Paul Surdez - Director of IR
Bill Klitgaard - Corporate SVP and Chief Financial Officer
Joe Herring - Chairman and CEO
Greg Bolan - Wells Fargo
John Kreger - William Blair
Eric Coldwell - Baird
Robert Jones - Goldman Sachs
Dave Windley - Jeffries & Company
Todd Van Fleet - First Analysis
Douglas Tsao - Barclays Capital
Sandy Draper - Raymond James.
Covance Inc. (CVD) Q3 2009 Earnings Call October 22, 2009 9:00 AM ET
Good day and welcome to the Covance third quarter 2009 earnings call. Today's conference is being recorded. At this time, I would like to turn the conference over to the Vice President of Investor Relations, Mr. Paul Surdez. Please go ahead, sir.
Good morning and thank you for joining us for Covance's third quarter 2009 earnings teleconference and webcast. Today, Joe Herring, Covance's Chairman and Chief Executive Officer and Bill Klitgaard, Covance's Chief Financial Officer will be presenting our third quarter financial results. Following our opening comments, we will host a 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 and webcast which are not historical facts might be considered forward-looking statements. Such statements may include comments regarding future financial results and are subject to a number of risks and uncertainties certain of which are beyond Covance's control. Actual results could differ materially from such statements due to a variety of facts including the ones outlined in our SEC filings.
Now I will turn it over to Bill for a review of our financial performance which begins on page four of the slide show.
Thank you, Paul, and good morning, everyone. Net revenues for the third quarter were $475 million, which is up $9 million sequentially and an increase of 8% over last year. Year-on-year, foreign exchange negatively impacted revenue growth by 3.1% or approximately $14 million. A historical schedule of foreign exchange impact on revenue can be found in the appendix of the slide presentation. At quarter end exchange rates, FX will become a tailwind going into Q4.
Operating income in the third quarter was $58 million, which is down $2 million from last quarter and down 17.4% from the third quarter of last year. Operating margin was 12.2%, which compares to 12.9% last quarter and 15.9% in the third quarter of last year.
Net income on a GAAP basis was $51.1 million and included a $5.9 million after tax gain on the sale of our IVRS business and a $2.1 million favorable resolution of income tax positions. Excluding those items on a pro forma basis, net income was 43.1 million, which is up $0.5 million sequentially but down 15.6% from the third quarter of last year.
Earnings per share on a GAAP basis was $0.79 per share and that includes the $0.09 from the gain on sale and $0.03 in favorable tax items. Excluding these items, EPS was $0.67 per share in the quarter which is up $0.01 from the $0.66 we reported last quarter, so down $0.13 in the third quarter of last year.
The effective tax rate in the quarter was 24.6%. This includes a tax impact of the gain on sale of business which was booked at a 35% rate and $2.1 million in benefit from favorable disposition of income tax items. Excluding nonrecurring items, the effective tax rate was 26.6% in the quarter and 27.5% year-to-date. Note that the 27.5% is the rate we expect to incur and sustain on a go-forward basis.
Please turn to page five of the slide show. In the third quarter of 2009 Early Development contributed 41% of our revenue and Late-Stage 59%. In terms of country and currency mix, 56% of our revenue came from the United States, 12% from the United Kingdom, 15% from Switzerland, 6% from countries within the Euro zone and the remaining 11% from the rest of the world.
Now please turn to page six to discuss segment results. In Early Development, net revenue declined 8.8% year-on-year to $196 million. The impact of foreign exchange on year-on-year revenue growth was a negative $7 million or 330 basis points for the quarter. Early development operating income for the quarter was $22 million, a decrease of 59% over last year.
Operating margin was 11.4% versus 13.6% last quarter and 25.5% last year. The sequential decline in operating margin is primarily attributable to a lower level of study activity in our clinical pharmacology and chemistry specifically metabolism areas.
In toxicology, revenues were up slightly and operating income was flat. However, recall that the second quarter of this year included the closure of a building at our Vienna campus. If adjusted for that expense, operating income in toxicology was down quarter-to-quarter.
Turning to Late-Stage development, in the third quarter central labs and clinical development delivered exceptional results exceeding our expectations. Net revenues were $279 million, which is up $13 million sequentially and 24% over last year. The impact of foreign exchange on year-on-year revenue growth was negative $7 million or 290 basis points. So in constant dollars, Late-Stage development revenues grew 27% over the third quarter of last year.
Operating income was $69 million, which is up $3 million sequentially and 56% over the third quarter of last year. Margins were a record at 24.7% compared to 24.6% last quarter and 19.7% last year. I note that we continue to forecast a slight different operating margin in the fourth quarter in the segment as we continue to hire new talent to service our growing backlog.
Now please turn to page seven to recap our order and backlog numbers. Adjusted net orders in the quarter were $623 million, representing an adjusted net book-to-bill of 1.31 to one for the quarter. Backlog at September 30th grew 12.8% year-on-year to $4.79 billion and that compares to $4.25 billion at September 30th last year, it's up $135 million from the end of last quarter. Foreign exchange helped sequential backlog growth by $51 million in the quarter.
