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Covance Inc. (NYSE:CVD)

February 26, 2013 2:15 pm ET

Executives

Joseph L. Herring - Chairman and Chief Executive Officer

Analysts

Garen Sarafian - Citigroup Inc, Research Division

Garen Sarafian - Citigroup Inc, Research Division

I'm Garen Sarafian, I'm an Analyst within Citi's Healthcare Technology and Distribution Team. Today we have Covance joining us. Here with us today, is Joe Herring our CEO; and also Paul Surdez, VP of Investor Relations. So today, we'll have a bit of a hybrid approach. There'll be a few slides with level setting, if you want us to, what Covance does, who they are. And then we'll sit down for the rest of the time we have. We'll have Q&A and audience participation as you'd like. Joe, do you want to start with the slides?

Joseph L. Herring

Yes, okay. Well, good afternoon, everyone. It's my pleasure to represent almost 12,000 Covance employees around 60 countries who helped our clients advance their important medicines through the marketplace. Some see our industry as roughly $25 billion in size and we estimate that the growth rate of the industry over the next 5 years is going to be somewhere in the 5% to 10% range, and we are clearly a market leader in this business.

Some of the statements I make that aren't historical facts could be considered forward-looking statements, so we've posted our Safe Harbor. In my comments, the actual results could differ materially and you can see this on our website if you have any questions.

So first of all is describing Covance. We're a company that has of a range of services that are a mirror image of a pharmaceutical, R&D organization, and we are unique in that perspective. On the left-hand side, you can see discovery and drug safety. And roughly 40% of our revenue in the red represents that segment. And so that would be before a drug actually goes into a patient, determined whether it's -- primarily whether it's safe and whether it's effective in non-human models. In the right-hand side, is to determine the efficacy in any post-marketing opportunities for the product. And there, we have our clinical and our central lab business.

In summary, Covance generates more drug safety and efficacy information on behalf of the pharmaceutical and biotech clients than anybody else in the world. If you think about our revenue attribution, 60% comes from our late-stage business, that are here in dark and light blue, and roughly 40% in early development. Let me talk about early development first.

Many people think of Covance, as a neuro development company. Because between the year 2000 and 2008, we generated the majority of our profits there, it grew at a very fast rate, we were gaining market share. But over the last 4 years, as pharmaceutical companies have focused more of their efforts on the late-stage side of the business, the demand for early development services across the industry is down about 40% or 50%.

Roughly half of that business was sort of caught up in this -- now what appears to be a permanent downdraft to the market. The other half of that 40% of our revenue has been basically sort of flattish. The challenge that we had over the course of roughly 3 years was trying to determine where the bottom of the market was, and we called it precisely wrong several times and had to continue to close laboratories, lay off staff, rightsize and to try to match supply and demand.

Last year, we had significant take out in our cost structure with the closure of our Chandler facility, downsizing our Munster laboratory by about 1/3 and taking in a very significant chunk of the overhead cost in that business. So in the first quarter of last year, that business generated 5.5% gross margin. After the cost actions in the third and fourth quarter, it was in the 12% and 12.5% margin.

So our forward look for that business is flat. In the last couple of years, we've said it would grow a little bit, and in fact, it was flat to down a little bit. So this year, we're forecasting it to be relatively flat with full year operating margins somewhere in the 11% range, a little lower in the first quarter, which is the historical pattern and then improving throughout the year as volume comes on or gets back to sort of fourth quarter levels.

On the right-hand side, our late-stage business represents 60% of our revenue and 75% of our profits. So a major change for investors who knew us 3 or 4 or 5 years ago, and we spent a lot of time talking about our early development businesses. Now, with 75% of the profits coming as well as superior growth and revenue, superior margins and superior return on capital. We spend more and more time talking about our Phase II, III clinical trials businesses, as well of our central lab, which is clearly the #1 central laboratory in the world.

In terms of net revenues, our company has grown revenue every single year despite economic downturns and credit market seizures and pharmaceutical pipeline issues and patent cliffs and all the other turbulence that the CRO industry has experienced. We have grown revenue every single year, and our revenue forecast this year is mid to high single-digit growth with majority of that growth coming from the late-stage businesses.

