Covance Inc. Q1 2010 Earnings Call Transcript

Executives

Paul Surdez – VP, IR

Bill Klitgaard – Corporate SVP and CFO

Joe Herring – Chairman and CEO

Analysts

Ross Muken – Deutsche Bank

John Kreger – William Blair

Greg Bolan – Wells Fargo

Eric Lo – Banc of America/Merrill Lynch

Dave Windley – Jefferies & Company

Eric Coldwell – Robert W. Baird

Todd Van Fleet – First Analysis

Steve Unger – Lazard Capital Markets

Douglas Tsao – Barclays Capital

Andy Schenker – Morgan Stanley

Derik De Bruin – UBS

Tycho Peterson – JP Morgan

Covance Inc. (CVD) Q1 2010 Earnings Call Transcript April 29, 2010 9:00 AM ET

Operator

Good day and welcome to the Covance first quarter 2010 investor conference call. This call is being recorded. At this time, for opening remarks, I would like to turn the conference over to the Vice President of Investor Relations, Mr. Paul Surdez. Please go ahead, sir.

Paul Surdez

Thanks, operator. Good morning, and thank you for joining us for Covance's first quarter 2010 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 first quarter financial results.

Following our opening comments, we will host a Q&A session. In addition to the press release, 19 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.

Bill Klitgaard

Thank you, Paul, and good morning, everyone. Net revenue for the first quarter was $482 million, an increase of 9.2% over the first quarter of last year or 6.2% at constant exchange rate. Sequentially, net revenue declined $3 million, but increased $4 million at constant exchange rate. Operating margin was 11% in the first quarter versus 12.7% in the first quarter of 2009.

Net income in the first quarter was $39 million, which was down 2.9% in the first quarter of last year. Earnings per share in the first quarter were $0.60 versus $0.63 in the first quarter of last year. We continued to enjoy the benefit of a lower effective tax rate resulting primarily from a shift in the geographic mix of earnings towards our foreign operations were tax rates are lower. The effective tax rate in the first quarter was 25.2%, and we now expect our 2010 effective tax rate to be in the 25% to 26% range versus our prior expectation of 26.5%.

Please turn to slide five. In the first quarter of 2010, Early Development contributed 43% of our net revenue and Late-Stage 57%. And in the first quarter, 56% of our revenue came from the United States, 14% from Switzerland, 12% from the UK, 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, in the first quarter, net revenues grew 6.5% year-on-year to $205 million, and that represented an increase of $2 million sequentially, primarily from growth in clinical pharmacology. Global toxicology revenues were essentially flat from the fourth quarter level. Market conditions for our Early Development services appear to be firming up, and we now expect sequential revenue growth from this point forward.

Just to claim [ph] this, the Early Development revenue rose sequentially $2 million a quarter for the remainder of the year as it did this quarter that would translate into a 5% year-on-year growth rate for the lower end of our current growth expectation. First quarter Early Development operating margins were 11.2% versus 11.3% last quarter and 14.1% in the first quarter of last year. Looking forward, Early Development operating margins, excluding the facility rationalization costs in the second quarter, are expected to expand sequentially throughout the year.

Turning now to Late-Stage Development, net revenues in the first quarter were $277 million, which was up 11.3% over last year. On a sequential basis, revenues were down $5 million in reported dollars, but flat at constant exchange rate. And $11 million decline in Central Labs revenue is the primary reason for this drop. We anticipate Central Labs revenues to retain sequential growth in the second quarter. However, this increase is not expected to offset lower Q2 revenues in clinical development, where we expect a reduced level of revenue due to delays in the commencement of three large clinical trials.

In terms of our full year outlook, we now anticipate year-on-year segment revenue growth in the mid-single digit range in 2010. This compares to our previous expectation of mid-teens revenue growth. Operating margins in Late-Stage Development were 23.9% compared to 22.6% both last quarter and first quarter of last year. Operating margins in the quarter benefited from the efficiencies recognized in a number of projects in clinical development and in Central Labs to a shift in mix to lower price but high margin automated kit.