Now please turn to page eight for a review of cash flow data. Net DSO at September 30th was 42 days, that's up one day as compared to the end of last quarter and compared to last year. Cash and equivalence was $266 million at the end of September and that compares to $204 million at the end of the second quarter, $209 million at the end of the third quarter last year.
At September 30th, short-term debt was down to $25 million and by the way, we expect to pay that off in the fourth quarter. As we paid off $33 million in debt during the quarter, free cash flow for the third quarter was a stout $88 million consisting of operating cash flow of $115 million less CapEx of $27 million.
Due to lower levels of capital spending, we now expect full year cash flow to be approximately $120 million and capital expenditures to be approximately $140 million. Free cash flow targets for 2009 assume DSOs will end the year at 40 days.
Corporate expenses totaled $34 million in the quarter. As we continue to make investments that will improve our ability to provide strategic partnering and integrated services as well as investments in infrastructure to enhance our ability to manage growth.
Finally, we ended the quarter with 10,170 employees which is up 169 from last quarter driven by the growth of our Late-Stage services business.
Now I'd like to turn the call over to Joe for his comments.
Thanks, Bill, and good morning, everyone. The breadth of our drug development service portfolio continues to be both a strength and a competitive advantage for Covance. In the third quarter, due primarily to project delays, Early Development results were below our forecast. However, our Late-Stage team exceeded expectations once again and positioned us to achieve the revenue and earnings guidance we provided during our second quarter investor teleconference.
A clear highlight in the quarter was our success in new business development led by another outstanding Late-Stage performance and improved orders in Early Development, adjusted net orders in the third quarter were a record $623 million. This was about a 20% increase both sequentially and on a year-on-year basis.
We feel Covance is gaining a greater share of the dollar spent on pharmaceutical research and development with the largest share gains coming through helping our clients convert in-house capacity to strategic outsourcing. On slide nine you can see that despite the challenges of 2009, our constant dollar revenue growth of 12.6 is tracking above the previous five-year average.
Moving now to Early Development services, we think the analysis on slide 10 will help explain the various puts and takes in our results between the second and third quarter. The largest contributor to the sequential decline in Early Development profitability was project delays within clinical pharmacology. The nature of these delays in clin pharm was not unusual. However, having these delays fall right on top of each other in a tight period of time significantly impacted our results.
Looking forward, the elevated level of project delays and cancellations in Phase I during Q3 lead us to forecast a further decline in clin pharm in the fourth quarter. Chemistry services, particularly our metabolism services also saw a sequential reduction in both revenue and operating margin. While our metabolism business is market-leading and has been running very strong over the past several years, we experienced a lower level of new order activity which impacted our results.
Finally, toxicology was also impacted by project delays as well as pricing mix. Revenue increased moderately and operating margin on a reported basis was roughly flat from Q2. But as Bill said to fully characterize the underlying operational performance of our toxicology business, keep in mind that Q2 also included the one-time cost related to the closure of a building on our Vienna campus. So, on an apples-to-apples basis, excluding the closure cost, toxicology operating income declined by approximately $2 million sequentially.
So let me provide a little more specific information to help bridge the gap between our actual Q3 results and the forecast we made during our July investor teleconference. Recall that we were confident of a sequential increase in toxicology revenue because of previously awarded studies that were scheduled to start in the third quarter. In other words, we were looking at work in hand.
However, as the third quarter moved forward, a number of those scheduled studies were delayed out of the quarter. While we're able to replace some of those studies with newly sold projects, the timing and the mix of these new study starts resulted in less than expected revenue generation in the third quarter.
Due to excess capacity in the industry, the lead time for clients to place studies has dropped from the historical level of three to six months to a month and sometimes less. Also, because capacity is more readily available, clients are more comfortable reshuffling schedule study starts. In this environment short-term forecasting has become much more difficult. As we look ahead, we are again seeing an uptick in schedule study starts for the fourth quarter. This is based in part on stronger September toxicology orders.
Let me take a minute to comment on toxicology pricing. In order to stay competitive, our average toxicology pricing has trended downward towards the pricing levels offered to our larger strategic clients. As the year progressed and more of the 2009 orders flowed through the P&L, we have seen an increasing impact on our margins.
In response, we've been making decisions on managing discretionary spending and only selectively backfilling employees who voluntarily leave the company. A good example is that 80% of the Chandler staff came from internal transfers from our Vienna and Madison labs rather than new hires.
Now I'd like to comment on progress with our new Chandler facility. We experienced increased revenues in the third quarter which helped reduce the startup losses we experienced in the second quarter. For the fourth quarter, we are projecting increased activity levels once again and even smaller operating loss. We've now had six non-anchor clients place pilot studies at the site and the facility just received a lack of accreditations with no recommendations for improvement from the auditors. Client feedback with our Chandler facility has been fantastic.
Moving to Greenfield, we just celebrated the one-year anniversary of our landmark collaboration with Eli Lilly. I think it's fair to say that both Lilly and Covance in public statements have talked about how thrilled they are with the success of this partnership. In the third quarter results in the Greenfield site improved sequentially and our roster of non-Lilly clients is now up to 13.