From an operating income trend standpoint, you can see the red bar is being early development, the rapid growth we experienced up until 2008 and then sort of bouncing along the bottom after that. And if we were only an early stage company, obviously, our fortunes would be very different. In the summer of 2006, we decided to make strategic investments in our clinical trial business, and we expanded from being in roughly 30 countries to 60 countries, we made IT investments, we made people investments, we made process investments. And then coupled with our central lab, which has about 40% market share and generates superior returns in the space, you can see the blue line, more or less, offset the downdraft in early development.

The other comment that I'd like to make when looking at this chart is the margin profile of the blue line, being late stage. Since that's 60% of our revenue and 75% of the margin, it's worthwhile recognizing the margin expansion. So back in 2006, that business generated about 15% or 16% operating margin and through the strategic partnerships that we signed and the growth that they brought, you can see the margins are in the 21% range this year, and that's even considering that we're making substantial investments in IT, which are about a 100 to 200 basis point drag. So even though a number of investors are concerned about strategic partnerships and the impact it had on the industry, particularly for our competitors, for Covance, it does mean accelerated revenue growth rate and margin expansion from 16% on an adjusted basis, call it 20% or 23%. And of course, that's without applying the corporate overhead cost which would dial all of those numbers down a bit.

So the late-stage business has on a 15% to 20% growth rate the last several years and certainly highlighted by our clinical trial business, that's been growing roughly 25%.

In terms of earnings per share, if you ignore the blue bar and just look at the last 4 years, you could argue that, that's relatively flat. And again, the attribution would be a significant decline in early development and a significant acceleration in late stage, generating net flat.

In 2012, even though we had flat EPS compared to 2011, that included about $0.25 in extraordinary IT investments, which will occur again in 2013. We're going to grow despite that headwind. And then in 2014, it becomes a tailwind of the company as IT goes from growing 11% a year to relatively flat. And if revenue continues on the 7%, 7.5% growth rate that we've been experiencing, then it creates a 20%, 25% tailwind in 2014 beginning in the -- roughly in the second quarter.

So the blue bar represents our guidance for 2013 in a range of $2.85 to $3.15.

In terms of adjusted net orders, suffice to say the last 5 quarters have been the strongest sustained booking performance in a very long time for our company, only one time prior to that timeframe did we sell over $700 million in a quarter, and we've now done it for 5 consecutive quarters, culminating in a book-to-bill of 1.37 in the quarter and for the full year last year, a book-to-bill of about 1.32. So we're very excited about this order performance. Because of delays and cancellations that characterize the type of business that we're in, we don't forecast off of these numbers, that if cancellations stay in the sort of historical range or even a little higher than that, then this would suggest that the late-stage revenue growth rate that we've been experiencing, could and should be sustained.

Then finally, our balance sheet, cash flow, CapEx, I guess, the comment here is we moved from a largely capital-dependent business that we were back in the 2005 to 2008 timeframe to a little bit more modest capital investment. 2012 and 2013 are artificially high because of the strategic IT investments that we're making, but we see a combination of higher cash flow, more modest CapEx, improving the return on capital profile of our company. So we're asked to make limited upfront comments. So that's my story, I'm sticking to it and I'm happy to take questions.

Question-and-Answer Session

Garen Sarafian - Citigroup Inc, Research Division

So just starting the question -- is the mic on? Yes, it's on, I hope. So just starting the questions, this year, Citi's theme is the value imperative. I mean, a little bit of a softball question, but just to kick things up, how do CROs and Covance, in particular, demonstrate value to your clients? And can you help us, how do you quantify to your clients?

