do you think Covance’s relationships and perhaps some of these preferred provider relationships allow you to have those types of discussions or are clients in fact not say pushing the envelope as much as maybe we feared a year ago or longer in terms of trying to push out some of the milestone payments in contract?

Bill Klitgaard

Well, I think the answer is, it doesn't have anything to do with the size of the client as I was mentioning to Jon Wood. I think it has to do with managing the contract and I give credit where it is due here. People like Allison Connell [ph] in our clinical business and John Grant [ph] in central labs, they have been actively working this and trying to explain to our clients the nature of our cash flow and making sure that we end up more neutral. So that ends up in more upfront payments and it ends up in better contract payment terms and so forth. And all of our head of finance around the company are active in this. That is why DSOs improved. It is their effort.

David Windley – Jefferies & Company

And does the, the ending level, I think you mentioned that 37 is within one day of your record low, so is ending the year at near that record low, have any impact on where you see the average being in 2009, and what implication that has on your operating cash flow the assumption?

Bill Klitgaard

(inaudible) DSO roughly speaking is about $5 million of cash flow. And as we indicated, we are modeling for the 40 day DSO next year, $90 million of free cash flow. So if you want to change the assumptions in your model based on that, you kind of have the mechanics for doing that.

David Windley – Jefferies & Company

Okay, all right. Thanks. And Joe, on early development, the slowest start in Early Development is, is it mainly tox or mainly clin pharm or is it kind of across the board? I just not understand where those specific dynamics were?

Joe Herring

It is strong in chemistry, light in tox, light in clin pharm, and seasonally light in research products.

David Windley – Jefferies & Company

Okay. And the discussions that you're having, you mentioned I think to Eric’s question that the orders are still coming in, it is really not a function of orders or competitive position or anything like that, is the softness that you are seeing a continuation of these delays of noncritical path studies, or are there other dynamics at play there?

Joe Herring

In clin pharm, that was the answer I gave to Eric. It is continued orders and continued delays. In toxicology, it's a combination of the delays out of the fourth quarter. The clients aren’t having the budgets and plugging those in yet, and lower new orders from sort of at risk biotech clients, who as we said before, every month, we are used to getting to 2, 3, 4, 5 studies from clients we have never heard of, and that we do work, and we never get from them again, and then other clients come in that we never heard of and drop volume in. That 10% of our sort of revenue is obviously revenue basis down in terms of new order flow.

David Windley – Jefferies & Company

Okay. On the – as you move into the first quarter here, and you are moving a dedicated capacity client from Madison down to Chandler, and you've already commented about not backfilling some of that staff et cetera, I think you're also developing or bringing the Greenfield side along to be able to go out and sell some of those capabilities to non-Lilly clients. How do – are the functions or the capabilities different, so we need to think about those as different business lines, or I'm trying to think about how you're going to manage the available capacity that is coming on in Greenfield and the capacity you made available in Madison by the clients move to Chandler ?

Joe Herring

Well, first of all, the largest part of the cost structure, the Chandler facility, is going to be in payroll and related employee benefits. Of the 80 employees that we are going to have on board the day the facility starts doing work, 52 of those are internal transfers, and we're not backfilling those positions. That work is primarily going to be GLP toxicology initially. Over time, we will be bringing other IND enabling services.

The Greenfield campus is in totally different service lines, non-GLP toxicology, in vivo pharmacology, preclinical imaging, and I guess the non-GLP tox. So that will be a preclinical service line, much more aligned along lines of IND enabling as opposed to GLP toxicology which comes later and onco studies which are highly correlated to Late-Stage development.

David Windley – Jefferies & Company

Okay. And those are different than what is freed up in Madison? Madison and Chandler?

Joe Herring

Greenfield volume is very different than Madison.

David Windley – Jefferies & Company

Right. Okay. And then I guess a broader question then, if you were to think about kind of a matrix, the top 15 or so clients on one axis, and your service lines on another axis, and checkboxes where you have preferred provider agreements in place, how full is that matrix? And as you – I am sure your head of sales things about it something like that and where you can expand those, are we working along both continuing, say taking an existing preferred provider in clinical and expanding that up to other pieces and then adding in the top 15 where you don't already have?

