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Executives

Joe Herring – Chairman & Chief Executive Officer

Bill Klitgaard – Senior Vice President & Chief Financial Officer

Paul Surdez – Vice President of Investor Relation

Analysts

Greg Bolan - Wells Fargo

Ross Lukan [ph] – Deutsche Bank

John Kreger – William Blair

Bob Jones – Goldman Sachs

Douglas Tsao – Barclays Capital

Todd Van Fleet – First Analysis

David Windley – Jefferies & Company

Eric Coldwell – Baird

Jane [ph] – JP Morgan

Isaac Ro – Leerink

Covance Inc. (CVD) Q2 2009 Earnings Call Transcript July 30, 2009 9:00 AM ET

Operator

Good day everyone and welcome to the Covance second quarter 2009 earnings conference call. Today’s conference is being recorded. Now at this time, it is my pleasure to turn the conference over to the Vice President of Investor Relations, Mr. Paul Surdez. Please go ahead, sir.

Paul Surdez

Thank you operator. Good morning and thank you for joining us, for Covance’s second quarter 2009 earnings call conference and web cast. Today Joe Herring, Covance’s Chairman and Chief Executive Officer; and Bill Klitgaard, Covance’s Chief Financial Officer, will be presenting our second quarter financial results. Following our opening comments we will host a brief 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 web cast, 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’ll turn it over to Bill for a review of our financial performance, which begins on page four of the slide show.

Bill Klitgaard

Thank you, Paul. Net revenues for the second quarter were $466 million, which is up $25 million sequentially, an increase of 6.7% over last year. Year-on-year foreign exchange negatively impacted revenue growth by 6.4%, or approximately $28 million due to the strengthening of the US dollar.

A historical schedule of foreign exchange impact on revenue can be found in the appendix of the slide presentation. At quarter end exchange rates, the negative impact on year-on-year growth rates and the strengthening of the US dollar peaks in the second quarter. It will still be ahead in Q3 and then will become a slight tailwind in Q4.

Operating income in the second quarter was $60 million, which was up $4 million from last quarter but down 11.1% from the second quarter of last year. Operating margin was 12.9%, which is up 20 basis points from last quarter, but down from 15.4% last year.

Below margin items, which include $160,000 of interest expense, $1.2 million in FX transaction losses, and $655,000 of gain on sale, in other words a net $746,000 headwind negatively impacted EPS by approximately eight-tenths of a cent.

Net income, excluding the gain on sale, was $42.6 million, which was up $2.3 million sequentially, but down 15.3% from the second quarter of last year. In total earnings per share, excluding the gain on sale, was $0.66 per share in the quarter, which is up from $0.63 in the first quarter and down from $0.79 last year. The year-over-year FX impact on EPS was a negative $0.07 in the second quarter.

Due primarily to the geographic shift in our earnings, we benefited from a lower tax rate of 27% in the quarter versus 29% last quarter. And there was a blended rate of 28% in the first half of 2009. We expect the tax rate to continue to be approximately 28% on a go forward basis.

Finally, we also had some M&A activity announced in the last few weeks. The first is the sale of our IWRS service to Phase Forward for $10 million. This business has generated revenue of approximately $5 million to $6 billion a quarter for the last 6 to 8 quarters. In our revenue pie chart, we have historically included these revenues with central labs and other.

The second, announced last night, was the acquisition of Merck's genomics laboratory in Seattle, Washington, and associated strategic service revenues pursuant to which Covance will recognize a minimum of $145 million of revenue over the next five years. Combined these transactions have a relatively mutual impact on the company's earnings and revenues for 2009.

In the second quarter of 2009, Early Development contributed 43% of our net revenue and Late-Stage contributed 57%. In the second quarter, 59% of our revenue came from the United States, 10% from the United Kingdom, 15% from Switzerland, 7% from countries within the euro zone, and the remaining 9% from the rest of the world.

Now please turn to page six to discuss segment results. In Early Development, net revenues declined 6.3% year-on-year to $200 million, but increased $7 million compared to the first quarter. The impact of foreign exchange on year-on-year revenue growth was negative $11 million or 540 basis points for the quarter.

Early Development operating income for the quarter was $27 million, a decrease of 50% over last year. Early Development operating margin was 13.6% versus 14.1% last quarter and 25.4% last year. The sequential decline in operating margin is attributable to the increased cost in Chandler as depreciation began, and we hired and trained staff, costs related to the retirement of the oldest building on the Vienna campus, and a lower level of study activity in toxicology. These items were partially offset by improvement in our clinical pharmacology, chemistry and research products businesses.

Turning to Late-Stage development, net revenues were $256 million, which is up $18 million sequentially and 19% over last year. The impact of foreign exchange on year-on-year revenue growth was negative $17 million or 740 basis points. In constant dollars, late stage development revenues grew 26.4% over the second quarter of last year.

Operating income was $66 million, which is up $9 million sequentially and 52.4% over the second quarter of 2008. Operating margins were exceptional at 24.6% compared to 22.6% last quarter and 19.2% last year. This marked a 200 basis point improvement over our previous record high level last quarter.

Both central labs and clinical development achieved record margins in the quarter. In central labs kit volumes again exceeded expectations and marginal profitability of the higher volume, coupled with a shift in mix towards more complex and highly priced tests led to the margin expansion.

Looking forward, we are modeling continued high levels of kit testing volume, albeit with some moderation from the typical summer slowdown, and return to more normal mix of kits, which we expect will result in margins trending back below this quarter’s level in the back half of the year.

Clinical development also delivered very strong second quarter results. Looking forward, we expect clinical development profitability to moderate somewhat in the back half of the year due to increase in planned staffing levels, in order to service higher study activity projected in Q4 and into 2010 coupled with the typical summer seasonal slowdown.

Turn to page seven please to recap the order and backlog numbers. Adjusted net orders in the second quarter were $516 million, representing an adjusted net book-to-bill of 1.11:1 for the quarter. The company’s backlog at June 30 grew 55% year-on-year to $4.66 billion, compared to $3.01 billion at June 30, 2008, and it is up $240 million from the end of last quarter. Foreign exchange helped sequential backlog growth by approximately $85 million.