Joseph L. Herring

Well, obviously on the backside of patent cliffs, our clients are trying to replenish their pipeline. And as they think about our new clinical asset becoming a new product, they worry that it takes too long to get it to market. And once it's in the market, they worry about the patent expiry and how steep the cliff is. And so the amount of time to sell underneath the patent is more and more limited, particularly with small molecules in western markets. So a real value driver for us is that we are consistently completing clinical trials for our clients, 3 months, 6 months, and 9 months ahead of schedule by using informatics and our expertise. So if you can think about the net present value of a molecule, if we get it to market 6 months earlier or 9 months earlier or beat a competitor to market and be first to market with a new category, then that is incredibly valuable. And particularly, when you compare it against what would be the value of another 5% discount in the trial, because you already have 5% off or being in the market 6 months sooner, I don't think there's any question that you want to be in the market sooner. And even though Covance in the clinical trial market is #5 in size, the independent survey showed that we're the most preferred and it's because of outperforming both time and budget requirements of the client. And the proof in the pudding is that our revenue growth rate has been superior to the industry and we've been expanding margins with accelerated revenue growth rate. So to me, it's crystal clear that, that's a value creator.

Garen Sarafian - Citigroup Inc, Research Division

Got it. And then given the environment today, you mentioned patent cliff, of course, and reimbursement models, the political environment right now. What are your clients saying to you in terms of the R&D spend, as well as what portion of that spend they're thinking of outsourcing to you guys, to your industry.

Joseph L. Herring

Yes, sure. It's been interesting in the last 3 or 4 years with pharma gearing the patent cliffs, taking actions to try to rightsize themselves, maximize their opportunities with billion-dollar-plus drugs that make 95% gross margin going generic. The most recent information tells me that most of our clients are on the backside of those patent cliffs now. And with the actions they've taken, they actually had a pretty good year. Most pharma stocks were up 20%, 25%. They're on the backside of the patent cliff, they've either diversified, some in-licensing, gone after cost structures. And it feels like the mood is changing. I would call this, they're not yippy skippy jumping up and down, but they're saying it's time to get back to work. So we haven't seen official numbers, but my belief is that R&D spending grew more in 2012 than anybody has forecasted. It could've been as high 6%. So that's R&D, we think D grew faster than R, and within D, development, we think Late-Stage Development grew faster than early stage development. So I'm estimating clearly, but what I believe is that the outsourced clinical trial market grew about 10% last year. And we believe that it's going to grow a similar amount in 2013. So when we look at our central lab in a constant dollar basis last year, we grew 10%. And that's better than the last couple of years, there were the last cancellations. But we basically held our market share, maybe took a little bit. The clinical development business though grew 25%. So even in a vibrant market, we took market share. So it just feels like, for now, that our clients are less living in fear and more trying to re-accelerate some growth and to capture market opportunity for their company.

Garen Sarafian - Citigroup Inc, Research Division

Got it. And you sort of implied this in your response that previously, you said that some of your clients don't really lock their budgets for the year until February timeframe. So given that was a couple of days from the end of it, I mean, how is it now versus what your expectations were a month ago?

Joseph L. Herring

Well, first of all, it's not like they locked their budget and then call Joe Herring next week say back up the truck. It's generally on a roundabout sort of a way. And so when we say roughly February, it's somewhere in February, maybe even early March timeframe. And when you know the budgets are locked, is when they start calling to place work. So if I break it into 2 buckets, so early development, the 40% of our revenue that falls into that category, I'm coming up on 17 years with the company. And every January and February, it feels like we're going out of business, nobody's placing work. Sometime in late February and into March, when orders start come in, you scrape by in the first quarter. And for that reason, first quarter revenues are always lower, margins are lower because capacities are not well utilized. And then it starts to ramp up in the back of March and into April and May. So that's sort of the normal pattern. So when and have budgets are fixed there, it's pretty important whether they tell us or not. Moving to late stage, the 60% of our business that generates 75% of the operating profit of the company, we rarely have those discussions. So, for example, in Phase II, III clinical, 88% of the revenue we expect this year is already in backlog and those trials that are already commenced and they're flowing along. What we're trying to get to and to approve now are orders. So I'll fill in a little bit in the fourth quarter instead of up 2014 and 2015. So we rarely have those discussions in late stage. And then of course, the central lab has that dynamic.

Garen Sarafian - Citigroup Inc, Research Division

And how is that 88% compared to prior years?

