Covance's CEO Discusses Q4 2013 Results - Earnings Call Transcript

Feb. 5.14 | About: Covance Inc. (CVD)

Covance, Inc. (NYSE:CVD)

Q4 2013 Earnings Conference Call

February 5, 2014 9:00 am ET

Executives

Paul Surdez - VP, IR

Joe Herring - Chairman & CEO

Alison Cornell - CFO

Analysts

Ross Muken - ISI Group

Greg Bolan - Sterne Agee

Robert Jones - Goldman Sachs

Jeffrey Bailin - Credit Suisse

John Kreger - William Blair

Dave Windley - Jefferies

Tim Evans - Wells Fargo Securities

Todd Van Fleet - First Analysis

Ricky Goldwasser - Morgan Stanley

Tycho Peterson - J. P. Morgan

Eric Coldwell - Robert W. Baird

Steven Valiquette - UBS Securities

Rafael Tejada - Bank of America-Merrill Lynch

George Hill - Deutsche Bank

Sean Wieland - Piper Jaffray

Operator

Good day everyone and welcome to the Covance Fourth Quarter 2013 Investor Conference Call. This conference is being recorded. At this time, for opening remarks and introductions, I would now like to turn the conference over to Vice President of Investor Relations, Mr. Paul Surdez. Please go ahead, sir.

Paul Surdez

Good morning, and thank you for joining us for Covance's fourth quarter 2013 earnings teleconference and webcast. Today, Joe Herring, Covance's Chairman and Chief Executive Officer; and Alison Cornell, Covance's Chief Financial Officer, will be presenting our fourth quarter financial results. Following our opening comments, we will host a Q&A session.

In addition to the press release, 28 slides corresponding to our prepared comments are available on our website at www.covance.com. Before we begin the discussion, 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. Certain of the financial measures we will discuss on this call are non-GAAP measures, which exclude the effect of events we consider to be outside of our normal operations. We believe that providing these measures helps investors gain a more complete understanding of our results and is consistent with how management views our financial results.

For a reconciliation of GAAP to pro forma results, please refer to the supplemental schedules included in our press release issued last night.

Now I will turn it over to Alison for a review of our financial performance, which begins on Page 4 of the slide show.

Alison Cornell

Thank you, Paul, and good morning, everyone. Let me begin by covering the items that we had excluded in arriving at our pro forma results for this quarter and for the full year. First, are the costs associated with our ongoing restructuring and other cost reduction actions. Those costs totaled $4.9 million for the fourth quarter and $22 million for the year.

Second, we have excluded $4.9 million of asset impairment charges taken in the fourth quarter relating to two assets we have been marking for sale. One is our Manassas Virginia land, and the other is our Basel, Switzerland property, formerly the site of our Basel Phase 1 clinic that was closed last year. These impairments were taken to write the properties down to current estimated fair market values.

Last, we have excluded favorable income tax developments in the fourth quarter totaling $3 million relating largely to income tax provisions taken on prior year tax returns filed in late 2013.

Our commentary which follows will focus on our pro forma results. You may find the GAAP to pro forma reconciliations in the release we issued last night and in the presentation we are reviewing today.

As we highlighted last quarter, our fourth quarter results reflect the normalization of the UK R&D credit. As you recall, there was a two-quarter impact in Q3, and only one quarter impact in Q4. This resulted in a sequential operating margin headwind of approximately 100 basis points in Early Development, 45 basis points in Late-Stage Development, and 65 basis points at the consolidated level, as well as 450 basis points tailwind in the tax rate from Q3 to Q4.

Now to the results. Consolidated net revenues for the fourth quarter were $623 million, up 11.1% year-on-year on a pro forma basis. Foreign exchange contributed 130 basis points to this growth rate. Sequentially, revenues increased $16.4 million, with foreign exchange contributing $8.1 million of that increase. For the full year, consolidated revenues were $2.4 billion, an increase of 10.6% over the prior year or 10.1% on a constant exchange rate basis.

Pro forma consolidated operating income in the fourth quarter was $64.7 million, and our operating margin was 10.4%. This is a 100 basis point year-over-year increase. Pro forma consolidated operating income for the full year was $244 million and our operating margin was 10.2%. This is up 23.2% compared to operating income of $198 million in the prior year.

Pro forma diluted earnings per share in the fourth quarter were $0.87, up $0.14 or 18.6% from the fourth quarter of 2012. Sequentially, EPS was up $0.04, driven by both clinical development and the Early Development segment especially toxicology, and roughly a 200 basis point reduction in our fourth quarter income tax rate resulting from the finalization of our 2013 earnings mix, as a greater percentage of our global earnings ultimately changed from foreign operations.

Pro forma diluted earnings per share for the year was $3.23, up 19.6% from the $2.70 achieved in the prior year.

Please turn to Slide 6 of the presentation. In the fourth quarter, Late-Stage Development contributed 63% of net revenues, while Early Development contributed 37%. Revenues from our international operations again exceeded our U.S. operations, coming in at 53% ex-U.S. versus 47% U.S.

Turning now to Slides 7 and 8, where I will review segment results for the quarter. In Early Development, net revenue was $228 million in the fourth quarter. This is a 5.7% increase when compared to last year's pro forma net revenue. Sequentially, this represents an increase of $7.9 million, driven primarily by growth in toxicology services. Net revenue was $871 million for the year, 1% increase from 2012.