The $145 million minimum contract commitment from Merck, which was signed at the end of June, is included within our reported backlog. However, like other dedicated backlog this win will be recorded as a component of adjusted net orders over time as the revenue is earned. So none of that $145 million order is included with our adjusted net orders this quarter. 37% of Covance’s backlog relates to contracted volume commitment.

Please turn to page eight for a review of cash flow data. Net DSO at June 30 was 41 days, compared to 39 days at the end of last quarter and at the second quarter of last year. Cash equivalents were $204 million compared to $190 million at the end of the first quarter and $196 million at the end of the second quarter of last year. At June 30, 2009, short-term debt totaled $58 million, as we paid down $22 million during the second quarter.

Free cash flow for the second quarter was $19 million, consisting of operating cash flow of $49 million less capital expenditures of $30 million. Year-to-date, free cash flow is a negative $12 million, consisting of operating cash flow of $59 million, less CapEx of $71 million. This is slightly lower levels of capital spending. We now expect full-year free cash flow to be approximately $85 million, and capital expenditures to be approximately $170 million. The free cash flow target for 2009 assumes DSO at 40 days at year-end.

Corporate expenses totaled $33 million in the quarter. We continue to make investments that will improve our ability to provide and strategic partnering and integrated services as well as investments in infrastructure to enhance our ability to manage future growth. And finally, we ended the quarter with just over 10,000 employees versus 9,879 heads last quarter driven by the growth of our late stage services.

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

Joe Herring

Thank you Bill and good morning everyone. Speaking on behalf of Covance employees around the world, I am happy to report that our business results improved nicely from Q1 with sequential revenue growth of 3.8% in early development and 7.1% in late stage. Operating margins also improved sequentially by 20 basis points.

Strong late stage results, a lower tax rate, and a slightly weaker US dollar enabled us to increase earnings $0.03 a share to $0.66. Both this revenue and EPS was a little ahead of our expectations.

Please turn to slide nine, despite lower demand in the early development market, you can see that our constant dollar revenue growth of 13.4% in 2009 exceeded all but one of the previous five years and is higher than the 5, 4 and 3-year historical average growth rates. So we remain a solid growth company during very challenging times. We remain a solid growth company based on the extraordinary talent of our teams, our world-class facilities, our relentless focus on service excellence and productivity improvement, and our success in building mutually beneficial strategic partnerships with our clients.

Covance commercial efforts were on track in the second quarter with Early Development orders increasing from the first quarter, and Late-Stage delivering solid orders with cancellations at the low-end of our historical range. Our adjusted book-to-bill was 1.11:1, which does not include the $145 million contract from Merck, which we signed at the end of the second quarter and announced last night.

Let me expand a little on this tentative agreement, which provides for an asset transfer of Merck’s Seattle base gene expression laboratory to Covance. If you remember our landmark deal with Lilly last summer, and that was a big step into discovery support services or the R part of R&D, and now we have added another exciting discovery capability to the Covance service portfolio. This world-class team of talented scientists and technology, formerly known as the Rosetta gene expression lab, is a well-established and highly respected pioneer in gene sequencing and gene expression analysis.

In fact, they built the largest genomic testing laboratory in the world. For the past two years, we have recognized the need to expand our genomic testing capability to support our clients’ discovery efforts in the development of personalized medicine. This asset transfer provided a faster and a superior entry point than either the buy or build options we're been considering. We are excited to build his business with Merck as our anchor client.

This unique contract provides revenue and profitability from day one to its five-year duration. We're also excited that we are marketing this important genomic capability to other clients.

So to summarize our second quarter sales results, we performed well in our traditional drug development market, and we continue to create novel outsourcing models, which allow to deepen relationships with our clients and enter new markets.

Moving now to our early development services. The 3.8 sequential revenue growth in the quarter was led by improved results in our clinical pharmacology services, some of our chemistry services, and in research products. These performances more than offset the revenue decline in toxicology, we have previously forecasted for the quarter.

On slide ten, we put together an analysis we hope will be helpful to investors as they think about where we have been and where we are headed in our early development business segment. This slide bridges our various strong results, which we reported in the third quarter of last year to our results during the first half of 2009 with emphasis on the factors impacting operating margins.

As you can see the margins have declined from 26% to 14%, and have broken down this 1200 basis point margin decline into two buckets, market factors and Covance operating decisions. Market factors include lower levels of demand from our biotech and pharmaceutical clients, the negative impact of foreign exchange translation, and pricing.

We estimate that the combination of these three items impacted our margins by approximately 500 basis points or about 40% of the total. The reminder of the margin decline can be attributed to Covance specific factors, which are the result of our operating decisions we have taken. This includes the one-time costs of consolidating two Phase 1 clinics in the first quarter, and the one-time costs associated with the retirement of the oldest building in our Vienna campus in May.

While the Vienna decision, which included the severance of about 90 employees and the transfer of another 30, we have realigned a portion of our cost structure in toxicology. Of course, we have also been reducing headcount through attrition and aggressively managing discretionary spending.

While the clinic consolidation and building retirement impacted margins in the first half, we expect them to provide a tailwind in the back half the year. Other operating decisions include the opening of our Chandler facility, which had significant start-up costs in the first quarter. Costs further increased in the second quarter as depreciation kicked in and higher staffing levels and training costs were incurred to open this new facility.

While we believe the biggest impact is behind us, Chandler is not expected to be profitable until the end of the year. So the back half expectation for Chandler is a significant improvement over first-half results, but still a negative impact on full-year margin comparisons.

Another Covance specific factor is the Greenfield lab, which will continue to impact the margin comparisons to the third quarter of 2008 as we build volume. We do expect some margin improvement in Greenfield as the year progresses, but even though Greenfield has had a lower margin percent in the reminder of Early Development, and is solidly profitable and accretive.

While we made a hard decision to realign costs in Vienna, improving orders and hard scheduled study starts lead us to believe demand is coming back in Harrogate, Madison, and Muenster. We also had dedicated rapacity toxicology clients, who are committed to reaching their contracted volumes by year-end. So in order to profitably service our clients and maintain their confidence, we are holding staffing levels above what is required for current study volumes. In addition, employees at all Covance locations including toxicology were given a modest pay rise in May.

While these decisions had a significant impact on margins, we are managing this business for the long term and we want to be in position to take market share as demand recovers. Again our improving order trends in toxicology, and a healthy sequential increase in study starts scheduled in the third quarter indicate we will need the staff we have maintained to service that backlog.