Joseph L. Herring

It's a little bit higher. I know we've had some competitors that give a lower number. But for our company, it's always been in the, if the business is doing well, in the 80% to 85% timeframe, I think the difference is, is we have got really strong orders at the end of last year and then the second thing is, we are taking some orders that have a little bit different profile over the last couple of years, and that is when a client says, "Look, we're going to give you this $100 million clinical trial but we want you to take 100 of our employees. We'll pay the defined benefit pension plan and sever them, do all the things we need to do, but we just would like you to take them." But we were going to have to hire people anyway. And so you get trained people, but then we bill them for that employee. And so you end up, if you had 200 of those employees coming in, that revenue's identified, because those employees are here. So a combination of things gets it up to 88%, which is pretty much the all-time high, but it's a good number.

Garen Sarafian - Citigroup Inc, Research Division

Yes, good. Switching gears a little bit, strategic partnerships, sort of a popular topic. In the past, I don't want to put you in a little pickle here, but in the past, you said that you wish the term strategic outsourcing would never have been used in this industry. So can you just elaborate? Is it because it's overused or less used or just because it's so ambiguous? Just elaborate on that and how...

Joseph L. Herring

Well, the generic term that people use to describe 2 very different things. So when we talk about a couple of partnerships that we've announced, it's 10 years in length, guaranteed minimum volume commitment across a wide range of services, there is an executive steering committee, there is CEO oversight, there are goals and objectives, and there's a genuine transfer to help Covance be a strategic alliance partner over a very, very long period of time, and that's a strategic partnership. On the other end, we've seen some announcements that were purchasing driven, 3-year price contract that to even be able to bid, you have to agree to 90-day payment terms, and they use a reverse Dutch auction process to get the lowest possible price. And then you have to agree to hire people to ramp up and take the work on your nickel. So just to make the compare and contrast, we announced Sanofi. We said at least $90 million of revenue, new revenue this year and at least $0.20 of EPS. So you do the math and tells you that's more profitable than the company average. The one over here was, we announced this big new trial, margins are going to go down by 50% to 60% for a number of quarters. And hopefully, over time, margins get back to where they are or beyond and that we're going to have a lot of revenue growth. And what we didn't say and then in 3 years, it gets rebid again. So it's hard to call, have one word or a couple of words that describe these 2, because they could not be more different. So when people saw some competitor's margins get cut in half or 2/3, then they said, "Boy, I don't like these strategic partnerships." When you hear one, run for the hills and buy later in terms from an investment standpoint. And so our strategy has been, beg our clients not to announce it. We don't announce it, we just show it to people in the P&L. So the reason why our clinical business has expanded margins and grown 25% revenue is because of the strategic partnerships. It's not we're asking for a year off of earnings and earnings -- margins are going down, it's 2 very, very different things.

Garen Sarafian - Citigroup Inc, Research Division

Yes, I know. Appreciate the clarification. So because not all partnerships are announced, could you give us sort of insider perspective as to the level of activity within the partnership? It's among industry participants overall, since they're not all announced. I say, what's going on relative to, let's say, 6 to 12 months ago, what the activity is?

Joseph L. Herring

I guess I'd start by saying, overwhelmingly, pharma's learning how to become a strategic partner. And so some have taken a big bite of the apple and they're sort of forcing themselves to learn how to be a partner. Others are, it's more procurement driven, and they really didn't have to support their organization. Their goal is to get a purchasing trophy and make their bonus, and that's an unfortunate situation. But I still think it's in the early innings. If you look at the majority of the volume that could come to our industry, it's not a strategic partnership, and a large part of the volume of the industry now, less than half of it is from really strategic outsourcing. But I look at it this way, Garen, it's taken 20 years to get to like 45% outsourcing in clinical development. But over the last couple of years, now, all the top 5 CROs have a much bigger clinical development footprint than any client, it's in the right geographies to accelerate patient enrollment and making investments in IT systems and automation, that we think surpassed what any single client is doing. So it feels like we're now the tipping point where outsourcing could actually accelerate. I'm not predicting that, but if you look at the ingredients in the pot, you could see it accelerating.

Garen Sarafian - Citigroup Inc, Research Division

And what's in distribution? I'm trying to just visualize the level of interest in partnerships, those have already partnered, of course, those that are laggard. But within the laggards, just visually, is it evenly distributed or how does it look like?