Pro forma operating income in the fourth quarter was $27.6 million, up 6.7% year-on-year or margin of 12.1%. Sequentially, income was down $1.2 million due to the UK R&D credit headwind and normal seasonality in clinical pharmacology, which more than offset growth in toxicology. For the year, pro forma operating income was $101 million representing an operating margin of 11.6%. This compares to pro forma operating income of $83 million or an operating margin of 9.6% last year.

This $18 million or 200 basis point year-over-year increase is driven by the strong performance in our clinical pharmacology services and improving results in toxicology, coupled with the shift of the above margin treatment of the UK R&D credit, which more than offset a decrease in profitability in our discovery support services.

Turning to Late-Stage Development. Net revenues in the fourth quarter were $395 million, an increase of 14.5% versus the fourth quarter of 2012, or 12.8% excluding the impact of foreign exchange movements. Sequentially, revenue in this segment increased $8.5 million, including a $5.4 million foreign exchange tailwind. Year-on-year revenue growth was led by continued very strong performance in central lab, where net revenue was up 17%, as well as in clinical development where revenue was up 13%.

For the full year Late-Stage net revenue was $1.53 billion, an increase of 16.8% in reported dollars or 16% at constant foreign exchange rates. Growth was driven by the very strong performance in central labs; where net revenue was up 21% as well as in clinical development where revenue was up 15%.

Pro forma operating income in the fourth quarter grew 22% year-over-year to $89.5 million. This represents an operating margin of 22.7%, which is up 140 basis points year-on-year. Sequentially, operating margins were up 10 basis points.

Pro forma operating income for the full year was $343 million, an increase of 22.9% or $64 million from 2012. Operating margins for the year expanded 110 basis points to 22.4% in 2013.

Please turn to Slide 9 where I will now review the order and backlog information for the quarter. Adjusted net orders in the fourth quarter were $769 million or an adjusted net book-to-bill of 1.23 to 1. For the full year the adjusted net orders were $2.99 billion or adjusted net book-to-bill of 1.25 to 1. Backlog at December 31 was $6.92 billion versus $6.83 billion at the end of last quarter. Changes in foreign exchange rates positively impacted backlog by $36 million sequentially.

Please turn to Slide 10 for a review of cash flow information. We generated very strong cash flow information -- cash flows again in the fourth quarter driving $136 million sequential increase in our aggregate cash, cash equivalents, and short-term investments balance, which grew to $729 million at the end of December.

Free cash flows for the fourth quarter was $134 million consisting of operating cash flow of $193 million less CapEx of $58 million. Free cash flow for the year was a record $243 million, consisting of operating cash flow of $406 million less CapEx of $162 million. Q4 and full year free cash flow significantly exceeded our expectations largely as a result of two factors. One was DSO, which finished the year 6 days favorable to our 40 day target. The second was a receipt of a payment from a client for value added tax totaling $28 million, which had been pending resolution between the client and tax authorities throughout 2013. Following a resolution within Q4, the client paid the VAT to Covance. We will in turn remit the VAT collected to the tax authorities in Q1 of 2014. So this was $28 million source of cash in 2013 it will be a use of cash in 2014.

In November of 2013, we issued $250 million in senior notes and used the proceeds plus cash from operations to fully repay the $265 million outstanding balance on the revolving credit facility. We plan to maintain the revolver to provide flexibility to execute our growth strategy over the long-term.

The higher weighted average interest on the senior notes resulted in increased interest expense of approximately $1 million in the fourth quarter and an expected incremental $7 million in 2014.

We currently project 2014 CapEx at approximately $160 million and free cash flow of approximately $130 million. This assumes DSO in 2014 ends the year at 40 days as well as payment of $28 million VAT received in Q4 of 2013. These two combined to create cash flow headwind of approximately $70 million.

Turning now to corporate expenses. On a pro forma basis corporate expenses were $52.4 million or 8.4% of net revenue in the quarter. This is an increase of $3.7 million sequentially and $5.7 million year-over-year with a vast majority of both increases coming from corporate IT operating expense. For the full year, corporate expense increased $36 million or 22%. This increase was driven primarily by two factors: increased spending on a strategic IT initiative, which accounts for approximately 70% of the increase, and higher incentive compensation expense associated with the strong above budget level 2013 financial performance.

Looking into 2014, we expect to see a sizable decline in corporate spending, with pro forma corporate expenses declining from 8.3% of revenue in 2013 to low 7% of revenue range in 2014. The primary drivers of this decrease in corporate expenses are as follows. First, although we project only a small increase in our IT operating expense year-over-year the mix of that spending between corporate and the segments will be different with corporate spending decline were offset by increases in segment IT OpEx predominantly in Late-Stage development.

Second, we expect continued incremental savings in the corporate and functional support cost reduction action, which continue into 2014.

Third, 2014 incentive compensation reached at the budget level.

Fourth, in 2014, we realized the last year of timing benefit from the change in vesting of stock grants from three to four years, which we announced in 2012, as each year from 2012 to 2014 realized an incremental annual benefit of roughly $3.5 million. This three-year timing benefit totaling approximately $10 million reverses in 2015 as that will be the first year containing stock-based compensation expense from four years of grants.

And fifth, we're shifting the corporate portion of our informatics spend, which is several million dollars from corporate in 2013 to Late-Stage development in 2014 as those activities are directly related to enhancing our Late-Stage services. Netting it all-out, we see our pro forma corporate expenses declining to roughly 7% of revenues in 2014.

Finally, we ended the quarter with 12,501 employees, an increase of 142 from last quarter end.