Looking forward to the next two quarters, Late-Stage operating margin is expected to be approximately 300 basis points below the Q1 level due primarily to the under utilization of headcount and clinical development resulting from a delay in the three large trials just mentioned. For the full year, we now expect operating margins in the 22% range.

Please turn to slide seven to recap the order backlog numbers. Adjusted net orders in the first quarter were a record $490 million, which represents an adjusted net book-to-bill of 1.02 to 1. Backlog at March 31 grew 8.4% year-on-year to $4.79 billion, and that compares to $4.42 billion at the end of March last year. Backlog is down $78 million from the end of last year, with a negative impact in foreign exchange making up about half the decline.

Now please turn to page eight for a review of cash flow data. Net DSO at March 31 was 42 days compared to 40 days at the end of last quarter and 39 days at the end of first quarter last year. Cash and equivalents was $268 million at the end of March compared to $289 million at the end of last year. We remain debt-free.

Free cash flow for the first quarter was negative $10 million, consisting of operating cash flow of $20 million less capital expenditures of $30 million. Excluding annual bonus payments, free cash flow was solidly positive in the quarter. For 2010, we continue to expect full-year free cash flow to be approximately $120 million. That includes capital expenditures of approximately $170 million and operating cash flow of approximately $290 million. The free cash flow target for 2010 assumes DSO at 40 days at year-end.

Corporate expenses totaled $36 million in the first quarter compared to $32 million last quarter. For 2010, corporate expenses are expected to be approximately 7% of revenue. And finally, we ended the quarter with 10,437 employees.

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

Joe Herring

Thanks, Bill. And good morning, everyone. In the first quarter, our balanced drug development service portfolio enabled Covance to deliver revenue growth of 9.2%, operating margin of 11%, and diluted EPS of $0.60 per share. These consolidated results match the forecast we provided in January.

I’ll describe details of our business segment results in a moment, but I want to quickly get to headlines. Adjusted net orders were below expectations due to the late decision-making by some of our Late-Stage clients. To be specific, at the close of Q1, we expected the client to award a $28 million Central Labs study and expected another client to award a $78 million package of Phase III studies, both of our decisions were delayed by a couple of weeks. Fortunately, all of this work has now been awarded to Covance. Based on our healthy trailing 12-month book-to-bill of 1.25 to 1 and record level of pending RFPs, these are orders yet to be decided by clients. We expect a stronger order performance in Q2.

Early Development revenue grew sequentially for the second consecutive quarter, but we continue to see improving performance. We now anticipate full-year Early Development revenue growth and margin expansion. Central Lab revenue grew 9% year-on-year and margins expanded 90 basis points sequentially. However, clinical trial delays, the slower patient enrollment in some new trials, and a shifting mix to lower price but higher margin automated test led to a sequential decline in revenue.

We expect Central Lab revenue to resume sequential revenue growth in Q2 and for the balance of 2010. Our clinical development team delivered over 25% revenue growth and record operating margins in Q1. A few weeks ago, we were notified that three large clinical trials will start later and ramp more slowly than we had expected.

As a result, we are now forecasting a decline in clinical development revenue for Q2, with March recovery occurring in Q3 and accelerating in Q4 as these three and other studies begin enrollment. In light of these developments, coupled with the strengthening of the US dollar, we are reducing our consolidated full year revenue growth rate target to the 5% to 8% range.

Now let me provide more color on our first quarter performance. Turning first to Early Development, our results and outlook are improving. Revenues grew sequentially for the second consecutive quarter, and the adjusted book-to-bill was above the 1.0 to 1 for the third consecutive quarter. In fact, adjusted book-to-bill increased in each of those quarters for Early Development.

Toxicology revenues were roughly flat from the fourth quarter level with slightly lower margin, largely due to increased IT and incentive compensation expenses we discussed on the last call. Toxicology revenue increased each month of the first quarter. The past few months have shown signs that the market for toxicology is stabilizing. We are having more encouraging commercial discussions with clients and seeing stronger new orders, including the month of April.