And here is an interesting fact. Since we entered into the agreement, only two clients have expressed any apprehension about placing work on a competitor's former campus. One of those clients have since supported four studies with Covance Greenfield and the other has just issued their first RFP for services at their site.
As you will remember, the Greenfield site bolstered the Covance service portfolio by adding some exceptional scientific talent and new service offerings including non-GLP toxicology, in vivo pharmacology and molecular and anatomical imaging. We have also added new service offerings now to the Greenfield site including nutritional chemistry and biomarker services and several other new service offerings are being planned for Greenfield. Headcount on our Greenfield site has grown to 325, which is a 25% increase since acquiring this site in October of last year.
So in summary, a number of our Early Development service offerings continue to be choppy and less predictable. While we do have some positive data points, like stronger toxicology awards in the month of September and a third quarter book-to-bill of approximately 1.1 to one, we are being more caution in our expectations until we see a sustained pickup in demand coupled with reduced volatility and study starts.
I'd now like to discuss Late-Stage development. Performance in the segment was again outstanding featuring accelerated revenue growth to 24% and operating margins of 24.7%, which exceeded the operating margin percent record we set just last quarter. Orders were up sharply from (inaudible) helped us maintain our trailing 12-month Late-Stage book-to-bill of 1.5 to one. Looking forward, our list of outstanding proposals sits at a new record level.
In terms of the individual services, Covance central laboratories grew revenues over 5% sequentially. The primary drivers were a slight increase in kit volume and a richer kit mix. The drop-through on this revenue increase allowed central labs to deliver exceptional operating margin performance once again. Earlier this month, we approved an $8 million capital investment to automate the kit return and processing function which is a large and predominantly manual process within the laboratory.
Our central lab team has produced new orders at a compound annual growth rate of 20% over the past five years and in 2009 our central lab order growth is slightly above that 20% average. We believe there is opportunity for continued success by taking additional share and client accounts that already use Covance as a preferred central lab, but not exclusively.
In addition, our current backlog contains projects with only 34 of the top 50 pharmaceutical companies. We clearly see opportunity to penetrate those 16 companies who do not work with Covance Central Lab.
Now let me share our clinical development business results. Our global clinical team delivered very strong sequential revenue growth of 10%, powering right through the summer slowdown we normally expect to see. In addition, our clinical team posted record operating margin and record new orders both in the third quarter and on a year-to-date basis.
To put their growth in perspective, our clinical development business is now bigger than our toxicology business and it represents 20% of Covance's revenue. Based on the continued strong new order performance and continued robust RFP flow from our strategic clients, clinical is poised for continued strong growth in 2010. To support this growth, we continue to invest in clinical development infrastructure including seven office expansions this year in emerging markets, new automation investments, new client reporting, IT systems and key talent hires. Suffice to say, we are very pleased with the continued growth and success of our clinical development team.
Commercialization results in the quarter were also strong led by market access services why we are seeing accelerated revenue growth and increased profitability. In periapproval, results are expected to slow down in Q4 due to the wind-down of several existing projects coupled with the impact of a cancellation.
Please turn to slide 11 to discuss our outlook. We are encouraged by the exceptional strength of our Late-Stage development segment which now represents almost 60% of Covance's consolidated revenues. In Early Development, overall demand has been lower than we expected and the timing of study starts has become less predictable. We are projecting relatively flat Early Development results until we see a sustained recovery in demand.
On a consolidated basis, we expect fourth quarter earnings per share in the $0.64 to $0.67 range, which will bring full year earnings per share to the low end of our previously targeted range of $2.60 to $2.80. Note that we will plan to give 2010 guidance on our fourth quarter earnings call in late January.
Now, before we open up Q&A, I'd like to recap the factors that have shaped our results over the past year and how these factors may affect our future. We've discussed how lower demand and delayed study starts have impacted Early Development as well as our strong performance across Late-Stage. We expect both of these trends to continue in the near term.
However, there are several market dynamics which hurt our results in 2009 but appear to be improving a bit. First, a stronger dollar dampened our revenue and operating margin performance over the past year. However, if the dollar stays where it is right now, this headwind becomes a tailwind for the next four quarters.
Second, biotech funding which has been anemic over the last year has begun to increase. Now, I want to be careful not to overcall this, but it's great to see some life back in this environment. And finally, having six top pharmaceutical companies tie-up in mergers during 2009 produced a bigger impact on decision making and study volume than M&A activity in the past. However these mergers are now completing and our discussions with these clients lead us to believe they will be getting back to work on their pipelines.
For the longer term, we remain optimistic about our ability to grow our business through expanded and more strategic R&D outsourcing, market share gains and by winning work in new market segments. We believe we're on the verge of a step wise increase in outsourcing, so we're maintaining the bulk of our Early Development capacity as well as investing heavily in talent, IT systems in geographic regions to capitalize on what we believe is a very compelling market opportunity.
Recent discussions with senior level contacts at our client organizations confirm that they see both the rationale and inevitable need to adopt more strategic outsourcing strategies. They also see the need to choose long-term partners who have a broad portfolio to help them make it happen. With our service portfolio and our team, I like Covance's chances in this environment.
Operator, you may now open it up for questions.