For the segment as a whole, we are forecasting a return to revenue growth and improvement in operating margins in the back half of the year.

I would now like to discuss Late-Stage development. Performance in this segment was again outstanding, featuring constant currency revenue growth of 26% and exceptional operating margins. Late-Stage operating margins grew 200 basis points from the record we set just last quarter to 24.6%. Orders although slightly off the record face of the last couple of quarters produced a book-to-bill in excess of 1.2:1 in the quarter, and helped us to maintain our trailing 12-month Late-Stage book-to-bill of 1.5:1.

We believe this was the best performance among our public late stage peers over the last year, and new orders are of to a very strong start in the third quarter. We ended Q2 with record outstanding proposals in central labs, and proposals in clinical development were near all-time highs. We are well positioned to convert at least our fair share of these opportunities in the back half of 2009.

In terms of the individual services, central laboratory grew revenue of over 8% sequentially on increased kit volume. We continue to see the benefits of the economies of scale and our automation investments as the drop through on the increased volume allowed central labs to deliver yet another record operating margin performance in the second quarter.

Our clinical development team also delivered very strong sequential growth of 5% sequentially and again for that record operating margins in the second quarter. (inaudible) from our strategic clients is at an all-time high, and we are seeing renewed proposal activity in the biotech client segment.

Commercialization services also exceeded our expectations in terms of both revenue and earnings during the second quarter.

Now please turn to slide 11 for a commentary on our forward guidance, due to the weakening of the US dollar and a slightly lower tax rate, we are upwardly adjusting our 2009 revenue growth target to mid-to-upper-single digits, and our earnings per share target to a range of $2.60 to $2.80 per share, and this of course is excluding gains on the sales of our ECG and IVRS businesses. These targets assumed foreign exchange rates will remain at the June 30 levels.

In terms of cycling, we expect third quarter EPS to be roughly flat from the second quarter due to summer seasonal factors in Late-Stage and higher corporate spending. We then expect an up-tick in earnings in the fourth quarter. So that is a view on the next six months.

For the longer term, we remain very optimistic about our ability to grow our business to expand the drug development outsourcing by our clients, market share gains, and by winning work in new market segment. To help you better understand our long-term view, I would like to share some information from our five-year strategic plan we are currently developing.

And our markets are not easy to characterize and it is easy to oversimplify or miscategorize our opportunities. Let me explain some of the important new onsets, which were described on slide 12. The traditional CRO market has its target of $100 billion spend plus on R&D by hundreds of public pharmaceutical and biotech companies. Of that total, we expect $74 billion was spent on drug development or just the D part of R&D, and approximately 29% of those dollars are currently outsourced.

From discussions with key clients, we believe up to 60% or perhaps 70% of those dollars could be outsourced over time. So this segment of the market could double in the coming years even if R&D spending does not grow. However, these official R&D figures do not include dozens of private companies who do not report R&D spending in any fashion. One of these clients place over $150 million in orders with Covance over the past year, and several others are meaningful clients as well.

This leads us to believe the R&D spending is billions higher than the official number we publish. We also believe that total global CROs will take market share as pharmaceutical companies narrow their list of preferred providers over the coming years. This is another way large, global CROs can go faster than R&D spending. In fact here at Covance, we have grown quite a bit faster than R&D spending for five consecutive years.

Another consideration is our discovery support service contract with Merck [ph]. Through these strategic relationships, we have clearly expanded into the services that are in the R part of the R&D market, which happens to be a $36 billion spend. This is a very large market and is right in our wheelhouse. It is also advantages for us to enter this market with an attractive cost structure, world class talent and facilities, large and committed anchor clients, and a market leadership position.

Just these two contracts will deliver approximately 100 million per year or 5% of our revenue in discovery services revenue for Covance, and that is before we sell anything to another client. And none of this revenue is derived from the $74 million traditional development market.

Covance and several of our competitors also enjoyed nice revenue streams from services that are not counted within R&D budgets such as pharmaceutical analysis, which supports manufacturing, (inaudible) services, Rx to OTC switch studies, reimbursement hotlines for patients, and post-marketing clinical research.

Finally Covance also has exciting opportunities to grow in other market segments which fall under FDA oversight like food safety and other product labeling issues, which are in the paper and on legislative agendas every day. It is very clear that the current system of testing only 1% of the imported food source coming into the US is insufficient. Covance is a highly respected leader in this space and we are investing to grow our business.

We also have emerging opportunities to serve clients who have not traditionally utilized our services such as developments of biosimilars and biobetters, work for the medical device industry, comparative effectiveness studies for the US government, work in support of the expanded NIH funding, and animal health research.

So when you total it all up, and as you can see on the right-hand side of slide 12, at the end of 2009 our revenues will be less than $2 billion, total R&D will be well over $100 billion, and $150 billion when you count the other market opportunities, I just described. By capturing only a small fraction of the large market opportunity we see for our services, we have grown Covance constant dollar revenues over 13% this year, even during these very difficult economic times. And we believe we will continue to drive double-digit revenue growth in the coming years by helping our clients expand the use of strategic R&D outsourcing, entrance into attractive adjacent markets, and earning market share gains.

Based on the quality of our staff, our facilities and our broad service portfolio, I like our chances. That concludes our prepared remarks. Operator, we would like to open up for questions.

Question-and-Answer Session

Operator

Thank you sir. (Operator instructions) And we will take our first question from Greg Bolan with Wells Fargo. Please go ahead sir.

Greg Bolan - Wells Fargo

Thank you. Good morning gentleman. So Joe, just thinking about your continued strength out of your central lab business, so how are you feeling about central lab capacity at this point? Are there any plans to expand or are you just able to facilitate demand with existing capacity?

Joe Herring

Greg, we have actually the most scalable capacity in the company as in central labs. If you think about it, a big part of that is logistics, and the freight carriers that we use can put many more kits in the bellies of those jets, so that is really not a problem. The automation investments that we have made in our kit production line as well as on the IT systems, where we can accession kits and get them into the laboratory, expand our capacity significantly.

The overwhelming majority of the tests that are time sensitive for our clients are run in almost wiped out fashion on very modern testing platforms, and so when you think about it, the bottlenecks are really building the databases or specific for each individual study and that is a readily expandable capacity, and the ability to open kits in the back of our facilities early each and every morning, you know, and certain of those are lower scale positions that we can add very rapidly.