We have been able to improve bill rates in our Madison facility. We have seen the addition of new clients at our Chandler facility, and we’ve seen margin improvement in our European toxicology operations. All of these recent indicators point to sequential revenue growth and improving margins in toxicology as the year progresses.

In clinical pharmacology, revenue and OEM improved nicely as projected and new orders further strengthened in the first quarter. Our Greenfield, Indiana operations continued to successfully transition from in-house capacity serving one pipeline to a globally competitive discovery services CRO. We now have over 30 non-Lilly clients who placed discovery studies at the site over the past site, and 70% of them have returned to quite additional studies.

To further enhance our competitiveness, we are closing two of our smaller Early Development sites and consolidating the workloads into larger, more efficient sites. First I’ll comment on our research products facility in Kalamazoo, Michigan, which has been running at about 50% capacity utilization. This location has two core services; research product production and PK screening.

We will be consolidating research product production into our Virginia and Pennsylvania research product sites, both of which have had significant upgrades and have capacity to absorb this volume with room for further growth. We will be shifting the PK screening studies to our Greenfield campus.

Our second action is the closing of our 75-bed Phase I clinic in Austin, Texas, which was acquired as part of the Radiant Research acquisition back in 2005. We expect to shift Austin studies to our Dallas, Texas, or other North American clinics, all of which have been upgraded during the course of the last few years. After this action, we remain a market leader with seven global clinics and over 460 Phase I debt.

In addition to these facility closures, we also reduced overhead costs in support staff positions at other early development sites. In total, these actions will reduce our employee base by approximately 200 people at a cost of approximately $0.09 a share in the second quarter. We’ve set these actions to generate savings of at least $0.12 per share on an annualized basis going forward. These savings will ramp as the year progresses, with the full benefit beginning to be realized by year-end. So in summary, four months into the year, we now expect to deliver full year revenue growth across most of our Early Development service lines.

Moving on to Late-Stage Development, revenue growth was 11.3% and operating margins exceeded our expectations at 23.9%. Let’s talk specifically about clinical development, which had a very strong operating performance in Q1. Repeat work from our strategic clients, strong project performance by our clinical teams, and continued productivity gains of driving results.

Looking ahead to Q2 and Q3, as I mentioned earlier, backlog will not convert to revenue as previously expected due to recently communicated delays in three new large multi-protocol programs, which were scheduled to generate significant revenue in Q2. These three studies were expected to deliver $70 million in 2010 revenue. We now expect only $20 million in revenue from these studies, with $18 million of that reduction coming in Q2.

Let me turn your attention now to Central Labs. While we continue to perform well on an absolute basis and take market share, we are revising our outlook for Central Labs in 2010. Revenue in Q1 was below our expectations due to delay and slower patient enrollment in several new trials, a shift in the mix of kits received, and strengthening of the US dollar. Operating margins improved sequentially due to a higher percentage of automated testing.

Looking forward, while we are expecting growth in kit volumes from this Q1 level, full year revenues will be below our original forecast, with kit volume ramping from this lower starting point. As a result, we expect Central Labs full year revenue to be approximately $50 million lower than our original 2010 projection.

Please turn to slide 10. Summarizing the news today, our near-term outlook reflects lower Late-Stage revenue expectations and a stronger US dollar, partially offset by improving outlook in Early Development and a more favorable tax rate. Based on these inputs, we are reducing our 2010 full-year revenue growth rate expectation to the 5% to 8% range, and our earnings per share target by $0.10 to the $2.40 to $2.65 range.

This range includes the impact of the second quarter cost actions, but it does not include benefits from any potential strategic transactions. With respect to our near-term outlook, we expect second quarter earnings per share to be approximately $0.50, inclusive of site closure and severance costs outlined earlier.

Excluding those costs, we see the overall business being modestly down sequentially, as lower clinical revenue more than offset growth in the rest of the business. Despite the short-term volatility we described today, we believe we are operating from a position of strength in the CRO market. Our long-term growth opportunity remains very exciting, and we expect to capture at least our fair share of this dynamic growth market.