(Operator Instructions). We'll take our first question today from Mr. Greg Bolan with Wells Fargo.
Greg Bolan - Wells Fargo
Just thinking about Early Development activity these days and I realize this is an overly simplistic analogy, but it would appear to me that pharma has been fasting for a while now and need to consume in order a sustained life over the coming years. Joe, just thinking about outsource Early Development services as we lap the integration periods for pharm M&A deals, can you offer any color on outsourcing appetites for preclinical through clin pharm among biopharma exacts going into next year?
Well, Greg, as I mentioned, having six companies tied up in mergers is unprecedented, and so I think those companies, clearly, are going to come out of that and need to advance their pipelines. So I think that is a very significant factor. I also think that right now and over the next six to nine months, there are more decisions being made on fixed cost infrastructure in the pharmaceutical industry, at least as it relates to R&D, than any time that I can ever remember.
So I think sitting here today, it's difficult to call with certainty, but our belief is that outsourcing is going to accelerate. Keep in mind, 11 companies generate 50% of all R&D spend in this industry, and so to have six tied up, it is very significant. As they come out the other side, we think some big decisions are going to be made.
Greg, it's Bill. I just want to make one other comment. I like your thought about pharma fasting and I think it's clear that in the longer run, the pharma companies need to continue to invest in new molecule development and therefore the demand for Early Development services will be there in the long run.
Greg Bolan - Wells Fargo
Then just a quick follow-up. Joe, can you touch a little bit more on clin pharm this quarter? I mean, if I recall back on the second quarter call, clearly clin pharm had improved during the quarter. Just can you help me understand just the current dynamic there and any more color you can give in terms of the reasons for the extreme lumpiness, obviously knowing that this business is inherently lumpy?
Lumpy is the word and I guess I'd stitch it to unpredictable. Again, we had a much better clin pharm picture three-four months ago. There is no real trend here. There is a little bit of molecule failures. There is a little bit of delaying of portfolio decision of the client organization. It all sort of stacked right on top of each other and came in a very sharp, short period of time and is breathtaking. Again that will carry forward into the fourth quarter. As we have said before and the reason why we invest and you see other companies investing in Phase I in clinical pharmacology, it is that it's a very strategic point in the drug process. So I really can't give you much more color than that.
We'll now go to John Kreger with William Blair.
John Kreger - William Blair
Joe, can you give us an update on your Merck Genomics joint venture?
Well, as you know, John, it closed during the quarter and all the staff has been transitioned. We are working through a transition service agreement with them. The staff is largely intact. The volume is flowing through. We did promote someone from our central lab business, (John Grancy) to be the general manager of that business. He's moved out there working with John Williams who is the operational and in some respects the site manager of the site and it's all going well. We've had four client visits already. We have a couple of RFPs from external clients and Seattle is a nice spot.
John Kreger - William Blair
Then as a quick follow-up, realizing it's tough to predict at this point, do you feel like you've hit bottom in the early segment business or some of the pressures that you noted going from Q2 to Q3, might those continue in the coming months?
I think what we have said in the prepared comments, John, is that we're sort of getting out of the forecasting business in Early Development until we see sustained and consistent demand. I can't tell you how disappointing it was the first week or two in August to see studies in hand that were going to drive a nice pop in toxicology be pushed out. Again, you can bucket them up in three or four different ways and it's hard to look at any of those and say, well, that's going to absolutely continue into Q4 or Q1 of next year.
And it's hard to say that it couldn't actually decelerate a little bit more and that's the reason why we are a little bit more cautious even looking at the fourth quarter. So I just think it's best if we let revenue and OM flowing through the P&L be what we report to you and not a lot of forward-looking stuff.
Next is Eric Coldwell with Baird.
Eric Coldwell - Baird
Actually, I think Greg covered my main question on what the drivers of the lumpiness in Phase I and maybe metabolism have been if there was anything specific. But I guess shifting gears, Joe, several quarters ago, you were asked on a public call what you would do if tox and Early Development didn't show improvement over the longer term, and there was some suggestion that you might be a little more aggressive with cost-cutting and taking actions to help protect the bottom line.
We're now effectively a year into the slowdown in early stage for the industry and the margin did hit a new low this quarter. So I'm curious whether the company's attitude has changed at all regarding maintaining staff levels and infrastructure or whether we might see you get a little more aggressive with proactive cost controls over the next few months and just kind of how you're thinking about that philosophically.
To be honest with you, we continue to ask ourselves that question and sort of how we're thinking about this. First of all, we're not a toxicology company. We're a drug development company. And we don't necessarily run the business by looking at a trend line of numbers. Certainly that is one important factor, but there are other important factors. You don't have to look too far in the history to look at our clinical business and there was a lot of pressure from investors, particularly analyst to say, you know, your business would be a whole lot better if you were out of clinical and only did toxicology to get a higher multiple and all that good stuff.
We had bankers say and the only way you're ever going to get good in clinical is to buy somebody, so we'd like to help ourselves with some of that action. And we made a decision that, no, we were going to build it ground up with our people process, client philosophy, build in quality and that as we grew on the upside that it would be a good long-term decision for investors. In fact, that's played out.