So, you know, we can double the size of our central lab without any substantial capital investments.

Greg Bolan - Wells Fargo

Okay, that is helpful. And then in terms of actual deal with Merck, do you expect the revenue to flow evenly as in roughly say $30 million per year for each of the five years, and then secondly do you expect the Rosetta margins to reach early development type levels over the next few years?

Joe Herring

Well, Greg there is a couple of different pieces there. First of all, recognize that Merck is a very innovative company that invested in this technology. They saw the need for personalized medicine, and they want to be able to provide products that are either based on a personal genetic information of patients. So that is sort of a win for payors and a winner for patients if you have only taken a drug that you know is going to work.

So the contract is for a minimum volume of work, and I think the reason why they went to this contract with us as the volume is probably a little bit unpredictable and sort of lumpy. And so this minimum commitment again we think is the minimum amount of work that Merck will do. I don't want to go into the details for competitive reasons, but this is a very creative and innovative contract that guarantees margins the day we stick the key in the door, and it will remain solidly profitable throughout the contract.

Now we have been in discussions with four or five clients who have been asking us to expand into this service category over the last year or two, because they too see -- realize that this is important for the future, but demand for any one pipeline is a little bit choppy at this point in time. So I think this is clearly an easy outsource decision, if there is a quality asset that which you can outsource too.

The beauty of this talent in this facility is it is leading edge and it is the largest genomic laboratory in the world to have a proven track record, and so we think it is going to be very compelling for our other clients to look at this laboratory and say, “Wow, I would like to buy this kind of capability on a variable basis, you know, over the next couple of years.” And so then you have to factor in, on top of the unique contract we have, volume from other clients, and what that margin will be.

So I don't want to call it at any particular margin level today, but we do expect that we will be able to improve what is already going to be profitable in periods over time.

Greg Bolan - Wells Fargo

Thanks.

Operator

Thank you very much sir. Our next question will come from Ross Lukan [ph] with Deutsche Bank.

Ross Lukan - Deutsche Bank

Good morning and congratulations. In terms of the Early Development business, you started a number of markets factors, in terms of sort of one what surprised you in the second quarter relative to sort of initial expectations for this market for the year, whether on the positive or negative. And then sort of as we trend into Q3 in the back half of the year, where do you sort of have the highest degree of confidence and sort of an inflection point versus the parts that you would consider to be still the most murky?

Joe Herring

Ross thanks for the question. In terms of surprises in the second quarter, you know, we have predicted and forecasted lower revenues in the second quarter. So you know that really wasn't a big surprise for our toxicology business. You know the positive is that we have seen increased order volume. July has actually been surprisingly strong. So we really feel good about that. And then when you look at sort of the carrier analysis we provided on slide 10, I think you can see that there are a number of factors that weighed in the second quarter that will moderate in the back half of the year.

And so really when you think about forward margins for our preclinical business, I think you can see a pathway of how by year-end or entering next year we will get to a 20% range, but I think the other factors I guess I would like to share is the clients forward looks for toxicology studies. For the last five years they have been booking tox studies 6 to 9 months in advance, and they move around a little bit, but they were having to project that far in advance to be able to have capacity.

And in the current market, where there is excess capacity, people are calling with study starts literally 2 or 3 weeks down the road. So Q3, we think we have a strong line of sight to revenue and volume, and Q4 compared to even what we thought three months ago and certainly over the last five years is much fussier. And that doesn't necessarily mean we're expecting a bad outcome in the fourth quarter. It is just that clients are taking longer to make decisions.

So again net-net from a Q2 standpoint, we came in at or maybe slightly below what we thought in terms of toxicology, but we've pretty positive indicators as we look at Q3 or maybe a little more cautious about Q4 just because of the way the market dynamics are today.

Ross Lukan - Deutsche Bank

Great, that was helpful, and just one quick follow-up on the Late-Stage business. You made comments in the script about sort of RFP flow heading into 3Q, it certainly sounds pretty encouraging. You've taken quite a bit of shares into that market given sort of where your bookings have been relative to competitors. What do you think is driving sort of that level of interest both on the clinical labs side and the traditional business and just sort of you know, do you think that something more unique of this continued momentum you are seeing in your business are indicative of a bit of a market recovery in general.

Joe Herring

You know, this market is very large and there are a lot of moving parts that are very, very hard to predict. You know, we are trying to focus sort of what we do, and if you think about our central lab, we believe we have been taking market share in excess of three years just based on our book-to-bill compared to other organizations. What we saw three or four years ago is heavy purchasing involvement in central labs and there were some pretty aggressive pricing going on by new entrants.

And frankly we have a lot of clients who were burnt by placing what they thought was a commodity service capability on price, and if you remember Ross, we won a lot of what we call rescue studies. What we have seen over the last year are large pharmaceutical clients, who are saying, “Gee, I don’t need three or four or five central labs, you know, I need a sole source central lab, which we have a couple of those or we need an area, a primary and a backup.” And so I think that you know, sort of the dynamic and again because of the investments that we have made in logistics process improvement and IT systems, we've been able to scale up and ramp to that volume while providing our clients with outstanding service.

So I think this is a case of our very strong market position have continued to get stronger and clients are increasingly wanting to sort of narrow their purchases. So, you know, we like our chances. We've also been investing in support of the central lab in our biomarker development capabilities and we have expanded our footprint in terms of esoteric testing for efficacy, and so some of the business that we used to sort of form out, we brought in-house over the last couple of years and so we are insourcing in excess of 95% of the testing we do as opposed to you know, shipping some of that out. And frankly that's what really has given us the visibility to why we need to be in the genomics market in the bigger place.

So a long answer there, that is Central labs from a clinical development perspective. We have made substantial investments in talent, IT systems, and in informatics for planning clinical trials more strategically with our clients. As we shared in previous calls greater than 70% off all clinical trials being run by Covance are on or ahead of schedule and in excess of 90% with clients, who strategically partner with us.

So if you think about how do we create value for clients, making unrealistic promises upfront to win a study does not create value, getting on lower price does not create value, beating client deadlines for study startup, patient recruitment, and data reporting is how we create the most value for our clients. Meeting knowledge clients, you give them a choice between a 10% price discount or bringing the trial in a month or two months or three months ahead of schedule and allow them get to both market launch in peak market sales is a much better outcome, and the largest majority of the growth in our clinical development segment is with clients, who are not outsourcing before or clients who are expanding outsources based on the value proposition that Covance brought to them.