Looking at Covance opportunities more strategically, we continue to have significant discussions with clients. We are looking to adopt a more strategic approach to outsourcing R&D activities. The enormous challenges facing the pharmaceutical industry are causing our clients to look for ways to reduce R&D fixed cost structures, make those cost structures more flexible in speed, development timeline. The number and the nature of strategic R&D outsourcing partnerships as well as the public statements made without them continues to increase in momentum.

Let me provide one quick example. At a recent industry conference, we stood side-by-side with Otsuka Pharmaceuticals. If you recall a year ago, we mentioned the top 25 pharmaceutical companies following a thorough selection process involving 10 CROs chose Covance as their primary provider of clinical development services.

As Otsuka reported, multiple clinical projects were started in 2009, and they are seeing reduced cycle times, faster study startup and enrollment, harmonized and integrated workflows, and best practice to share between both companies. These benefits are being delivered on a very flexible cost model, a model we believe helps bring transformational change to the industry.

I’m also happy to report that our early successes with Otsuka have helped to expand the relationship to include earlier drug development projects, including program management and proof of concept studies. Also in the strategic partnering front, in early April, John Lechleiter, CEO of Eli Lilly, made public comments about their Covance collaboration, citing flexibility and faster cycle times as advantages of working with Covance. These couple comments are powerful proof points, as we discussed potential strategic opportunities with other clients. Happy early adopters are our best advocates.

During Q1, we advanced a number of such discussions with clients. In each case, a strategic outsourcing partnership with Covance makes good economic sense. And many of our clients want to learn more about the benefit of a flexible, more variable, and faster R&D model. We are highly motivated to leverage our broad service portfolio and drive strategic outsourcing and help our clients dramatically improve R&D productivity, and I like our chances.

Operator, we may now open the call up for questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from Ross Muken with Deutsche Bank.

Ross Muken – Deutsche Bank

Good morning, everyone. Joe, obviously a lot happened this quarter and there is a lot for all of us to digest. So if we have to break out all of what you discussed, Joe, sort of on the call in the different market segments, the sort of market-related factors or something in the macro environment that happened, that sort of impacted the business versus sort of company specific where you think it was execution-related versus sort of abnormality sort of things that – I mean, anomaly things that typically would not happen that are quite unusual as you look back over the last five years, it sort of stands out. How would you sort of break things up into kind of those three subgroups?

Joe Herring

Yes, Ross, thanks for your question. Ross, first let’s talk about orders. The orders I described in my commentary some two weeks early, we have a continued string of 12 or 15 quarters of very strong new orders and book-to-bill. So I have a hard time calling that a company problem or a macro problem. Regarding Early Development, things are tracking a little better than we thought. So we feel good about that. We like our competitive position, and orders continue to be a little bit better than we expected.

In terms of Phase III clinical trial delays, specifically at Covance, this happened in the first quarter of 2006. We called out three studies, said that they would start later in the year. In fact, they did and they set up a three-year run in clinical development where we outperformed, I think, a majority of the industry. You saw these delays hitting a number of our competitors last year. Covance was sort of immune to that. And so with our base of clients and their portfolio reviews, we sought to get our time in the barrel.

With regard to Central Labs, Ross, you very well know, we have been taking a significant market share. We want to win a – continue to win a very high percentage of every proposal that we bid on. Having trial slowdown is not a Covance operational issue. It is just the vagaries of the industry from time to time. If you remember, last year we called for a double-digit Central Lab revenue growth. We delivered over 30% based on factors we couldn’t control.

This year we were guiding you down from that 30% to sort of double-digit, and because of some studies being pushed out, one very large trial in particular, it’s a little bit slower than that. But our competitive position hasn’t changed. We think, if anything, the market is stronger this year than it was last year. And the strategic discussions that not only Covance is having, but other competitors are having, tell me that we are on the edge of a tipping point. And throughout this year and next year I think you are going to see bigger chunks of outsourcing driving. And frankly, that’s the key catalyst.