We also look at our central lab. I mean, there was crushing pricing pressure back in 2003 when some competitors came in the market and thought this was a simple business and client said there is a blue light special. It really hurt us in terms of short-term gains, it hurt our margins but we managed our costs down in an appropriate fashion while maintaining quality over time.
The main competitor that was using price has now exited the business and that's certainly been an upside for us over the last two or three years as they melted and we sort of look at toxicology in somewhat the same way. The difference is we think there is going to be some very substantial changes in the fixed cost infrastructure of our clients and we could have flowed through another $0.04 or $0.05 in the P&L in the third quarter and in the fourth quarter by shutting down a facility or having a massive reduction in our capability, but we want to sustain our ability to be at the table and say what you're asking us to do, we have done it before. We maintained the staff. You hear what the client says about how happy they are and we have a facility to do it in.
I guess the last thing, Eric, and you know very well, is that our commitment to talent and the time that we spend training and developing the specialized talent we need is core to this company, and we're not like a manufacturing facility where we can lay off a bunch of hourly workers and they go on unemployment for a while and they are happy when we call them back. You know, these are people that take six months to a year to recruit and three to six months to even get qualified to touch a study and a year before they are good and three years before they create value for clients.
I know that sounds like mom and apple pie, but that's how we're running the company. So we're thinking of ourselves as a drug development company. We continue to try to build the strength across the portfolio. There are times when one of the kids seems to always be sick, but the breadth and the depth of the portfolio has what kept us on track and we're very disappointed, clearly, with Early Developments. Some things really surprised us, you know, over the last couple of months, but we're not in debt. We're not crashing into debt covenants and we're managing for the longer term.
So the short answer, Eric, is I don't see any big decisions coming out right now and I just hope that investors and clients are happy six months from now when we are helping lead what we think will be a step wise change in outsourcing.
Eric, its Bill. I just want to add this two thoughts for you. One is we did close one of the older buildings we had, or the oldest building I think we had in the Vienna campus. That's one action we took of reducing cost. We've also as we've mentioned during the call allowed attrition to happen without necessarily replacing all those bodies. So there are actions little bit more subtle perhaps than some of what our competitors are doing, but I think it's clear that we're still managing our costs closely even in this environment.
Eric Coldwell - Baird
No. I really appreciate that, Bill and Joe. And I guess my follow-up question, since, Bill, you brought up Vienna, is I understand there has been some thinking about what the mix and the focus of the Vienna campus should be and I'd love to get an update on where you are with some of those changes if you're willing to share them.
Yeah, I'll make just a quick comment, Eric, that development on reproductive talks as part of the ICH battery, it's a business line that we've tried to ramp up several times over the last five years and unfortunately it requires quite a number of animal rooms. Every time we sort of got going and ramping up new wins from clients, a more profitable primate study or an oncogenicity study would come along and the room would be given to that study. So it's been fits and starts for us.
But development on reproductive tox is a business that we want to become much more competitive in. That's where we have our scientific talent there in Vienna. We are making some nice investments there from a facility standpoint and from a talent standpoint now to make a sustained and persistent run at that specialty segment and the early signs are encouraging.
We'll now hear from Robert Jones of Goldman Sachs.
Robert Jones - Goldman Sachs
Just a follow-up on that, then, just so I'm clear. It doesn't sound like there is any major cost initiative decisions that would be underway related to the slowdown demand on Early Development. Are there any leavers in the P&L on the Early Development side that we should look for that could help sustain margins or help grow them from here given what they have done the last few quarters?
Well, none that we haven't already talked about. It's largely the biggest part of our cost structure is headcount, Bob, so we've talked about that. Obviously as Chandler moves now closer and closer to breakeven, you know, that sort of helps. I think there is some flexibility to look at the drop-through, if you will, the leverage on incremental revenue being pretty good if capacity utilization is at its current levels. To the extent that you do see recovery in demand, I think the drop-through, if you will, on incremental revenue will be pretty good.
Robert Jones - Goldman Sachs
I guess my follow-up going over to the Late-Stage side, can you discuss a little bit the difference on the clinical and central lab margins? Then how sustainable do you think these margins are at these levels going forward?
Well, we don't breakout margins between the segments, but I think you can see that the consolidated margin, the progress that we've made there, I think we directionally stated that central lab margins are stronger than clinical, but clinical margins are very strong based on a variety of factors. I don't know, Bill whether you have another...
Yeah, there is two themes I would bring up. One is in the clinical business, we've made a concerted effort over a long period of time to have close management of contracts and close management of work that we do. And that involves a lot of different things including, routine month-to-month evaluation of studies, how we're performing against those and because of that our ability to run those studies efficiently and on time has improved dramatically. And that's represented I think in the margin in improvement in clinical.
Secondly in the central lab environment, you know it all depends upon the kinds of studies you have in the queue. As we've mentioned in the past, we've had a pretty nice mix of studies with good richness, if you will, of kits flowing through and that helps margins as well. So both of those factors are at work I think.
Operator, next question.
Next is Dave Windley of Jeffries & Company.