And so in that environment we think you know, we are still not number one, number two or number three, but we are taking share, we are signing long-term contracts with clients that we think, you know, they highly value and this has given us a chance to dramatically expand our global footprint, which we think will be important over time.

I hate to keep piling on here but, you know, if you go back to the gene expression laboratory opportunity, if you add on top of all of the value propositions I just gave you, the fact that we can help them develop strategies and capabilities for personalized medicine, then that further differentiates us because again no matter where you are in the world, more cost-effective healthcare is on every agenda and if our clients can increasingly develop new medicine that have evidence behind them that they work, I think that helps them in pricing and politics as well.

Ross Lukan - Deutsche Bank

Great, and congrats on the Merck deal, obviously genomics is something close to my heart. Thanks again.

Joe Herring

Okay Ross.

Operator

Thank you. We will now move on to our next question from John Kreger with William Blair.

John Kreger - William Blair

Hi, thanks very much. Joe just to kind of go back to the margin analysis that you addressed here, I think that was on page 10. The 700 basis point hit from the investments you have made, if you kind of look out let's say year-end, can you help us is that -- can you cut that half or can you eliminate it. How much of a change can we expect over the next couple of quarters in those more voluntary areas?

Joe Herring

Well John I won’t be able to give you specific answer, but let's just sort of walk through it. You know, Greenfield margins what we said is that you know, that will improve over time both growth with Lilly, our anchor client, as well as bringing volume in from other clients whom we continue to track new business to that campus. The Vienna building retirement was a one-time, you know, bad guy in the second quarter, so that will not repeat. The Phase 1 clinic closure was an one-time bad guy in the first quarter, and obviously that won't repeat.

The Chandler start up is really, you know, is volume dependent. You know, we had something along the lines of you know, $0.04 in the second quarter for that and as I said in my prepared comments, we expect Chandler to get to breakeven you know, as we exit the year. You know, obviously there is some possible variability around that, but you know, keep in mind this Chandler facility is the single biggest investment in the history of the company. It is a state of the art, ultramodern facility that wows clients, and it is right in the heart of you know, the biotech industry and we also have some other large West Coast clients, who are either contractually committed or who are wanting to contractually commit to that facility.

How fast that happens in the current market you know, remains to be seen but again based on the commitments that we have, we think we get to breakeven. That could dial up little fast or be, you know, little bit slower. And then finally the staffing levels above demand, I think John you know, our commitment to people in this company, we don't take laying off the specialized staff we have easily at all, and we believe that demand will recover.

We think our clients will continue to invest in innovation and R&D for new products, but we can't predict you know, exactly how fast that will happen, and we don't want to be overly optimistic but at the same time we want the clients to know that Covance is a company that maintains the staff that they know and trust and respect over time, and when they do get ready to return, it will be to a company that they trust and to people who they know as opposed to some hurry up, hire up, train up somebody that, you know, maybe they don't know. Maybe that is overcalling it, but that's how we feel about it and so how fast volume returns. I think it is pretty evident where we are and going to be in the third quarter, a little further in the fourth quarter, but we are hanging on to our staffs certainly at this point. So somewhere in there it is in between, you know, 0 and 700 basis point increase.

John Kreger - William Blair

Great, that's helpful, and a related follow-up question. If you think about the top of that slide, pricing, if you think about your more recent orders on the tox side, how would you characterize pricing, stable, getting better or still getting worse?

Joe Herring

I would say stablish. You know, keeping in mind you know, the stock market you know, despite what you know Channel Checks might say, you know, it's really not the majority or anywhere close to the majority of our volume. I think again slide 10 that you point to John gives you, I think, substantial new information and helpful information as to what the impact is on our margins and where that's coming from. Pricing is in the smaller of the two segments that we gave and is not even the largest factor in and therefore in the top of the page. So I guess that's what I have to say.

John Kreger - William Blair

Great, thanks very much.

Joe Herring

Okay John.

Operator

Thank you very much. We will now move on to Randall Stanicky with Goldman Sachs.

Bob Jones - Goldman Sachs

Good morning guys. It is actually Bob Jones on for Randall this morning. Thanks for the question. Looking at the late stage book-to-bill in the quarter, it looks like it was somewhere roughly around 1.2 to 1.25. As we think about the back half of the year, is this a fair run rate to use or do you think that this is a number that could improve going forward?

Joe Herring

Well, based on all-time record backlog in central labs, and I will tell you that July orders for central labs were a record July with a week to go. So that feels pretty good. Late-Stage has -- they are at or just a hair under all-time record proposals. So that tells me the demand for Covance services in Late-Stage remains very strong and it's just a question of how many of those decisions are made in the third quarter and the fourth quarter, but, you know, I would say book-to-bill would be, I guess at least that good based on those facts.

Bill Klitgaard

Bob, I like to just add one other thing. You know, we keep pointing out and I want to remind people that we think a better measure is a four quarter basis. We think quarterly variation is pretty wide and that if you look out on a four quarter rolling basis, you get a better sense of where the market is heading, and of course our numbers are pretty good on that basis.

Bob Jones - Goldman Sachs

That's fair, and then just one broader question. Obviously you guys have been at the forefront of strategic deals. Can you maybe discuss a little bit your methodology in evaluating these strategic deals? Maybe some of the internal hurdle rates you guys are considering especially in the current environment?

Joe Herring

Well, you know, strategic deals are not something you just make a phone call or drop in on somebody at executive level in a pharmaceutical company and push a button and, oops, it just shows up. You know, I think I've shared on numerous occasions you know, the top 20 or so, senior most executives at Covance are each assigned to an account for their career, and their job is to know the Ks and the Qs and the pipeline and as many executives they can know and they have been, you know, weighing in or making introductions and asking provocative questions and talking about strategic solutions these clients for, you know, for multiple years, and our goal was not to have executives doing any felony thing as to build our brand and share our know-how and how they really take assets off the books of a former company, and help them make their fixed cost structures more flexible.

And so you know, how these things happen is more related to longer term relationship building and then when they -- the platform gets hard enough. You know, they think of calling Covance and as we continue to add (inaudible) capacity agreements in toxicology as well as these asset transfers, I think we are building a track record and name recognition that we can get these things done.