Ross Muken – Deutsche Bank

Great. That’s really helpful. And maybe, Bill, as we sort of look at some of the cost actions, and I’m going to call it a restructuring, the $0.09 that we’re going to see in Q2, if we had to sort of tease out the cost between kind of the cost of goods line and the SG&A line, what would sort of the breakup be? I’m trying to get to a cleaner operating number, so we can kind of better model the recovery in earnings in 3Q and 4Q and obviously into ’11, because most of this is one-time in nature, I’m assuming.

Bill Klitgaard

Right. I think a lot of it is – I don’t really know, frankly, the split between SG&A and operations, but probably I would guess that maybe two-thirds of it is cost of sales because it relates to operational decisions you made around specific sites. And to your point, the $0.09 is the impact in Q2 of the cost, but we will start to begin to get some of the benefits that the net impact in Q2, the net of the cost and a little bit of the savings is somewhere in 7% to 8% – $0.07 to $0.08 range.

Ross Muken – Deutsche Bank

That’s really helpful. Thank you very much.

Joe Herring

Thank you, Ross.

Operator

Our next question comes from John Kreger with William Blair.

John Kreger – William Blair

Hi, thanks very much. Just on the strategic comments you were making at the end of your remarks, just curious, are you seeing those discussions that you are having bridge early and later stage or do they tend to be in one bucket or the other?

Joe Herring

Yes, John, that’s a very good question. We lead with the breadth and depth and global nature of our sort of R&D service portfolios. I think in our case, we are particularly competitive when we talk about the portfolio. And as you know, we continue to think asset transfers. The right asset transfers make sense. And being able to sort of bringing a number of different ways to solve an equation is a real advantage of Covance. Over the last year, we’ve seen more amenability to cross sell between early and late and late to early than any time in the past.

And I think the reason why is because we are at higher levels in our client organizations than ever. And a client who thinks our Central Labs is magical is more likely to consider us in clinical or let us talk to them about clin pharm is someone who doesn’t know us, or someone has done a big deal with us in toxicology and we have a sort of a trust-based personal relationship, they are more willing to pull their clinical people in the room and say, look, you really need to talk to these guys, you know. We trust them, they have a broad portfolio, they are an industry leader. And it tells us about the things they are doing clinical there that are pretty thought-provoking. So I guess the short answer, John, is we are seeing more of ability to leverage both early and late than in the past, not specifically in a quote, but in a more strategic deal.

John Kreger – William Blair

Okay, thank you. And then my follow-up is relating to sort of pricing and margin potential in the Early Stage part of your business. Now that it seems like demand is picking up a little bit, are you seeing any positive movement on price, and how does that change your outlook on getting back to where you were a few years ago in terms of margins in that segment?

Joe Herring

Well, I guess, John, we would call pricing stable. And we’ve been doing everything we can to try to lead. But I think it would be too early to factor that into our forecast. We haven’t done that yet. But I think some of the wild pricing of six or nine months ago have sort of subsided. And frankly, clients feel like they are ready to get back work. When they have no work to place and study being delayed, they can – they know about your time shopping than on pricing. But the starts that we are getting now are for – or the awards we are getting are for quick study starts. They are ready to go. How soon can you go? It’s usually a client who has been on hold for a while, and now they got a gun to their head to get the work done. And so that’s what we are seeing. And – but we do expect to see Early Development margins expand based on the cost actions we’ve taken, certainly not in Q2, but as we get to the back half of the year. And certainly a $12 million lower cost structure as we enter 2011 gives us optimism.

John Kreger – William Blair

Great. Thanks very much.

Joe Herring

Thanks, John.

Operator

(Operator instructions) Next we will be moving to Greg Bolan with Wells Fargo.

Greg Bolan – Wells Fargo

Thanks for taking the question. So maybe a slightly different spin on John’s question, assuming pricing remains stable, can you share the incremental margin on, call it, an incremental dollar of Early Development revenue as we move forward in time? Just thinking about detrimental Early Dev margins since 2008, would you think north of 50% incremental margins is a fair assumption?