Now I'll turn this call over to Joe for his comments.

Joe Herring

Thank you very much, Alison. In the fourth quarter, Covance again delivered better than expected results as pro forma revenue grew 11% and pro forma EPS grew 18.6% or $0.04 sequentially to $0.87. Results were led by the continued strong performances of our central lab and clinical development, as well as a return to mid single-digit revenue growth for our early development segment and even higher growth in toxicology.

On the commercial front, strong performances by our sales and project teams led to an adjusted net orders of $769 million. This is the second highest order total in the history of the company and produced an adjusted net book-to-bill of 1.23 to 1. This marks the ninth consecutive quarter of an adjusted book-to-bill in excess 1.2 to 1. This performance flows from continued successful execution of our operational and service excellence strategy, which also led to an increase in our net promoter score to a new all time high for our company.

For the full year revenue grew 10.6% to $2.4 billion, pro forma EPS grew 19.6% to $3.23, adjusted net orders grew to $3 billion, and free cash flow was a towering $243 million. Revenue, EPS, adjusted net orders, and free cash flow, were all new record performances for our company. We delivered financial results above our expectation each and every quarter of 2013.

Now I'll comment on our segment results. In Early Development, fourth quarter revenue grew 5.7% year-over-year and $8 million sequentially. Year-over-year growth was driven by clinical pharmacology and toxicology services. Toxicology was the primary driver of the $8 million sequential revenue increase. Clinical pharmacology services were the biggest driver of the year-on-year revenue growth and margin expansion in Early Development.

Key drivers of our continued success in clinical pharmacology include the strong operating performance that we're delivering for clients, which are producing high levels of satisfaction, and increased repeat work. We're seeing increased bed occupancy and we're seeing the evolution of clinical market towards early inclusion of patients in the Phase I trials versus just healthy volunteers. And finally, the increasing pull through of opportunities from our preclinical team into our Phase I clinics is buoying that business.

An important element of our Q4 results was toxicology revenue growing 8% year-on-year and 9% sequentially. Looking forward net new orders in toxicology exceeded our expectation in the fourth quarter. In toxicology, orders continue to exceed our expectation as January orders always ran substantially ahead of that elevated fourth quarter pace. We are especially pleased with this result as January has historically been the lead to toxicology order of the year. This sets us up for a strong start to 2014.

Turning to our other services in this segment, we experienced year-on-year declines in revenue and operating margin in our discovery support and to a lesser extent, pharmaceutical chemistry services.

Let me now comment on the sale of our Seattle based Genomics Laboratory, which offers high-complexity genomics analysis to Laboratory Corporation of America. As you may recall, we purchased this laboratory from Merck in 2009 as the role of genomics in drug discovery and development began to increase. Since that time, we've added over two dozen new clients to roster this business.

Our laboratory leadership team continually reviews and creates development solutions that combine both internal and external testing resources to meet the evolving needs of our clients. As part of this process, we concluded from a strategic perspective that we can enhance our genomic service offering by collaborating with an external partner who had access to a broader healthcare client base.

This should enable more rapid growth for the business, increase profitability, and further investment in new capabilities. We're excited to partner with LabCorp to offer these important services to our clients through a long-term relationship.

We will continue providing a range of genomic services directly to our client via central labs. But it's the high sequencing analysis requiring specialized equipments that will be performed in collaboration with LabCorp. Our internal investment for this acquisition significantly exceeded our weighted average cost of capital.

Finally, in Early Development, we've recently announced the expansion of our nutritional chemistry in food safety footprint by opening a new lab in our heritage site in order to service European clients. This high margin business continues to grow faster than our portfolio average.

Let me now turn to Late-Stage Development, where results continue to be very strong. Central laboratory capped off an exciting year of growth, margin expansion, and market share gains with fourth quarter revenue growth of 17% and the highest net order of performance of any quarter in 2013. Higher kit volumes and favorable mix were the primary drivers for this year-on-year increase. Operating margin in central lab expanded year-over-year, but declined sequentially from the exceptional third quarter level.

For the full year, central lab delivered revenue growth of 21% and operating margins expanded 300 basis points over 2012. In clinical development, fourth quarter revenues grew 13% year-on-year and $5 million sequentially.

Operating margin expanded both year-on-year and sequentially as favorable study mix offset normal Q4 seasonality. For the full year, clinical development grew revenue15% and operating margin percent declined slightly and that largely overcame the significant investments we're making in our clinical IT.

Our clinical development teams also delivered their second highest adjusted gross order performance ever, well similar to last quarter but somewhat offset by a higher than expected level of cancellation. We expect a nice sequential increase in clinical revenue in the first quarter.

Keep in mind we will be facing a tougher compare to the first quarter of 2013. We see year-on-year revenue growth accelerating as we progress through the year with 2000 full year clinical growth in the low teens.

Just to quickly touch on IT, we continue to proceed as planned with our strategic investment project and we're already delivering cost savings from those investments. Our IT OpEx will be 14% this year, which is a lower rate than the 17.5% we forecasted coming into the year. Essentially, we were able to remain over our project delivery timeline with lower than expected spending. This provided a nice tailwind in the back half of the year.

Looking to 2014, we expect the growth of IT spending to slow significantly, which as we previously said will be one of the key drivers of margin expansion this year and beyond.

Now let's turn to our forward outlook for Covance. For 2014, we are forecasting 6% to 10% revenue growth. The midpoint of this range is low double-digit growth in Late-Stage development and mid-single-digit growth in early development. Revenue growth expectations included headwind from the sale of our genomics lab of approximately 100 basis points on consolidated revenue and approximately 300 basis points on early development revenue.