Joe Herring

There's plenty of room for growth in both market segments.

David Windley – Jefferies & Company

All right, great. Good luck. Thanks.

Operator

John Kreger from William Blair has our next question.

John Kreger – William Blair

Hi, thanks very much. Two questions really in client consolidation. One, would you be willing to quantify what a combined Pfizer Wyeth would represent in terms of your revenue percentage? And then more broadly, if you think back to past combinations, can you just refresh our memory what is the impact that you‘ve seen when large pharma companies come together on your business, and conversely what the impact of any that you see when large pharma buys a smaller biotech company?

Joe Herring

The combined Pfizer Wyeth is less than 5% of our revenue, actually quite a bit less, Pfizer being the larger of the two. In terms of large pharmaceutical companies together, that has never been a material impact that I can remember on Covance in terms of order or revenue flow. I think most people know that Pfizer closed several toxicology facilities a couple of years ago, and I think most people know that a substantial portion of that did go to Covance, and that has worked out very, very well. I think that provides opportunities in the combined new company, to say, well, we have internal capacity and we have an external partnership with a large toxicology company in the world, that has worked very well for us, so I like that.

In terms of pharma companies bringing – purchasing biotechnology companies, I think we have seen a couple of impacts on the positive side. We have had a number of those acquisitions where we did program management. And pharma clients who did not use program management and outsourced on a tactical basis, looked at the time line to deliverables and the quality of the IND package that Covance did, and they were, wow, that is pretty impressive. That actually helped us in our Lilly deal.

In terms of on the downside, sometimes the biotechnology client may be developing five or six molecules, and once they are acquired, half of those may go away. But again on the number of projects we do across preclinical, it is not really a material impact. And I think looking forward, I would say that the Pharma internal capacity shrinking generally, and that may – it is likely to probably accelerate as they bring new biotechnology companies in, and they need to have the work done that I think that continues to favor the outsourced partner.

Bill Klitgaard

(inaudible) for Covance, we have a pretty diversified client base, so even if mergers happen, we don't really have an exposure that is more than 10% I think of any one client.

John Kreger – William Blair

Great, thanks.

Operator

Next question is from Todd Van Fleet from First Analysis.

Todd Van Fleet – First Analysis

Good morning. Joe, I was wondering, which segment of the market that you guys are serving on early stage would you kind of classify as being a little bit murkier or maybe a little bit less certain about what the future holds? Is it more the biotech customers, or is it large pharma? I would imagine that given what has happened over the last several months, macro economically speaking, all the change is coming to large the pharma, that there is plenty of reasons why you might want to revisit maybe sales and marketing strategy. So kind of two separate issues there, two separate questions, but I'm hoping maybe you can tie your answer together for both of those.

Joe Herring

Well, the biotech market is obviously softer because there is a percentage of that that depends on VC funding and VC funding has either dried up or the VC leadership of these companies have said, for example, your developing three molecules, in order to protect the burn rate, just develop two or just developed one. And so new orders from those clients has obviously dropped off. For large pharma, obviously, they have a tremendous need to get new products to market. And while the fourth quarter, sort of rationalizing and pushing out noncritical items was disappointing, it can't mar [ph] the future of the companies for ever.

So I think right now pharmaceutical companies are in the process of getting back to work in the new year and finalizing budgets and planning the studies that they are going to have for the year. So as I said earlier, in 13 years, January and February are always horrible months because you turn your backlog every 30 or 60 days. You're not hearing from your clients, they don't have budgets, they are not placing work. And then usually late February and into March, then orders just go through the roof, because now they have budgets, they want to get work started. It is just too early in the year to make that call and say, pharma is in big trouble, they aren’t doing any more tox, I don't believe that. But this is just not the time of the year to make that call with great certainty, but just based on our normal daily conversations with clients, we don't see any material change compared to historical.

Todd Van Fleet – First Analysis

So from a sales and marketing standpoint, then do you just kind of re-deploy some of those folks that maybe were going after some of the biotech business previously to maybe making inroads into other kind of maybe midsized pharma clients? Or do they go after maybe a level of biotech clients that maybe wouldn't have pursued previously? I'm just trying to understand you know where Covance is at within in kind of its understanding how it needs to develop or change its sales and marketing machine to really start making that top line move the way you need it to?