Bill Klitgaard

Greg, I don’t think we really want to get that precise right now. What I’ll just tell you is we expect margin expansion as the year progresses.

Greg Bolan – Wells Fargo

That’s fair. And then I guess my follow-up, Joe, relative to around spring of last year, do you feel like this three-quarter improvement in Early Development bookings is more concrete? I mean, I know it’s a tough question, but do you have more conviction that study start delays are somewhat behind us?

Joe Herring

I get really nervous answering the question based on where we were last year at this time because we had in hand study starts ready to go for a $15 million sequential revenue increase and those were pushed out. My gut, my discussion with my management team as well as directly with the clients tells me we are in a very different market. Clients a year ago were scared to death that they weren’t going to have a job, and the pipelines were frozen. The huge merges were in sort of a full swing. And I think it was sort of clients walk around in a day.

The clients now feel like we’ve got work to do, sort of ahead our year off, it’s time to get going. So it feels like a different sense of urgency. I think people have a different feeling of companies generally. I think they feel the pressure of watching new products. So it feels very different, but I don’t want to get too far ahead of ourselves. We’re talking about modest revenue increase sequentially over the rest of the year, and we believe based on the cost actions that we can expand margins. And we will be happy with that should we be better than that? Yes. But you don’t call it for sure. Go ahead, Bill.

Bill Klitgaard

Just a comment here, Greg. If we can continue to improve the fill rates, that takes fixed cost and absorbs the fixed cost better, so that helps margin. Also keep in mind that pricing in any one quarter really flows through as the revenue converts from backlog so that the pricing is stable. You will feel the benefit of that next quarter and the quarter after in Early Development. So there is – both of those factors should be beneficial in terms of the margin improvement story without a lot of heroic assumptions about where we are going to go from here.

Greg Bolan – Wells Fargo

Right, right. Okay. Thanks, guys.

Joe Herring

Thank you, Greg.

Operator

Our next question comes from Eric Lo with Banc of America/Merrill Lynch.

Eric Lo – Banc of America/Merrill Lynch

Hi, good morning, guys. There are two Eli Lilly deals that you guys have done where some are very different from other strategic partnerships they have done so far. And based on a lot of comments that are in public forums, it seemed like these deals are going to take a significant amount of time to close. Do you think other companies are still perceiving this as sort of revolutionary in nature? And what are your thoughts in terms of any other potential companies that may be close to doing something similar to these types of deals?

Joe Herring

Eric, thanks for your question. Frankly, every client is different. One of the things you said, I’d like to sort of reemphasize is that these things take time. I guess I’d characterize as every company sees their situations different. Everyone has a little bit different culture, different management, different view of outsourcing. But the one common thing that they all have – problem they have in common is they know that their R&D cost structure is too high, they know they needed to be more variable, they needed to be more global, they needed to be faster, and they need to make decisions quickly. And so it’s interesting some think they can solve that internally. Others look externally to consultants.

Others are increasingly seeing what Covance and some of the other competitors are doing. I mean, I think you know the (inaudible) partnership, Covance (inaudible) was the only late-stage partnership being discussed. You’re seeing in Harvard Business Review. You’ve seen these things on – in the Wall Street Journal. And three years ago, you’ve never seen any of that. You hear pharma CEOs and other executives talking about strategic outsourcing. So it’s hard to call the timing, but it’s hard to deny the momentum is building. And it’s just like IT outsourcing or sort of any other major swings in outsourcing, once the momentum gets going, then people sort of jump on the train because they see the benefit. And I think the good thing for Covance and the other CROs is that we are proving as an industry that we can get the job done.

Eric Lo – Banc of America/Merrill Lynch

And then to follow up on that, in terms of your book-to-bill, it seems like you guys have caught up with signing of that Central Lab deal on that Phase III study. So it seems like the book-to-bill would have been more like 1.24 as far as those two deals were done on time. And based on comments from competitors and yourself, it seems like RFP flow continues to increase and deals are getting larger in size, and you also have record proposals in place. Would you say that, and generally speaking, clients are signing to accelerate their decision-making process or are they still sort of taking their time when they come to making decisions on RFPs?