We expect full year pro forma diluted earnings per share in the range of $3.65 to $4.

In terms of cycling of 2014 earnings, in the first quarter we expect pro forma EPS to increase a couple cent sequentially from the fourth quarter level. Our first quarter view includes historical seasonal headwinds we usually see in our early development services.

Following the first quarter we expect the sequential growth of a few cents in earnings each quarter as we progress through the year, which would deliver earnings at the midpoint of our guidance range.

In terms of book ending the full year range, one possible way to hit the low end would be for the recovery we're now seeing in toxicology to fade, and or if we experience unexpected large cancellations in clinical and central labs.

On the other hand, we could finish near the top end of the range if Late-Stage continues to outperform expectations and/or if the uptick we're currently seeing in toxicology becomes even more pronounced given the significant earnings drop-through at current capacity levels.

Looking further ahead we continue to build a stronger Covance for the future, realizing the depth and breadth of our portfolio to create unique solutions for our clients. Our continued commercial success when combined with strong operational performance by our project teams then sets up for revenue, margin, and market share growth well into the future.

Investors in our IT systems and informatics capabilities are already paying off with improved productivity, quality, and increased scalability of our business. These capabilities along with the robust new informatics tools that are currently under development significantly enhance our competitive position as well as the value proposition we bring to our clients, especially as it relates to helping them reduce the timing cost of drug development. Increasing outsourcing penetration and our clients willingness to invest in new product development is creating better market conditions that we have seen in quite some time.

We're also seeing improving trends in toxicology. We believe these market dynamics provide a solid growth platform for us as we head into 2014 and Covance is very well-positioned to capitalize on these favorable market conditions.

In closing I'd like to thank Covance employees around the world for delivering exceptional service to our clients and helping them bring their important e-medicines to patients around the world.

Operator, you now may open up the lines for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) It appears our first question comes from Ross Muken with ISI Group.

Ross Muken - ISI Group

Joe, I guess, starting on early phase, it's obviously been a much better story the last several quarters than we've seen for some time, and obviously you're seeing encouraging things in the current year. Can you talk a bit about maybe what you are seeing in more detail just from a mix and from a sort of demand basis just in terms of clients, types of studies, and then also talk about where you are in terms of may be not providing numbers, but in capacity and what it would take to basically get to that next level where we will start to see price recapture and start to see some of the margin levels, maybe we knew this business for historically?

Joe Herring

Well, thanks for the question, Ross. I think the first thing that we're seeing is continued biotech funding and as a matter of fact the fourth quarter was the best in four years and usually it's not too long after an uptick in biotech funding that we see new orders start to flow into our business and in fact that's happening. I wouldn't say pharma is fully back to work, but we had a handful of our clients who are back to work and we function the pipeline and it's nice to see them drifting up a little bit. We added commercial resources to our business and there we're starting to see some benefits as well some other commercial improvements that we thought would make it easy for the client to align with Covance.

In terms of capacity, this uptick is as pronounced or even more pronounced that we're looking at, we have enough capacity for several years probably something may be we had a 10% revenue growth and we are not calling that necessarily but we have enough capacity for that. And we have ways to add capacity that are more friendly from a financial perspective than we did back in 2005 or 2006.

At this time last year, we recall the industry capacity utilization somewhere in the 50% to 60% range. Right now, I think we're seeing something more like in the 70% range and picking up and somewhere along those lines for our business as well.

Study starts are now pushing out a couple of months which is something we haven't seen in quite a long time. And if that trend were to continue I think you can naturally expect price to begin to jerk up although take a little bit of time for that to flow through the P&L.

So as I said in my prepared comments, Ross, January has historically been the worst order quarter of the year even in the best of times. And for us to be running significantly ahead of even the fourth quarter pace feels pretty good. But this business has had lumps in the past and we will report it as we see it.

Operator

Our next question comes from Greg Bolan with Sterne Agee.

Greg Bolan - Sterne Agee

So I think a couple of years back we talked about just the pipeline of, I would call, mega alliance opportunities like those of Asuka, Sanofi, Lily, what have you. Without actually I guess quantifying can you may be characterize what that pipeline looks like understanding of course the cell cycle for these types of alliances are very long, but if you could just maybe give us some type of characterization as to what that sales pipeline looks like for Covance?

Joe Herring

Well I'll tell you pooling off those deals is like capturing lightning in a bottle. It's not going to faint your heart; it doesn't happen overnight. We have throughout the last several years always had one or two sometimes three of those in discussions. And for whatever reason they wax and wane. There are several clients who are I think really looking much more acutely at the fixed versus variable cost combination of your business. And I think now that outsourcing providers like Covance and some of our industry leading peers have capacity and capabilities that exceed even the largest clients and we're all developing better IT tools and we have a more realistic global footprint for where drug development is. I think it's natural that they look at their cost structure and say man; we need to make this more variable and get ourselves from the grease of strategic freedom.

So we continue to have those percolate along. I think probably the other element where I guess that there are more and more I would say mid-size companies that are investing as much or more in actual new product development spend than even larger pharma companies. Larger pharma companies are spending a lot of R&D dollars on idle infrastructure over fixed cost related type of infrastructures where the smaller companies are driving more and sometimes more exciting products through the pipeline on a variable cost basis. So I think it's a very, very interesting time for this business and we feel very grateful to have the broad portfolio we have and the team that creates innovative solutions to help clients think through some of these things.