Joseph L. Herring

The guidance, having been in this industry said showed me once -- show me a pharma company and I'll show you one pharma company, that's it. They all -- we all have a different idea. But they're still, there's 800 CROs, and 5 companies have almost half the market. So it's still very, very fragmented and a lot of companies will have a primary, a backup and then a half a dozen specialties. I'd say that's best in class, there's still a number of them that still use 20 CROs. And every affiliate head in every country, picks their favorite sort of CRO. So I still see it as very much a forming market and from a strategic standpoint. But here's with what -- if I were the head of R&D of a pharma company, if I were the COO or the CEO of a pharma company and I was looking at my R&D cost structure, I would say, let's get to 80%. And the 20% that we keep needs to be some of the best minds in medicine and drug development and regulatory on the planet. They would need to understand mechanism of actions and the structure activity relationships, and a global regulatory compared with effectiveness. What used to be in the market? What are emerging trends? How do physicians practice medicine? Where -- or how do we penetrate emerging markets? A thousand people that knew that across 5 or 6 major disease states would create a lot of value. And then all the handle turning to get that done, I would do it with a couple of strategic partners that, no kidding around, it would be like they're part of our company. And so if cardiovascular, PCSK9s are hot for a couple of companies right now, you can't hire that mass of people in today's environment. So you don't hire them, you buy them on a flexible basis. If the trial blows up over 90 days, you help wind down the cost of the partner. But your CRO partners then can use it for some other clients and fill in that capacity relatively quickly. Or at the end-license of a drug that's in the category, that's not your historical wheelhouse, that's type 2 diabetes. Are you going to go hire a big class of people? No. Call in your CRO, they've probably done 10 of these in the last 3 or 4 years. Have them run the trial. And to me, accessing more novel medicines through small emerging biotech government academia, is going to replace the big research footprints that actually, weren't that efficient anyways. CROs are going to be the flexible structure and get it developed faster and cheaper. And then, to me, that's a big part of the answer to make pharma much more efficient. So people who have 1/3 outsourced or 1/2 outsourced, I think they're kidding themselves. Get to 60% and then get to 80%.

Garen Sarafian - Citigroup Inc, Research Division

So among the 7 of the top 20 pharma companies that you said you're gaining share, where you've been one of the top 3, who are you gaining share? Whose expense is accounted with other -- or with the other top 3, the other 2. The smaller CROs, in-source, any -- if you can give us a combination that you could be [indiscernible].

Joseph L. Herring

That's a good question. I don't know I have the exact answer. But the approximate answer is, the biggest share gains that we've had in our client is work that was done in-house, but that's now being outsourced and they chose us. And then, probably, the next biggest chunk is there are a couple of our CRO competitors who sort of went after a couple of really big accounts and soaked up all the resources and what they can beg and borrow. And there are some clients who felt a little bit behind and they preferentially chose us. And then the last piece would probably be some of the smaller subCROs in emerging markets.

Garen Sarafian - Citigroup Inc, Research Division

Got it. At this point, I have plenty of questions, but I'm taking questions from the audience. I think there's a one right there if you can get the mic.

Unknown Analyst

You mentioned about your margin on the development side, which is, I believe, less than 30%, if I remember correctly. What is your view about, including sum of high value, high-margin business inside the company? Specifically as an example, like medical imaging as a service within later-stage clinical trial. And the view is, are you going to continue using outside partners grow organically or acquire some of the existing CROs in that domain?

Joseph L. Herring

Yes. So for some of those type of services, it's sort of a make versus buy. And our belief is that buying it is much better than making it, because they're characterized by having high fixed cost investments, potential technological obsolescence, specialized staff, and I guess a number of investments that have to be refreshed to stay competitive. And we've made a conscious decision that, that's not where we want to invest and there are a number of high-quality providers there that we just scoop in and make a part of our proposal.

Unknown Analyst

You talked a little bit about the structure of the industry, how the top 5 have roughly half the business, but there's maybe 800 CROs. What's the value proposition of the bottom 400 or 500? What are they offering to clients? And why would a client choose to use them?