Joe Herring

Eric, it really depends on the client. We’ve got few clients that are slow at shopping. Others seem to have a real sense of urgency. But it kind of varies by client.

Operator

Our next question comes from Dave Windley with Jefferies & Company.

Dave Windley – Jefferies & Company

Hi, thanks for taking the questions. Joe, on these delayed studies, are these – it sounds like they are delayed different amounts of time for each one, but I’m wondering the relationship that you have with this client, is this a client that you feel like you know pretty well and you could have a reasonable level of confidence that they are shooting straight with you about their intention to continue forward with these studies, and kind of how much visibility or confidence do you have in a reset start date?

Joe Herring

Dave, thanks for the question. First of all, it’s two clients. It’s not one.

Dave Windley – Jefferies & Company

Okay.

Joe Herring

Both clients are strategic partners. So we have very open, very candid discussions with them. These are three very large clinical trials. The largest of the three was delayed due to feedback from the FDA. The good news is that the client has now heard back from the FDA, and we are restructuring the study, such small or bigger – just changing in that dynamics. And we are locking in on a sort of summertime start. And so that was barreling ahead. The second largest study is from a client who went through a pipeline re-sequencing exercise. And so they pulled some work forward in some smaller studies, and this is a very large study that they actually pushed out to the beginning of 2011.

So there would be no revenue from that particular trial in 2010. The last one is a similar internal pipeline re-sequencing. We were expecting $40 million in revenue from this trial this year and now we are expecting roughly $10 million, but the start is locked in. So again, three sort of different situations, but portfolio reviews are not uncommon in the industry. And we have these types of discussions with these clients sort of on a quarterly basis. Again, they are strategic clients.

Dave Windley – Jefferies & Company

Okay. Thanks for the detail. That’s actually very helpful. My second question, Joe, is kind of, I suppose, a Board level type question. I know that – I'm interested in your reflection of both the consideration around allocation capital. You’ve talked in the past about how management is incented on return on assets that’s obviously been hurt by the dampening in margin and things like that.

You also made some comments earlier on this call to John’s question about the right strategic asset transfer type of deal could make sense. And so I’m just – I'm interested in how you are thinking about CapEx reinvestment and the amount of that that needs to be done strategic deal potential and the capacity and so forth. I know we’ve talked about this in the past. It’s hard to call on timing and things like that. But around the basic incentive of return of assets, how are you considering – where are you putting capital to work, hopefully as the business returns?

Joe Herring

I guess our capital profile is actually changing. A big part of our capital over the last five, seven years, as you well know, Dave, has been building new tox facilities. And other than our China build, and we’re sort of out of that business for a while, we see the ability to grow our tox and our chemistry business has been within our existing footprint, including the new Chandler facility and the Greenfield facility. So that really dampens our capital needs in the coming years.

Our second biggest chunk is IT. And we continue to make big investments there that we think is going to produce significant client and productivity benefits, but it’s sort of painful as you are going through it. And finally, as you look at asset transfer deal, obviously if you acquire something that you can grow and you have the right contract terms, these are on very much more favorable sort of capital profile than building capacity. But it’s a tricky equation, and you got to have four, five key variables, both on our side and the client side fall in place to make them work. But I think if you look at the return on capital on the ones that we’ve done so far, we are absolutely thrilled with that. Bill is the guardian of the capital. I’d like him to comment as well.

Bill Klitgaard

Dave, the Early Development part of our portfolio is certainly the more capital intensive part. As Joe mentioned, we’ve done a fair amount of building over the last few years. So our need for additional capital investment there is probably more in the maintenance capital area. The Late-Stage is much lower capital intensive. And frankly, we’ve been doing very well in that part of our portfolio. So, as we move forward, I think you can look forward to a lower level of CapEx in Early Development, generally speaking, and probably more investments in IT, in automation, particularly in our Central Laboratory, in areas that should improve our competitive position. So we have not given up on return on capital or improving shareholder value through it.