Operator

Our next question comes from Robert Jones with Goldman Sachs.

Robert Jones - Goldman Sachs

Just looking at early development looks like obviously forecasting some pretty healthy core growth; I'm getting about 8% for 2014. I was just wondering if you could maybe talk a little bit what your assumptions are within early development specifically I'm thinking about discovery. Joe, looks like it's been a little bit of a drag now for a couple of quarters. Just curious what you're hearing, seeing from customers and may be given the healthy growth you're forecasting may be what are your expectations around discovery in early development for 2014?

Joe Herring

Yes. We'll talk; first of all, a very small percentage of discovery is currently outsourced to any provider. And the real challenge there is as opposed to given a study to a company like Covance, and it's a two-week study or a four-week study or a six-month study, many times they're handing dozens of compounds in the morning and they want the results in the afternoon on a non-GLP string kind of basis. And that's an inherent sort of problematic outsourcing paradigm.

Having said that, I think three and five years down the road a high percentages can be outsourced. And I think the way it's going to come is in chunks where a client says, you know what, we need to make this more variable we're going to figure this out, and it's going to take some partnership type activities to get that done. So I would look at Covance if this results in the short or middle term or looking back, I would and say that's very characteristic of the industry.

One of the issues that we face was at the genomics lab has been a drag. And we sat for two quarters that we're going to look what we could do with the organization to improve the performance of our discovery services business, and in fact we announced a transaction this, I think gives us a better forward looking and improvement for the company. But this is one of those I guess sort of option values whether you keep investing in it on a reasonable basis, you think it should be outsourced, you think it will be outsourced, and we want to keep another iron into the fire and keep working with our clients to find a couple of chunks that could come out well get over the barrier and then enable that market to continue to grow. But it's a huge opportunity but still a little bit early in the full development of outsourcing.

Robert Jones - Goldman Sachs

I guess, Joe, just on Late-Stage on the guidance I know historically you guys have been talking about kind of a mid-teens growth in clinical and I know overall for Late-Stage we're talking low double-digit anything you can share with us just about your expectations between central lab and clinical and then just kind of may be how the trends have been going in those two businesses as we exit '13 and enter '14?

Joe Herring

Well Bob, we've looked at our central lab business for a long time and if anything that it's a difficult business to forecast, sort of a year-on-year basis. But if you look at the 10-year, five year, the three year CAGR it's about 10%. A couple of years ago we have 20% we thought that was exceptional, but the next year it went up 30%, the next year it went down on a constant dollar basis 10-plus-percent. And behind all of that was very strong orders.

So it's a little bit hard to predict. So at this time of the year we call it something in the 10% range and if we do better than that that, I think everybody will be happy. If clinical is going to grow faster than that we said for the last couple of quarters that cancellations all those in the company started in the middle of the range, clinical is a little bit higher and so we're moderating that a little bit in the short-term but they continue to have very strong growth orders and we expect them to continue grow throughout the year. And in fact despite that we're going to have a very nice jump in revenue from the fourth quarter to first quarter so healthy growing business.

Operator

Our next question comes from Jeffrey Bailin with Credit Suisse.

Jeffrey Bailin - Credit Suisse

May be to follow-up Joe on the central lab comments, look at it growing over 20% in 2013 it seems pretty clear this company is taking some market share. And where do you think some of this share is coming from and kind of how you broadly characterize the competitive landscape within central lab?

Joe Herring

Well, first of all keep in mind the competitive position of our central lab approximately 40% of all industry sponsored clinical trials well utilize Covance and about 70% to 75% of all of those kits are made in a white tub manufacturing production environment that they're shipped in the belly of plans. The only time that human hand touches the kit is when the clinical investigator is actually seeing the patient. It's put in the box that shipped it's unboxed sorted out, applied and tested stored and put all the data into one of the clinical try to databases well as supporting information back to treating physician in 24 hours or less without anybody touching it and it's at a great than Six Sigma level.

So when you think about 90% of roughly of all the data that goes into an NDA filing being laboratory safety and efficacy data, yet it's only 10% of the cost. Why the company not order those as sort of the industry goal standard that has automation and extremely high quality. So I will call it a wild market share gain it just continues to drift up. And we continue to see another client roughly every three to six months that either goes sole-source or if they don't. The only sign of sole-source agreement we get most of all of their business and they just keep another company for sort of backup.

So I would just say it's the slow glacial drift up in terms of market share and obviously with our automation investment you're able to get the productivity benefits from that. But having said all of that it was a very, very good year for our central lab team from a new orders perspective, from a revenue and earning perspective, and from a quality standpoint.

Operator

Our next question comes from John Kreger with William Blair.

John Kreger - William Blair

Joe I think at the end of your prepared remarks you talked a bit about some of these new informatics tools that will be at your disposal giving your IT investments. Can you just elaborate a bit on that? Do you think those will be primarily new business drivers or productivity enhancers or may be some above?

Joe Herring

Actually be some above because if you think about how we as well as our competitors who are in clinical trials who seek cooperation with the client. So the biggest investment we could make to enable the informatics capabilities is all the infrastructure growth that we've done where you have data at -- conducted the right way at the right time in a very robust environment, a very fast network, so that we can pull that data and combine what we need in different ways that inform us and our clients simultaneously on how the trial has gone.