Dave Windley - Jeffries & Company
I wanted to focus on a couple of slides. The last couple of quarters you've presented some slides to walk us through margin in Early Development and you've also presented this constant currency revenue growth slide. I think last quarter I made the mistake of looking at that margin slide for Early Development thinking if some of these one-time charges that you absorb go away, that margins ought to go up and not total appreciating other moving parts.
So I guess there is kind of two questions in this. Are there other moving parts beyond what you've discussed today kind of hidden in the Early Development business that we should be aware of that have also lost their predictability? And secondly, on the slide on nine, the constant currency revenue growth, is it safe to assume that you believe that this double-digit to low teens year-over-year constant currency growth rate is sustainable at these levels, at kind of 10, 11, 12% levels?
Dave, with our slides and our prepared comments, we tried to give you complete transparency to everything that we see. I can't think of anything else that you don't see. And in terms of the constant currency revenue growth, you know, as we said, we will give 2010 guidance in late January.
The one comment I would make in Early Development margins is kind of the flow through of work and it was alluded to in Joe's comments. And that is as you know, these are six to nine-month kind of contracts on average, and so if you're winning work in one environment, it will actually flow through to the revenue and profit you achieve a quarter or two later. So one of the things that's happening in margins here between Q2 and Q3 was essentially the maturation of the wins or the backlog, and so some of that flowed through. I think it's fair to say that now that looks to be more stable and if pricing environment improves, of course, that will turn around.
Dave Windley - Jeffries & Company
The other question I have, Joe, is just kind of talking about forecasting your comments about getting out of the Early Development forecasting business for the time being, I'm trying to understand dynamic a little bit. You more than I think anybody else in the industry really have driven conversations to pretty high levels in the big pharma clients to talk more strategically about what they want to do. I suspect that the study delays and cancellations that catch you off guard probably come from lower levels in those organizations in more tactical decisions in the short run.
I guess I'm wondering, is there an opportunity to fortify sales team dialogue with those middle people that might be making those decisions to get a little bit more up to the minute feedback loop to help you anticipate study delays and cancellations a little bit better, for example. And then the downstream question is if Early Development is weak now, it's going to take a while, but one would have to assume that later down the road, maybe years down the road, there is going to be a cycle in Late-Stage.
I think the real question is how do you make your business more flexible to be able and attentive to market indicators to be able to flex your cost structure so that you don't take these kind of margin hits in Late-Stage when that date comes like we have in early stage now. So that you're a flexible organization and you haven't just inherited the fixed nature of the clients you're trying to serve.
Well, first of all, on the short-term forecasting, you know keep in mind that at any given time we're doing over 6,000 projects in our Early Development business. So, if we had our sales team and our client service team routinely calling clients on each one of those studies, we would just spiral downwards. So I think that that's very difficult. You are correct in that there is a different level of decision making on short-term. It's not at the senior executive level. And so I think it's very hard to call.
As I said earlier, for the last seven years we've benefited from the fact that there wasn't enough capacity in the industry and clients were scared to death to delay a project because they may have to wait five months to get back in the queue. And frankly that was an unnatural state for them. They didn't like it. Now, they can weave quite a bit. But we think as Early Development capacity continues to wind down and you don't see and hear about facilities closing as much as you hear about headcount reductions and down by attrition, Early Development capacity is substantially less than it was six or nine months ago.
So as supply falls in line with demand, I think that this will firm up and pricing should firm up more than it has, although it's been fairly flat but it certainly could improve from here. Then that's what we see.
In terms of making our cost structure more flexible, at least as we are sitting here today, we see revenue growth in both segments for the foreseeable future on a strategic basis and making our cost structure more flexible, I guess we could start outsourcing and doing some of those sorts of things, but right now I'd say that's not dominating our strategic thinking.
Dave, I'd like to give you two other thoughts on this in term of the flexibility. One is you can get some offset against that by having a good portfolio of clients and I would remind you that, we have a fairly diffuse set of clients. I don't think there is any one client that's more than 7%. Even I think that their single largest client is 7%.
Secondly, you also offset it by getting into strategic discussions which involve long-term commitments and involve sustained work over long periods of time. And I think we've been leading the industry with respect to driving strategic outsourcing and more comprehensive long-term commitments to our work, so hopefully that will lead to less variability for us.
Dave Windley - Jeffries & Company
Right. If I could just ask, so, Joe, am I to understand, though, that your portfolio is so diverse and you have so many different studies that it's not possible to keep up with them all?
I don't think that's what I said, Dave. I don't know.
Dave Windley - Jeffries & Company
No, but 6,000 studies. I mean if you can't handle it and you can't forecast them, I mean, in all due respect, I don't think that was a very fair answer.
So, Dave, our focus has been on doing an outstanding job on all Early Development projects for clients and I think we have a demonstrated track record of doing that. In addition to doing their work, calling them every day and saying you think this study is going to cancel would be counterproductive. I guess we will agree to disagree.
Dave Windley - Jeffries & Company
No. I appreciate the clarification.
We'll now hear from Todd Van Fleet of First Analysis.