In terms of you know hurdle rates, I think we have demonstrated track record of being good stewards of the corporation’s capital. You know, we were not interested in signing a deal that doesn't substantially exceed our weighted average cost of capital. We wouldn’t buy something that doesn't fit our strategic plans of how we want to continue to build out the breadth and depth of our service portfolio. We wouldn't take on an asset that's -- we don't think other clients would be willing to buy and you know, if you really think about it, you know, this is a very, very cost-effective way for Covance to continue to build its service portfolio as we said on favorable terms. We thank our clients and in the case of both Lilly and Merck, you know, we assume market leadership positions, you know, sort of the day we stuck the key in the door, but we've said, no to two or three other asset transfers in the first half of this year because they did meet the criteria I just laid out for you.

Bob Jones - Goldman Sachs

That's helpful, thanks.

Joe Herring

Okay.

Operator

Thank you. We will now take our next question from Douglas Tsao with Barclays Capital. Please go ahead sir.

Douglas Tsao - Barclays Capital

Hi, good morning. Bill, I was just hoping that you could provide some context in terms of the margin we saw in the Late-Stage business. You indicated that there is favorable study mix in the central lab as well as the benefit from incremental volumes. Just, can you give us a directional split between those two, you know, is a little bit more of one or the other.

Bill Klitgaard

You know, I think what we indicated in the first quarter of the year was that the study mix and volume were both factors, I think it is the richness of kits, if you will, compared to last year was still stronger in Q2, but going from Q1 to Q2, I think you would look at it as being primarily attributable to volume, not a shift in richness of kits.

Douglas Tsao - Barclays Capital

Okay, and then also we saw a fairly, you know, sequential increase in the corporate expense line this quarter. I was just hoping you could provide some, you know, color behind that as well as sort of your expectations in terms of where, you know that number should finish the year?

Joe Herring

Well, you know, I think we've said a couple of things that were from a thematic point of view, we are trying to increase our ability to be better at strategic partnering and integrating our services and really driving strategic outsourcing, and also we are making investments to improve our information technology. And so that are sort of the two themes that are driving this increase in corporate expense. But in terms of the dollars, if you look at the sequential increase, it was about $5.7 million between Q1 and Q2.

About $2 million of that relates to information technology expenditures, and another $1.3 million relates to people, costs including investments in our integrated drug development and strategic partnering areas. Another $1.3 is due to FAS 123 (R) and there is a bunch of assorted other things that go through there. You know, I think the current level at you know 7% of revenue you know, it's maybe a little higher than that. It is probably going to be something you'll see continue for a while as we continue to invest in our ability to integrate well with clients and drive strategic output.

Douglas Tsao - Barclays Capital

Okay, so we should -- the level we saw this quarter is probably a better proxy for the go forward rate than the first quarter that we saw, which was around the 6.24 level?

Joe Herring

Right, that's correct.

Douglas Tsao - Barclays Capital

Okay, great. Thank you very much.

Operator

Thank you. We will now take a question from Todd Van Fleet with First Analysis. Please go ahead sir.

Todd Van Fleet - First Analysis

Hi, good morning guys. I'm wondering if you could tell us how the minimum commitments that we have for many of your dedicated space agreements is playing into your outlook, in particular for the margin for early development for the back half of the year. I guess more specifically I'm wondering whether you expect minimum commitments to be met in Q3, and should we expect a meaningful kind of true up in the Q4 time frame, and then I have a follow-up on Early Development. Thanks.

Joe Herring

Yes, Todd. It is really not as binary as your question would suggest. You know, a number of those clients are well on that ramp. Couple are well ahead of that ramp, and the ones who aren’t on that ramp, you know, have monthly updates and sort of know what they need to do to get there. I mean, we don’t see anybody writing us a check at the end of the year if that's what you're suggesting. So I think that's my answer.

Todd Van Fleet - First Analysis

Okay. It has been a while since you kind of experimented with the prospect of moving more heavily, I guess, into China on the preclinical side with WuXi joint venture and such, and I'm just wondering since that time have you seen any evolutions in that marketplace that would make you want to perhaps move back in a more aggressive fashion or just trying to get a your sense as to how you see kind of the Chinese (inaudible) market place with respect to preclinical at this stage, and what your appetite is for getting back in that market?

Joe Herring

Well, first of all Todd, you know, we've been in China for a long time. Our clinical business is growing very rapidly there. Our central lab volume is ramping, you know, substantially. You know, they're getting the new lab we built a year or so ago there, you know, it's getting to the breakeven stage. Our bioanalytical lab there is growing very nicely and is approaching breakeven at this point, and we expect, you know, continued growth in China. In terms of more preclinical capabilities, I guess specifically tox, I would just say stay tuned. For competitive reasons, we won’t be able to make a comment as to where we are right now, but you'll be hearing more on that I think in the coming quarter or two.

Todd Van Fleet - First Analysis

That's helpful. Thank you.

Operator

All right sir. We'll now move on to David Windley with Jefferies & Company.

David Windley - Jefferies & Company

Hi, good morning. Thanks for taking the questions. Joe, congratulations on a really good quarter. The one area in Late-Stage that doesn't get a lot of lip service but has actually improved quite a bit over the last couple of quarters is the commercialization segment. I was hoping you could elaborate on some of the, you know, some of the business you've picked up or the drivers there.

Joe Herring

Well, as you know, David it's a smaller part of our portfolio. So we don't talk about it quite as much, but our reimbursement hotline business you know, had sort of gone through a lull, but we have -- we've had some competitive conversions that have been very helpful. Again, these are clients who sort of look somewhere else on price and I think saw the, you know, the impact on market uptake and insurance verifications at the beginning of the year, some of the things that may feel like a commodity but when we see an inability to either ramp the launch of the drug as fast as you can based on patient reimbursement or do the insurance verifications on a timely basis at the beginning of the year. It has a substantial impact on the revenue line, and so, you know, here again I think it's more you know, pricing in the short term creating a headwind, but quality of service and the talent of the team providing longer-term benefits for Covance. And so I guess in a word I would characterize as more around competitive conversions.