Ultimately, we think that we're going to be able to give the client better visibility with our clinical trials than they have ever had in the past. And most of what we're doing right now is automating some of the tools that we're already using for our preferred clients, so that we can make them available into an automated basis. And these tools will allow us to consistently meet and meet -- very frequently meet our client deadlines for their clinical trials and John Millers as well as I do the net present value of a molecule is much higher if we can finish a trial 3 or 6 or 12 months early then a 10% discount. And that is what we are sort of pushing for our company.

On a more forward basis, we are using and building algorithms that allow us to better forecast and close the trial how it's going to progress and what is needed in terms of data management pace, pages, monitoring resources, truck supply, and everything else that drives, I think tremendous weight in clinical trials. And to the extent that we are successful in that and then we had display tools that allow the client to see this and improve decision making, we are going to help our clients take the time and cost out of drug development. And that in turn I think drives a lot more strategic outsources if you get the cheaper, faster, and better, through a trusted partner then why would you back off the truck.

John Kreger - William Blair

May be a quick follow-up for Alison. If you think about the Late-Stage margins which have piled up very well, three to five years out where would you hope for that number to be? Can it go higher from here?

Alison Cornell

I would say three to five years out, I would say there is an opportunity for them to improve from where they are. And we think about our ongoing investments in automation that help from a central labs market perspective. If you think about the productivity that we're getting as a result of our investment in IT that allow us to give the same amount of work with fewer people. Those are opportunities by themselves for margin improvement.

Operator

Our next question comes from Dave Windley with Jefferies.

Dave Windley - Jefferies

I want to focus on margin and Joe the numbers in 2013, if I look at the numbers it looks like you grew EBIT margin a little over 100 basis points year-over-year and that is with still significant growth in IT spend. So if I not neutralize the IT spend, it looks like that that margin expansion could have been as much as 200 basis points. As I look at 2014, my curiosity is, is that now that IT spending is becoming a tailwind, it's something like 200 basis points in the cards and if not what other areas are requiring spending or investment that would prevent that from happening?

Alison Cornell

So we talk about IT specifically from a margin impact perspective on an ongoing basis. It's about a 50 basis points impact incrementally per year in terms of contributions to our operating margin.

Dave Windley - Jefferies

Okay. I think it's more than that but?

Paul Surdez

David, its Paul. When you think about what we did in 2013, don't forget the end of 2012, we took a lot of actions and that was part of the earnings growth story last year. So where you have earnings margin expansion in the future on top of the 50 basis points in IT it's corporate expense coming down as a percent of revenue you have, as Alison just told John some Late-Stage opportunity over time and we were still 200 basis points below our all time high on Late-Stage. And it's really the big levers in early development we're only at 12% now in margins we're double that at some point not that we would ask anyone to go there, but if the market continues to improve and where Joe talked about if that happens pricing can move in the right direction, there is a lot more leverage there. So you kind a get in a whole bunch of places.

Alison Cornell

And I think just a minute on the guidance that we did give, I mean in terms of the midpoint of the range or it's just 125 basis point year-over-year increase and at the high end of the range it could be up to 175 to 200 basis point increase.

Dave Windley - Jefferies

If I could follow-up real quickly, just Allison on the movements out of corporate into Late-Stage that you walked through kind of qualitatively, would it be possible to give us a quantitative like if corporate overhead goes from the low 8% to 7% how much of that goes away completely, and how much of that gets redistributed into another segment?

Alison Cornell

What goes away -- what Ms. Is really the informatics expense in the short-term is a lower-level. That is redistributed to late stage. We as Joe said expect to invest a lot more in informatics over time. While it is several million dollars moving from corporate today, up until Late-Stage saving, we plan to invest more and more in that type of investment over time and so that would have a bigger impact on those smaller amounts.

So the investments we've already made in terms of the Late-Stage IT, that too is moving from corporate beyond informatics to corporate up to the Late-Stage segment. So that would be ongoing. And so, as you think about our IT expense we spent about $230 million in IT that's going to grow 2% to 3% for the year, but that's going to be redistributed. So the IT growth on the bottom line 2% to 3% but it's redistributed from corporate to IT. That's something that I would say doesn't go away.

What does go away is the functional and corporate headcount reductions that we did. Remember back in 2012, we reassessed our overall corporate spending, IT, finance, HR, legal, and made those reductions which continue into 2014. And so you'll see in 2014 was an incremental $10 million worth of savings embedded in our guidance associated with the corporate folks leaving. And that will be expenses that will reduce.

Joe Herring

Yes, Dave, let me just add a little bit of commentary, I would smear over top of all that and say largely it's total expense going down in a way. There is some going into business units but largely it's down in a way. And the second thing from an informatics investment standpoint we don't have some big news coming, some big proclamation about an extraordinary outside incremental informatics investment. It's going to drift up, but it's also going to drive more new orders, more revenue, more OEMs and it won't be extraordinary stuff that you would call it out. And we're also building some of these tools that will actually become revenue, we believe will become revenue generators and very accretive to the business. So it's different than the infrastructure investments, it's more of an investment that's going to drive accretive revenue and OEM.

Operator

Our next question comes from Tim Evans with Wells Fargo Securities.

Tim Evans - Wells Fargo Securities

I just wanted to tie a couple of loose ends there. I didn't hear much commentary on market access research models or nutritional chemistry. Could you maybe just give us a brief comment on year-over-year directional growth in those three areas?

Alison Cornell

From a nutritional chemistry perspective, it was actually booked year-on-year as well as well as sequentially. From a market access perspective there I think roughly down, I'd say from a -- on a year-over-year basis although had a healthier fourth quarter, so up sequentially.