Joe Herring

Well, first of all, Todd, we don't have a very large sales and marketing machine. And so it is not a material move in terms of our cost structure or deployment, sort of in this environment. I would say the biggest change in our commercial effort over the last six months is tremendous increase in enquiries from companies who have either never outsourced or outsourced on a very transactional basis, who have seen the extreme client satisfaction with Covance dedicated capacity agreements and the Lilly deal, and they are being pressured by executive management to do something much more strategic and much more transformational. And we are – it is all hands on deck developing presentations and going to meetings but it is still very early. I'm not calling anything on this at this point in time. But a high percentage of our time is developing much more strategic solutions and ideas and analysis of what they can do to dramatically transform the way they are doing preclinical work. So that's where most of our time is spent right now.

Todd Van Fleet – First Analysis

Thanks for that. If I can get one for Bill, I'm trying to calibrate how quickly the D&A line is going to start ramping here into 2009. So if you spent $300 million or so in 2008 and another $200 million or so I guess in 2009, can you help us understand kind of the depreciable life of these investments, is it 40 years mostly for the PP&E or is it kind of on a blended basis maybe 30 years, just trying to quantify how quickly maybe we should ramp D&A?

Bill Klitgaard

I think, Todd, it jumped about $2 million in Q4 due to a number of factors. As you were saying, the 40 year assets coming into service, we will see some more of that when Chandler comes online. Also the pickup of Greenfield, and we had investments in infrastructure in terms of systems and things like that which have come online. So I would expect the $19 million level will jump up into the 20s during 2009.

Todd Van Fleet – First Analysis

Thank you.

Bill Klitgaard

Yes.

Operator

(Operator instructions) Our next question is from Douglas Tsao from Barclays Capital.

Douglas Tsao – Barclays Capital

Hi, good morning. Joe, I was just hoping you could sort of go through your assumption in thinking that preclinical will rebound between the second and the third quarters?

Joe Herring

So sort of looking at how many – what percentage of studies that are not critical path can be delayed, and how long they can be delayed, and so our assumption is really based on big pharma clients telling us when they see starting studies and a recognition that they can't delay them for ever. So it is largely based on that; I guess that's all I have to say.

Douglas Tsao – Barclays Capital

Then sort of baking that into that, any sort of assumption on a pickup in demand from smaller biotech clients?

Joe Herring

Well I don't think we are baking in a lot for small biotech clients. We're not calling. So I don't know why you would bake that in.

Douglas Tsao – Barclays Capital

Okay. And then also you indicated that the chemistry business was up very nicely in the quarter. I thought that was largely sort of correlated with the tox business. I was the sort of wondering if you could give us a little color around the mechanics on how why that would be up whereas the rest of your businesses were down in the quarter?

Joe Herring

Well, I think your assumption is maybe off. Not all of it is correlated to tox work. We have a nutritional chemistry business and as you read the paper everyday there is another food scare, and so that business had a good fourth quarter. We do bio analytical testing of samples in phase 2,3 clinical trials. We do immunoassay support work in clinical trials, drug metabolism work. So it is not necessarily tied to IND enabling work. And we also feel like we have been taking share in chemistry, so it is a good job.

Douglas Tsao – Barclays Capital

Okay. And then you know obviously you've indicated that toxicology revenues were a little down from the third quarter, how should we think about the sort of factors driving that relative to utilization versus price? Obviously not looking for specifics, just sort of direction with some color.

Joe Herring

Well, utilization was down ex-Greenfield, and so obviously that has an impact on margins. From a pricing standpoint, as we have said a number of times, there are a couple of clients that really like Covance, and we have in the past five years turned away $30 million to $50 million a year because we didn't have the capacity and they weren’t paying our prices and we turned them away. In this environment, we have capacity and we are surgically going after a couple of those clients who would like to use Covance and we're going to meet their price. That does not impact total pricing or the impact on pricing across the company in any measurable way. And there are a couple of areas where we have low capacity fill and we are aggressively going after that as well. But a large percentage, a very, very large percentage of our toxicology pricing is locked in contracts.