David Windley - Jefferies & Company

Okay, and I guess I would from a broader, stepping back to just a broader view, you commented on this a little bit already in terms of the people process in clients and focusing them on quality. As I look at Covance's results, on balance very strong set of data that stands out as a positive outlier versus, not versus, Covance's historical performance so much as the peer group, and I think what's unprecedented here is how much one company is separating itself from the group or the trend and you mentioned, I guess I'm trying to kind of bullet point in my head the variety of things that are contributing to that. I think you mentioned that a big driver of your backlog growth is clients that perhaps haven’t outsourced in the past and now have or didn’t do it very much. Is that -- did I get that correctly and if you could kind of elaborate on your thoughts on just kind of the macro picture, I'd appreciate it.

Joe Herring

Yes, there -- David we've been signaling strength in Late-Stage for the last three or four quarters, and I think you know, with the economic downturn nobody really wants to hear it, and we also signed a number of strategic, not dedicated capacity contracts, but strategic partnerships with clients in Late-Stage, where they set up what we like to call bake-offs in the back half of last year, and they narrowed from 10 or 12 providers to two. Three of those or actually two of those went from 10 or 12 to 2, one went from not outsourcing at all to preferred partners, and one went from 12 to 1, and, you know, we couldn’t call that an order, and they didn’t want to crow about something because it wasn't, you know, immediate revenue but what we signaled is we thought that that was going to give us, you know, strong and predictable revenue growth in good client relationships over time.

And so I think what you're seeing is that volume, you know, sort of washing over Covance and as you well know, we are pretty good at cross-selling and integrating our services. So, increasingly those wins include the central lab, and also some of the services that we have moved off our books but still strategically sell, you know, this is you know IVR, our ECG business, and so, you know, to me that is a very, very large I guess contributor to our success.

We also continued to invest significantly in our six Sigma program, which gives us productivity improvement, but more importantly I think what the client benefit is we continue to narrow the variation of the service delivery. So what they ask for, what they contract for you know, they get. So, you know, I can't speak about, you know, the broader segment. We try to characterize the market opportunity, but, you know, from our perspective we feel very good about where we are.

David Windley - Jefferies & Company

Absolutely. Well, it's clearly had some benefits, and I guess it is fair to assume that these clients where you have been on the winning end of these vendor narrowing efforts by the clients that those clients have kind of ploughed through this economic downturn, and I mean obviously by your win, we pushed out a lot of business. Can you say that they will perhaps not -- didn't react like some of the other companies in the space that we have clearly seen be affected by the economic downturn or does the perhaps kind of activity that they needed to push out the door because they were waiting on this vendor selection process to complete. I am just trying and get a little perspective on that.

Joe Herring

Yes, you know, Dave each and every one has a slightly different story. I wouldn’t necessarily say they powered through the downturn, and I would say the common characteristic is that they see that spreading your work around 10 or 12 companies and having purchasing drive, the selection of strategic partners, which is probably not a great idea and as they thought about outsourcing woes, you know, they become more strategic.

I think there maybe a couple of characteristics that may be helpful. One is we are doing more sort of typical (inaudible) pharm you know, clinical trials, you know, for these companies. We are not getting, you know, sort of the low probability scraps you know, that they may have used in more tactical outsourcing, and I think the second thing is just a little bit of good fortune, because I think cancellations of clinical trials you know, have certainly been talked a lot about over the last several months, and if it is a safety or efficacy issue, you know, the CRO sort of gets whacked, and I think we've just been – we have had a little bit of good fortune there.

David Windley - Jefferies & Company

Great, I appreciate the answer. So thanks a lot.

Operator

All right. Moving on we'll now take our next question from Eric Coldwell with Baird. Please go ahead sir.

Eric Coldwell - Baird

Thanks. Actually most of mine have been covered. Just a couple of quick ones, first off, did I hear a commentary that Chandler would be at breakeven at year-end or profitable at some point during the fourth quarter. Could you just clarify for me please?

Joe Herring

Yes and yes. It's a little bit hard to call. If you layer in the contract commitment and all those studies hold and you know little bit of volume from some other clients, we get to breakeven by year-end. You know, the cone of uncertainly around that is that it could be better than that or you know could be not quite so good, and I guess the other comment Eric I would tie to this is that for the past five years, our tox clients have been booking studies 6 to 9 months in advance due to limited capacity.

And now with slack capacity, you know, we are seeing clients booking studies, you know, two or three weeks in advance. So what we said earlier on the call Eric is that we have very good visibility in Q3. We have less visibility historically into Q4. And so, you know, the bottom end of the range that we put out today, I guess, allows some flexibility for Q4 would not be you know, quite as robust as we would hope. We are not signaling that. What we are saying is you know, our leading indicators aren't as robust they have been in the past and, you know, it could be better than what we have in our model or it could be a little bit less.

Eric Coldwell - Baird

Thanks Joe. Just to be clear, the leadership for the Merck gene expression lab, is that Deb Tanner? And I guess second follow-on to that is what are the expectations for bringing additional pharma clients into that facility in terms of -- is it something you would expect to do by year-end or sometime in the first half of next year or do you even have a game plan on selling outside of Merck?

Joe Herring

We absolutely will sell outside of Merck. As I said earlier on the call there have been three or four clients who have been asking us to provide these services and in fact, we have been in a build or buy decision making process for you know, approximately a year. So this particular asset transfer is a far superior and far faster entry point that anything that we sort of had in our mind. So we are going to rapidly -- I think we are set to -- we have a definitive agreement but set to close in the next couple of weeks, and we plan to get in there very quickly and build our commercial story and get back to these you know, these three of four clients who we know have a need.

And I think the issue here Eric is that I think all of our pharmaceutical clients thought this is probably a bigger opportunity several years ago, but they realize not every drug is going to have a easy clear-cut strategy to a genetic -- a personal genetic market that will impact you know, efficacy, you know, for a marketed product. But I think they all know that they need to build it over time, and have a personal medicine both in storing and capability, but I think it is very obvious to them that owning something that should only use on every so often basis at this point is probably not a good idea, and staying on the leading edge in terms of technological developments from Affymetrics and other tool suppliers is expensive and maintaining the staff is expensive.

So I think this is a capability that makes tremendous sense to buy on a variable cost basis, especially if you're outsourcing to what most people think is the pioneer and the world leader in genetic sequencing and gene expression analysis.