Joe Herring

And the order flow for that business is definitely picking up, but for the year that's accurate. And research products I think was sort of a roughly at expectation year but off to a very good start so far this year.

Operator

Our next question comes from Todd Van Fleet with First Analysis.

Todd Van Fleet - First Analysis

Just a quick question on clinical development. Joe, how do you feel about the balance between the workload and staffing in that particular business segment? I know growth has been very strong for you but is it -- are we at the point here at the beginning of 2014 where kind of that balance between demand and the staff required to support that that demand provides a source of operating leverage for the company?

Joe Herring

I think we're in very good shape in terms of staffing supply versus demand. We have a very, very good recruiting team there that keeps us in pretty good shape as well as very good resource management tools and we use a variety of staffing models to sort of ramp up and ramp down. To me, I think one of the nearly most interesting strategic elements of that business is clients are going to give us more and more of their staff, so as they place a $30 million, $40 million, $50 million clinical trial or we sign an agreement where we take on something that's more than $100 million range, they're asking us to take staff and so we get people who know the company, know the molecule. And as I've said before, the greatest benefit of that is it helps us improve that client relationship because the clients or the employees that come to Covance largely stay with us and say good things about the culture and the climate and tools of the company. So I would say we're well and out.

Operator

Our next question comes from Ricky Goldwasser with Morgan Stanley.

Ricky Goldwasser - Morgan Stanley

Just a few short questions here. The first one, if you can just help us quantify what percent of the backlog and bookings growth that we're seeing is coming from your strategic partners and kind of like the cross-selling opportunities between Late-Stage and preclinical?

Joe Herring

Ricky, I'm sorry. I think we missed the very beginning of your question. Would you mind repeating please?

Ricky Goldwasser - Morgan Stanley

Sure. The question is like what percent of kind of like the growth that you're seeing is coming from strategic partnerships and the cross-selling between the Late-Stage and preclinical?

Alison Cornell

The percentage of growth coming from strategic partnership in the early stage is increasing. We don't have an exact number to share but from a training perspective it's increasing.

Ricky Goldwasser - Morgan Stanley

Okay. So you're saying that it kind of like pull through from strategic partnerships that you're signing on the Late-Stage coming through under preclinical?

Alison Cornell

I think preclinical is especially Phase I proof-of-concept, where you've seen actually in our results an increase in (inaudible) performance as well as ECB performance. So you're seeing more and more folks have massively covered although some firm very early in preclinical covered.

Ricky Goldwasser - Morgan Stanley

And when you think about the additional work that you are getting from your clients, can you parse it out by is it there increased spent in R&D sounds like what we've been hearing from Pfizer lately, is it you gaining share, or are you actually seeing kind of like just more outsourcing work that they really didn't sent to see those before?

Joe Herring

I would say first it would be the increase in the utilization of outsources, which is good for our whole industry and then within that we feel like we're taking market share across at most every business that we're in, not wow but it just continues to sort of drift up. Really based on operational performance and repeat work of clients where we once we get in, we can definitely tend to stay and continue to grow within those lines.

Operator

Our next question comes from Tycho Peterson with J. P. Morgan.

Tycho Peterson - J. P. Morgan

Joe, I went to dive in the decision to exit the Seattle genomics Lab a little bit more. I mean clearly you have relationships with customers in that market. In talking to sequencing companies obviously growth is happening within pharma and the cost of sequencing are clearly coming down. And for you guys it seems to be tied with both early stage and Late-Stage. So maybe just talk through the thought process of getting out of that business just as pharma seems to be embracing sequencing?

Joe Herring

Yes, well, the majority of the business that we've had came from one client. And then we added a number of other clients. As that market has changed, the client needs change and really one of the strengths of our company is the breadth of our portfolio. So when we enter into a strategic deal we've got a lot of different elements that we can bring to make a deal work financially. If a client needs change, we have a broad range of solutions to help them transfer that C&D to other areas that are in their best interest or in our best interest to keep the deal whole. And so as that client needs dropped off, he collects the agreement, everybody is happy, but we ended up with the volume that we didn't think was in the best position for our business going forward.

So we were looking for a partner who had all the potential revenue sources beyond just drug discovery and development that could drive more volume, margin, and back in the business, because as you know Tycho from your experience there is a lot of technological change and obsolescence in that business. And it just didn't feel like there is something that we needed to only to service our clients. Some stuff we own, some stuff we partner and that's a whole strategy for our central lab it's called the e-lab and we make those decisions based on a variety of the factors. So I think it's all said and done, it was a good investment for our company this asset transfer agreement, we're happy to get it and we will continue service those clients.

Tycho Peterson - J. P. Morgan

And then just a couple of very quick follow-ups hopefully straightforward, but with free cash flow picking up again as you highlighted any change in usage of cash and then you called out elevated cancellations last quarter in central lab and clinical, so I'm wondering if those have mitigated?

Alison Cornell

Good to talk a bit about cash flow and our use of cash. And so as we had announced, we had $100 million authorized for share repurchase. For that, we're using domestic cash to repurchase our shares. So our capital deployment priorities really haven't changed. We focus on three things; one is invest in the business to generate profitable organic growth, to drive free cash flow ongoing, as part of strategic capabilities for example specialty areas as well as for investment informatics and then third is the return excess cash to shareholders. We have repurchased $785 million in 2010 and beyond that have 100 million shares authorized for this year. But just as a remainder our cash is predominantly overseas and so we keep that in mind while continuing to invest in the business and create value for our shareholders.