Dave Windley – Jefferies & Company

Okay. Thank you.

Joe Herring

Thanks, Dave.

Operator

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

Eric Coldwell – Robert W. Baird

Thanks. Just a couple of quick ones. I think, Bill, in the prepared remarks, you commented about Early Development had a $2 million sequential increase quarter-over-quarter, you are at the low end of your target. Is that guidance or is that kind of just a baseline for how low the improvements can be to just at the low end? I’m curious that that was a comment that had more meaning than maybe it sounded.

Bill Klitgaard

The data before show that it doesn’t take huge assumptions to get to the 5% growth year-on-year. And we’ve had improvement in revenue in Q1. We had improvement drop the quarter in tox. So I think what we said at the start of the year was, we are not going to call it, should we see it. And so I think we are just starting to see a little bit of it, and we are trying to get an indication of fairly conservative assumptions that could be made.

Eric Coldwell – Robert W. Baird

Sounds great. The Early Development operating margin expansion commentary as well that you – I thought I heard you say you expected it to be up year-on-year. So the first question is, is that an accurate assessment to north of, I think, 12.6% for the full year? And if so, is that inclusive of the $0.09 charge in the second quarter?

Bill Klitgaard

I think what we are seeing for Early Development is a margins will expand, absent the cost actions in Q2. So we expect margin expansion in Q1, throughout the year to Q2 to Q3 to Q4.

Eric Coldwell – Robert W. Baird

And again, to clarify, with the charge, would you still expect the full year operating margin to be ahead of last year?

Bill Klitgaard

Probably in line with last year, maybe up slightly.

Eric Coldwell – Robert W. Baird

Great. That’s it. Thanks so much.

Operator

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

Todd Van Fleet – First Analysis

Hi, good morning, guys. Hoping you can comment qualitatively on the resourcing for the business both on Early Development and Late-Stage given the pipeline of activity that you have. I guess more specifically, I’m wondering – are you in a kind of an accelerating cycle in terms of hiring – I guess there for Late-Stage, I would imagine there is probably not a whole lot of new resource is being brought on in Early Development, but again I’m just wondering if you can kind of talk about that qualitatively. Thanks.

Bill Klitgaard

Todd, well, we have been adding staff in our clinical business, but based on these delays, we are holding off on hiring new staff, and we are continuing to rerun our demand model based on when these three trials are going to start as well as other new studies that we win. But I think it’s suffice to say, we are going to be flat in Q2 for sure and probably flattish in Q3, but we also don’t want to miss the wave later in Q3 and in Q4. Central Labs will be flattish, and in preclinical, largely flattish. I mean, we do have some barriers that are growing as we’re having the resource on nutritional chemistry businesses doing very well. And obviously things are – as we’ve indicated, they are picking up in clin pharm. But generally speaking, I would say you net all that out very slow, if any, headcount growth over the next couple quarters.

Todd Van Fleet – First Analysis

Great. Thanks, Bill. And the follow-up on the margin discussion regarding Early Development, how does your thinking of how Phase I is going to play out for you guys over the course of 2010? How was that factoring in to your margin expectation for Early Development?

Joe Herring

Well, Todd, as you know, the Phase I business is lumpy. That’s how we describe it. And so we sort of feel nervous about projecting Phase I margins on a go-forward basis because it depends on how many studies drop in and stick. Right now, again it feels like we are – it's a rising tide. If that happens, we will absolutely have margin expansion, plus we have the leverage of consolidating the volume out of the Austin clinic. But we tend not to get too far ahead of ourselves projecting the Phase I business.

Todd Van Fleet – First Analysis

So would it be fair to say then, Joe, that if the Phase I business does kind of see this rising tide type of phenomenon that there could be an opportunity for Early Development margins to perform better than kind of how you are currently describing them?

Joe Herring

Yes.

Todd Van Fleet – First Analysis

Okay. Thank you.

Operator

Our next question comes from Steve Unger with Lazard Capital Markets.