Joseph L. Herring

Well, obviously there's a lot of answers to that question, but if I can just smear it across a couple of things that immediately are obvious. One is there is certain geographies where a local provider has built up pretty substantial headcount and expertise in a market that the large global CROS are not yet fully penetrated in. So that would be one example. And then there's some very specialized areas. I won't tell you any current ones for competitive reasons, but one, maybe 5, 6 years ago, was ocular-based trials, the large public CROs. There weren't enough ocular trials to maybe warrant their attention, and there's some specialty companies who -- that's their background, maybe their founder, had a lot of expertise there. And then some of the rest of them really exist to give specialized sort of attention to really small companies who don't want to run a global trial. They want only to run a regional trial, west of the Rockies, as opposed to global registration. And if they get approval and they start to grow in the U.S., then they have maybe the wherewithal to become global. So it's more about regional expertise than headcount and some medical scientific specialties.

Garen Sarafian - Citigroup Inc, Research Division

Can you spend a second just talking about CapEx plans, again? You said they were coming down, but maybe give us a little history where they were? Where they're going and then maybe what your return targets are?

Joseph L. Herring

So we had these extraordinary IT investments that are in our CapEx right now. But let's just look on the backside of that starting in 2014. Something in the $120 million range, 20% sort of, and $40 million in maintenance. $40 million sort of in IT and $40 million for sort of growth initiatives. So that's a rough approximation. And from a return perspective, we're actually in sort of a transition. We've always sort of measured return on assets because it was a much easier calculation for us, and we're looking at some other methods of doing that. But suffice to say, I mean, currently, we're above our lack. And on the backside, the IT investments that we say on the growth rate we're on, I think we will improve our returns. On invested capital.

Unknown Analyst

[indiscernible] Okay, just fastforwarding to the competition. I wanted to just ask specifically on -- it's a 2-part question. One is, of course, it's about 1.5 years ago now that CPDI went private. And more recently, there's been one of your private competitors that filed an F1. So I'm just wondering, within the industry, as some of your competitors go private and others with recent anticipation of going public, what have you seen in your years of experience? Or how the changes the dynamics of competition, whether it be pricing, change of strategy, IT, what have you?

Joseph L. Herring

Yes. I can't think of any big watershed sort of change. For a company to go from private to public in the hands of private equity, a general rule of thumb is they're going to maintain or raise prices and cut costs. I mean, that's sort of their model. And I think that's held out. Going from private then to public, we haven't had much of that. But the company we're talking about is a reputable company, responsible company. They don't put much of their equity out yet, so they probably feel pretty good about where they are. But from a competitive standpoint, I can't point to a story where a company really changed their stripes either way they were public or private. And frankly, I'm shocked, but our clients rarely seem to care about that. And we've seen particularly clinical companies, really on the rocks financially, and the purchasing people in the client organization don't even do their homework. They don't even notice that they're crashing through bank covenants and or either going to go private or go out of business, they don't seem to care and don't do their homework. So I don't think clients look for anything all that different. Because most of them don't pay that much attention. And I haven't seen companies dramatically change their stripes whether they're public or private. A big company coming back into the market, I think brings a lot more investor interest. I mean, there used to be 15 publicly traded CROs, now there's 4. And one, it doesn't exactly look like the others from profile standpoint. So hopefully bring some liquidity and interest back in the space and a lot more data points would help people understand where there industry is and where it's going. Because in today's market, it's pretty tough. You've got a tough job man.

Garen Sarafian - Citigroup Inc, Research Division

How do you think that changes the strategy of the public CROs?

Joseph L. Herring

I'll just be speculating. For us, we know exactly where we want to go, and we know we're investing preferentially. We are delighted with our service delivery and client relationships that we're building on. And hopefully, some combination, the superior orders, the automation this IT is bringing, the success of our partnerships and getting our cost structure right in early development. Some combination of those working together, we look at the year, and particularly, into 2014 with the tailwind coming from the backside of those IT investments, we're happy with where we are.

Garen Sarafian - Citigroup Inc, Research Division

I think we should wrap it up there.

Joseph L. Herring

We've got 22 seconds left.

Garen Sarafian - Citigroup Inc, Research Division

I was going to ask for closing remarks, but I think you just gave them.

Joseph L. Herring

No, I gave them. I'm all done. Thank you, very much.

Garen Sarafian - Citigroup Inc, Research Division

Thank you. Have a good one.

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