Eric Coldwell - Baird

And Deb Tanner is overseeing the group, but I suspect there is a site head or a specific division head that will be staying with the company. Do you have somebody you're bringing in just in terms of leadership? Could you help us out?

Joe Herring

Yes, let me just clarify. We are going to report this in early development, because it is a discovery services support, and yes Deb Tanner is going to provide the leadership and oversight, and a big driver for that is that Deb has been building an incredibly talented biomarker leadership team of PhD's, and one for sure have responsibility for these capabilities in one the largest pharmaceutical companies in the world. So he knows gene expression, gene sequencing extremely well, he knows how to apply it both in discovery and has a vision for you know, applying this to clinical trials as well. So scientifically it aligns with Deb’s biomarker development capability but for reporting purposes it will be in the early development P&L.

Eric Coldwell - Baird

Great Joe. Thanks very much. I appreciate the answers.

Joe Herring

Okay Eric. We got time I think for one more, two more.

Operator

All right, great. Our next question will come from Tycho Peterson with JP Morgan.

Jane - JP Morgan

Hi this is Jane [ph] for Tycho. Thanks for taking the questions. Kind of going back to the Merck deal announced last night. Could you give us more color in terms of what kind of structure you have picked up in the process, you know, in terms of number of employees as well as you know, number of sequencers and also kind of, you know, if you could provide us kind of your thoughts on opportunities outside of pharma such as in adjacent market such as academic or at bio for example?

Joe Herring

Yes, we are taking over the space that's there in Seattle. Frankly it has a largest footprint that's needed for the current volume of work. So we're doing a little bit of consolidation there in terms of square footage. The number of employees coming over somewhere in the 70 or 80 range. In terms of instruments, you know, we considered that confidential you know, as does Merck, but I think most people will either know or would suspect that, you know, there are more active instruments on that one cycle than any other place in the world, and so, you know, we have plenty of capacity, and plenty of capability, and as I just said in my previous question, you know, we are real excited about marketing this to other clients, and we think that there'll be a high degree of interest to commit and sort of see that lab, need the talent understand you know, their capabilities and again help our pharma clients see a way to make their fixed cost structure more variable.

Jane - JP Morgan

Okay, and if you could also comment on opportunities for academic as well as other additional markets, and also was there a competitive bidding process, either formal or informal, and if so, you know, what was exactly the advantage for Covance in genetic in genomic analysis capabilities?

Joe Herring

Well, we don't really serve as academic institutions except for very, very small segment of our business. Our clients are you know, pharmaceutical and biotech clients. So I guess we would have to think about that, but we think you know, the biggest value will be helping our clients move to more strategic outsourcing. The second part of your question I'm sorry was --

Jane - JP Morgan

Whether or not there is a competitive bidding process, either formal or informal, and whether, you know, what the competitive advantage was for Covance?

Joe Herring

No, you know, I think there were some initial forays into that, but I think it's, you know, the sort of relationship we have with the client. Our senior scientific team who knows and understands you know, the genomics market interacting with them. Just keep in mind, I shouldn't speak for Merck, but I would say more broadly for all of our clients, you know, we are talking about dealing with their intellectual property, we are talking about dealing with you know, potential, you know, new medicines that they're counting on you know, to grow their company and I think it was more about you know, which company knows and understands this asset, has an interest in growing this market and that has a credible offer, and, you know, I think what we ended up with was a very unique and very creative agreement that's a win for Merck, it's a win for Covance, it's a win for our other clients, and hopefully it is win for you know, patients around the world, as we help discover and develop more personalized medicines.

Jane - JP Morgan

Great, thank you very much.

Operator

Thank you. And our final question will come from Isaac Ro with Leerink.

Isaac Ro - Leerink

Hi, thanks for taking the questions. First off, could you just may be elaborate a bit more on the shorter lead times that you mentioned you're seeing in toxicology, and I'm wondering if that's entirely a function of the excess capacity in the marketplace or maybe you see a little bit more you know, impact from the price in fact that you're getting from competitors that might extend negotiation periods?

Joe Herring

Well, I think if you go back to, you know sort of the steady state, I mean clients really don't like to have to schedule toxicology start six or nine months in advance. The biggest reason why tox studies are delayed is because of problems in formulation and so, you know, having discovered that far in advance is not a natural state.

I think it expanded because of limited capacity in the industry and, you know, so I feel that the shorter lead times are just sort of getting back to what you know, a normalized flow would look like. So I don't necessarily read, you know, anything into that. I don't think it has anything to do with pricing in the marketplace. It's pretty easy to call up and get a couple of prices and the average value of a tox study is around $50,000, something like that.

So there's not a lot of -- there is no RFI, RFP, and the function of wrangling back-and-forth. It's pretty straightforward. So I wouldn’t relate it to that, but I would also say that you know, the 10% to 15% of our company that was emerging biotech companies, you know, lost funding and, you know, that reduced demand in the marketplace and freed up [ph] capacity, and some of the delayed decision-making by pharma, which we are starting to see firm up now, still isn’t back to the go-go days. And so I think somewhere in all of that tells you that study starts are not going to be booked six or nine months out any time soon, and that, you know, on a go-forward basis you know, we're not going to be able probably see quite as far as we did in the past. But we do think our clients are going to continue to invest in innovation, and we do believe R&D spending is going to grow over the next five years, and so we remain constructive on space.

Isaac Ro - Leerink

Great, thanks very much. Secondly on the Merck facility, (inaudible) is moving currently moving their core technology to a new platform. So I'm wondering if you could talk a little bit about the type of investment that might be required at that facility to get it up to sort of you know, industry leadership you know, levels?

Joe Herring

Well, I don't think we are prepared to share that information, but a part of our acquisition was to evaluate both the technology that was there as well as the coming technology, and we put it in our model for this acquisition. Where we thought the technology was going and the capital that would be required during this contract period to keep Merck on the leading edge, because that's important to them and that's, you know, that's within the model that we built for the acquisition.

Isaac Ro - Leerink

Great, thank you very much.

Operator

Thank you and that does conclude our question-and-answer session today. Mr. Surdez I'll turn the conference back over to you.

Paul Surdez

Thank you everyone for your participation today. If you have follow up questions, please feel free to call me later today. Have a great day.

Operator

And that does conclude today's conference call. Thank you for your participation.

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Source: Covance Inc. Q2 2009 Earnings Call Transcript
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