And I know this very well from early in my career, as we started improving in quality, I want to pass on price increases, and the contract people will come back and say, here is work that’s already started, here’s contracts that we signed, and… and what I learned at the end of the day is passing along a big price increase, even if you got it, would not have a material impact on that year’s earnings. And so now on the flip side, picking a few clients and a few studies on the margin and giving it a good deal to help fill capacity doesn't have a big impact on total pricing. And in fact, from a margin perspective, it will have a better impact on total margins by having higher capacity fill than that price trade off in the short term. So those are my comments.

Bill Klitgaard

I might add a little bit of color commentary there, the drop in revenue is due principally to volumes. And as Joe was mentioning, we want to maintain our staff, which is a competitive advantage for us. And so the incremental on the downside in that environment we're maintaining staff is more of an impact on OM than anything else. It is not a pricing issue, it is more the volume flowing through to OM rather than pricing effecting OM.

Douglas Tsao – Barclays Capital

Okay. And then just finally just one question, relative to the tox business, sort of even speaking within that, are you seeing sort of any particular strength or weakness relative to IND enabling studies, long-term (inaudible) studies, sort of nonclinical studies that support longer, even the longer clinical studies, clinical trials, if we think about all the different sort of numerous buckets. I was just wondering, are you seeing any noticeable trends or is it just sort of more broad-based?

Joe Herring

Doug, I don't have the facts in front of me, but obviously longer-term toxicology work is on the critical path for an NDA. And I know that our fill with that type of work remains high. But again a lot of those studies were already in flight, because they are two year and not (inaudible). But IND enabling work, there is a sort of blend there between not as many baby biotechs showing up, but also an increase in large pharma utilizing program management as well as large biotech specialty pharma and well funded biotech. So I just don't have enough information to conclude the answer to your question at this point.

Douglas Tsao – Barclays Capital

Okay, fair enough. Thanks a lot.

Operator

Our next question is from Ricky Goldwasser from UBS.

Ricky Goldwasser – UBS

Good morning. Can you walk us through what is the R&D growth rate for the industry that’s embedded in your guidance?

Joe Herring

As we said in our prepared comments, 1% to 3%. We do have September year to date R&D and R&D spend is on track for about $114 billion, actuals is $114 billion in 2007. And that is looking at 731 cohort companies, there is over 2,300 companies that have drugs in development that are not a part of that, and that includes companies where there is no financial data. That also includes a couple of top 50 companies that are private that aren’t in there , and there are companies that we're actually doing $20 million, $30 million worth of revenue this year in Late-Stage that don't appear in there. And so overall, we still think we have properly sized the total market. The growth rate I think in 2008 is going to end up being a little higher than people think, or have been projecting, but in our guidance for 2009, we have 1% to 3% revenue growth.

Ricky Goldwasser – UBS

And just for us to compare, what was the embedded growth rate for 2008?

Joe Herring

Well, we don't have the final numbers yet, but it is going to be more I think in the 6% to 8% range.

Ricky Goldwasser – UBS

And was that the rate that you factored in in your 2008 guidance?

Joe Herring

We actually didn't factor it in in 2008. Again, we have had 30 years of 8% to 10%.. And going into 2008, we felt like it would be in that range. It actually came in probably – it is going to come in somewhere towards the lower end of that range, and it was not something we had factored in specifically, because we do some very, very small percentage of R&D. It is just that we try to take that a little bit more in consideration as we look at not only 2009, but as we look at our capital structure and capital spending for the next five to ten years.

Ricky Goldwasser – UBS

Okay, thank you.

Operator

And that is all the time we have for questions today. Mr. Surdez, I will turn the conference back to you for additional or closing remarks.

Paul Surdez

Thank you, operator, and thank you everyone for your time and wealth of questions this morning. If you should have any follow-ups, I am available all day. Thank you.

Operator

And that does conclude our conference call today. Thank you all for your participation.

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Source: Covance Inc. Q4 2008 Earnings Call Transcript
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