Joe Herring

And Tycho, just on your second question, we highlighted a little bit in the opening comments canceled central lab normalized in the fourth quarter clinical had a second consecutive quarter of elevated cancellations.

Operator, we have a few more people in the queue, I'd like to just everyone since we are passed 10 o'clock. Everyone in the queue could please try to ask one question if there is a follow up that's important feel free but if not just to try to get everyone in and try to squeeze in one question.

Operator

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

Eric Coldwell - Robert W. Baird

Average CapEx over the last five years has run $141 million, you did about $162 million last year, your forecast seen a flat number for '14 at $160 million. I guess the question is what is the long term view on CapEx, where does it go and what are you investing in? You have spent the last few years investing in four businesses and facilities, you've got plenty of tox capacity, central lab is automated, IT is wrapping down. I just don’t know where this $160 million is coming from and the third chance to take that number perhaps substantially lower over the next few years? Thanks.

Alison Cornell

Since our profitability as a company is coming more and more from the late stage space we predominantly are investing in that part of the business. And as you know, late stage space is less capital intensive and so we see CapEx as a percentage of revenue going down over time. What the current investment is that why we are saying its $160 million level is we continue to invest in process automation that help us to continue to extend our margin in the late stage space, but as I said it is expected to go down as a percentage of revenue over the time. And with no expectation to invest in fixed cost facilities to drive further early development capacity with no expectation whatsoever to do that.

Operator

Our next question comes from Steven Valiquette with UBS Securities.

Steven Valiquette - UBS Securities

Just in relation to all the discussion on the acceleration and growth in toxicology and the associated drivers, can you just give a little more color, let's say just qualitatively on whether you now anticipate these trends to be sustainable in over several years or it's just too difficult to have crystal ball for this beyond 2014? Thanks.

Joe Herring

We burning in the backlog in the business approximately every 40 days and so we don't have great certainty beyond June of this year. And so I wouldn't call a two year trend, but most recent signs are certainly encouraging, but I guess this business would rather show it to you in the P&L than forecast it six to nine months down the road.

Operator

Our next question comes from Rafael Tejada with Bank of America-Merrill Lynch

Rafael Tejada - Bank of America-Merrill Lynch

Just a quick one on clinical pharmacology. Joe, you have noted ongoing strength in this business. Just wondering if you could discuss about occupancy rates in 2013 versus what you are sort of expecting in 2014 and is this an area where additional beds may potentially been necessary or the current sites sufficient to support the current market demand? Thanks.

Joe Herring

Yeah, I think we have plenty of fixed cost capacity for where the business is but more and more of this business is in an actually in early patients, which actually don't or may not frequently don't require beds at all. So we will enroll clinical pharmacology both we domicile volunteers if they need be but also early patients. So I think we are in really good shape and this business sort of the year looks like a bell-shaped curve with the first and fourth quarter seasonally off either holidays and patients not seeing their docs and certainly with the weather we've had on the east coast in the U.S. that probably has a pronounced effect but we expect to see and do much better sequentially in the second and third quarter. But it's really, really nice to see that business performing like it is after a number of years of sort of being in trough and I think we have a first rate great team leading that business.

Operator

Our next question comes from George Hill with Deutsche Bank

George Hill - Deutsche Bank

Just a quick question. Can you quantify the change in the level of trial complexity in 2013 versus 2012 and kind of how should we think about how the trial complexity impacts net cost per trial and kind of the contribution of complexity to revenue growth? Thanks.

Joe Herring

Yes, target can really quantify what I would say is directly up for sure more test per kit, more esoteric testing which drives price per test, generally more patients in trials and more information needed from those patients in terms of inclusion/exclusion criteria and data. So our clients are trying to learn as much as possible in their drug development spend, but frankly it's been drifting up over last several years and that's what's been driving success in both of our life science businesses.

Operator

Our next question comes from Sean Wieland with Piper Jaffray.

Sean Wieland - Piper Jaffray

So at the JPMorgan conference you called out the hiring of 30 new data scientists. So my question is what these new hires tasked with and then more broadly what do you see is the big opportunities for disruption in your business?

Joe Herring

Yes, thanks Sean. Well, first of all we got 20 of those people were transferred from other parts of the company and we're ramping up towards the 30 number, and they didn't work and -- the 20 had been more at district level and they are focusing on their very dynamic leader who has an incredible vision for our informatics capabilities. But it's really, I said this in an earlier answer, so I will try not to be redundant but just summarize in saying that there is already a lot of automation tools that we have that we need to enhance and there is a lot of algorithms and sort of forward forecasting and data mining that we can do with data that are variable and available to us and that we are looking to bring the company through partnerships and potentially through acquisitions.

I've said for years there is no process that I know about in business as more broken in drug development. And I don’t say that critical of our clients, I say that critical if all of us involved with it. And the way I think that this is going to become faster, cheaper and better is through automation, better decision support tools and better decision making earlier. And frankly, we want to position ourselves as a thought leader and industry leader and someone who brings this kind of transformation disruptive breakthrough to our clients and we are hell bent determined to do that.

Paul Surdez

Operator, I believe that was the last question. Assuming that's the case, I'd like to thank everyone for all their time today. If you have follow up questions I'm available on email or phone. Thanks a lot and have a great day.

Operator

That does conclude today's conference call. Thank you all for your participation.

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