Todd Van Fleet - First Analysis
You had indicated that you're kind of continually asking yourself, how do you respond or what's the right way to respond perhaps from a resource perspective in the current environment? How important is the outcome of the kind of the 2010 budget cycle to your decision-making? So as you sit here today and looking at the landscape with all the uncertainty that it has, how important is the 2010 budget cycle so we get into kind of the first quarter of next year and you come to understand a little bit better, get better insight as to what these folks, your customers are thinking for 2010 and beyond.
Is that a critical point for you in terms of deciding whether or not you guys are higher and others are out there letting folks go in the Early Development segment? How critical are kind of the next three to five months, let's say, in terms of swaying your thought process one way or another?
Well, the first step would be our 2010 budget process, which is extraordinarily detailed by business subunit and by geography. And so, we'll be starting that process here, I think, next week or the week after. And the second thing would be the client's budgeting process. I'd like to tell you, Todd, that our clients say the budget is done and here is exactly how much you're going to get.
You know, the reality today is that most of our client contacts are scared to death about whether they are going to have a job. They are being more and more told what to do by administrative types and executive types than anytime in history. And so, frankly, it's hard to get straight answers from a lot of folks who we know very, very well because they are not sure.
I think the pharmaceutical industry is in uncharted waters and for us to be able to predict is very difficult. We've had a lot of very senior executive meetings over the last couple of months and we got some very important ones coming up over the next three to six weeks. And even sitting with those folks, it's very, very difficult. So I think certainly their budgets will color, but I don't know that they are going to be able to be as definitive as they might have been in the past.
But again, having said that, the lifeblood of the pharmaceutical industry is new product development and R&D. I think for the long-term sustainability of their companies, they are going to have to get back to work on their pipelines. The clouds are always darkest in the middle of the storm. I guess, again, we could give an extra $0.04, $0.05 a quarter, this quarter, next quarter and maybe in the first quarter and maybe that would make some folks happy. But we believe outsourcing is going to increase substantially over the next three, five or seven years and I think we're going to be happy that we maintained our quality and we maintained a team that we think is world class.
Todd, just a couple of other comments and thoughts on this. You know, your point about clarity to intention of our clients, keep in mind over the last year, there has been a huge funding crisis out there and that's really impacted the whole industry and that cloud seems to be lifting to some degree. Secondly, as Joe mentioned, there has been a lot of turbulence caused by the mergers that have gone on between many of our large clients and that seems to be now getting behind us or will be behind us, I guess, by the end of this quarter.
So, hopefully, those sort of fog of war what we call them, that kind of confusions will be lifting and give us more clarity as to their true intent. Then on a strategic basis, I think it's clear that the pharma companies need to address their cost structure and in many sense their business model. And we are part of the solution for them to get to a more variable cost to have better and more efficient way of developing drugs. So in that light, I think all those factors are positives.
Todd Van Fleet - First Analysis
I think that much is clear. I think Covance and most on this call probably believe that Covance is the answer to what (aids), I guess, or in a position to help meaningfully, you know, its customers. But I think just the question that we're trying to pin down today is, is Covance willing to kind of continue with the current strategy believing that the demand is going to come, excess capacity will be more fully utilized even if that occurs a year plus from now, that Covance is going to kind of maintain the course or are there potentially a series of events or nonevents that would cause Covance to perhaps address the cost structure a little bit differently than it does today, so we're just trying to draw that out a little bit better.
Yeah. Todd, let me rewind the clock again back to the end of July. We were sitting at the end of July with a big increase on a sequential basis coming in toxicology and the clin pharm business that had recovered and was looking good. In my 13 years with the company, I'm not sure I've ever felt better than when I got off of that call and two weeks later I was on family vacation and started getting calls and notes about studies being pushed out and cancelled. And a bunch of were crammed right on top of each other in a short amount of time.
So the question is, is do you say, okay, in this business based on three weeks' worth of activity, do I change saw off a part of my infrastructure that keeps me from growing in 2010 and 2011 or do I say, you know, I'm pissed off, I'm disappointed, I'm shocked, but we are a strategic player in one of the biggest outsourcing trends going on in business. I don't want to overcall that, but I'm getting fired up here. I just don't see making those kind of strategic decisions on a very unfortunate set of circumstances.
And if we continue to see that type of activity, believe me, I know how to close facilities. I've done it in the past. I've done it here and it doesn't take a lot of courage to do that. The question is, you know, what is the strategic impact on the company? I guess we're going to maybe take an unpopular but a longer-term view right now. And at any given time, we know where and how to get that and we can pull that trigger and we can pull it fast and we can say we got a one-time set aside, one-time charge or one-time call-out and harvest that and when the time comes, we will.
Operator, There is still a bunch of folks in the queue. We're going to have to hold everyone else to unfortunately just one question each and if there are follow-ups, we'll be taking questions after the call.
We'll now go to Douglas Tsao with Barclays Capital.
Douglas Tsao - Barclays Capital
I think Bill or Joe, you referenced seeing study delays related to the pharma mergers. I think this is the first time we've sort of heard about that. I was just wondering if you could provide any kind of quantitative color around that, I mean what magnitude do you think it is? In terms of any commentary you might have had because obviously two of the deals have closed, one of them some time ago, and did you see a subsequent uptick there?
Well, I think it's sort of quantified in our numbers.
I don't think we said the study delays particularly were caused by these mergers. What we said is decision making was affected by the mergers. So the study delay that we talked about coming out of Q3 and pushing into Q4 and maybe into Q1 of next year wasn't necessarily related to those pharma mergers. But what we're indicating here is that with those pharma mergers closing, we think there is a good opportunity for strategic outsourcing to expand with those particular clients.
Douglas Tsao - Barclays Capital
We'll now go to Isaac Ro with Leerink Swann.
Isaac Ro - Leerink Swann
Just wanted to talk a little bit about the pricing environment and Early Development and maybe if you could try and break out how you would weight the impact of sort of recent competitive pricing pressures, if any, that you're seeing either in clin pharm or tox and then maybe you contrast that versus the impact of just sort of rolling off of year-over-year pricing trends from maybe the 2008 period when pricing was a little stronger, sort of how you compare those two in terms of both the components that drove pricing this quarter.
Isaac, obviously, it's very uncomfortable talking about pricing for a whole variety of reasons. We carefully thought about what we said in our prepared comments and I guess I would just direct you back to that comment. I think that's enough. That's as much as we feel like we can say.
Isaac Ro - Leerink Swann
Then maybe if I could just take a mulligan there and real quickly ask about sustainability of growth in the central lab business. I think in the past you said it's 10% growth business for the long run, so I'm wondering if you see any near-term reasons either for year-over-year comp or otherwise that might lead to a slowdown there in 2010.
Well, I don't know that we would model it. I think if you use our pie chart you get to something in the neighborhood of 30% growth. I don't know that we would model it as that but keep in mind, you know, we're sitting on three years of consecutive book-to-bill of 1.5ish and we're bringing automation, we have got 16 clients that don't even use our central lab. We are adding some new services in central labs that we'll be probably talking about in the next couple of quarters, the two sole source contracts that we signed continue to ramp up. We had a competitor largely exit the business.
We have invested in esoteric testing so that we only send out a small count on one hand percentage of our testing whereas we used to send out 20% or 30%. Some of those more esoteric tests are richer in terms of value. There continues to be global expansion of clinical trials, so transportation of kits coming in and out of emerging countries impacts that. And we just like our competitive position. So I don't know that I would model 30%, but I don't think I'd model 10% either.
We'll now hear from Sandy Draper with Raymond James.
Sandy Draper - Raymond James.
Hopefully, Joe, this doesn't come back in the same question in terms of pricing. But one of your competitors, I think it was a quarter or two ago commented that there is going to be sort of a new pricing paradigm, you commented that pricing had come down. My sense would be as capacity comes back, there is potentially a rebound for pricing. Do you have any views longer term whether we are in sort of a new lower pricing paradigm? And then, what would you see coming back first, do you think capacity leads and then you have some pricing power or is it, you can start to firm up pricing and then the capacity starts to fill up?
I just think it's pretty hard to call right now, Sandy. I don't know any other way to say that. But certainly having the excess capacity over the last six or nine months has not been terribly helpful. And you never know sort of what's going to happen. We've had some monster cost structure reductions and a couple of competitors and, frankly, I don't think of this as a commodity business. It wouldn't surprise me to see us get some rescue studies or be the one that's capable of responding to RFPs. So I don't know, I think there is a lot of dynamics there. I don't think you're going to see the pricing component improve dramatically in the short to medium-term. Again, as we said earlier, as the '09 pricing is sort of now fully in our P&L, getting to a better maybe 2010 price is going to take some time to feather in as well.
We'll go to Tycho Peterson with JPMorgan.
This is (inaudible) in for Tycho Peterson. Just quickly the last slide in the appendix, the 20% of your business coming from these adjacent markets, could you comment on kind of the performance of that business in aggregate relative to your core drug development business in the quarter as well as your outlook in the near term?
Yeah. Well, let me just comment on a couple of them. First of all, there is the discovery business in that blue bar and that is primarily in our Greenfield and now our gel. So suffice to say, both of those are growing. I don't have the numbers in front of me but growing faster than the portfolio average. The private company bar is soaring because, again, we have a couple of clients that are major clients that are growing that don't report R&D as a part of the historical bar there on the far left.
Biosimilars, I think everyone would tell you that RFPs and strategic discussions about big packages of biosimilars are flooding into the Late-Stage market right now. I think there are a lot of expected and unexpected players that want to get into the biosimilars game. So I wouldn't call that in a P&L right now, but it's certainly in the RFP flow.
And then as you look at the adjacent markets, the bar on the right-hand side our nutritional chemistry business is unaffected by any of the events over 2009 and is growing faster by far than rest of our chemistry businesses or I should include central lab because that is central business, but growing faster than our Early Development chemistry businesses and margins are very, very strong.
With no further questions in the queue, I'd like to turn it back to management for any additional or closing remarks.
Thanks, Operator, and thank you everyone for your questions today. As I mentioned earlier, I will be available if you do have follow-up questions, feel free to call me in the office. Thanks, Operator, you can cancel the call now.
Ladies and gentlemen, once again that does conclude today's conference. We thank you for your participation.
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