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Covance (NYSE:CVD)

Q2 2014 Earnings Call

July 30, 2014 9:30 am ET

Executives

Paul Surdez -

Alison A. Cornell - Chief Financial Officer and Corporate Senior Vice President

Joseph L. Herring - Chairman and Chief Executive Officer

Analysts

Robert P. Jones - Goldman Sachs Group Inc., Research Division

Jeffrey Bailin - Crédit Suisse AG, Research Division

Michael P. Ward - Sterne Agee & Leach Inc., Research Division

John Kreger - William Blair & Company L.L.C., Research Division

Steven Valiquette - UBS Investment Bank, Research Division

Eric W. Coldwell - Robert W. Baird & Co. Incorporated, Research Division

Ricky Goldwasser - Morgan Stanley, Research Division

Garen Sarafian - Citigroup Inc, Research Division

Tejas Savant - JP Morgan Chase & Co, Research Division

Ross Muken - ISI Group Inc., Research Division

Rafael Tejada - BofA Merrill Lynch, Research Division

Todd Van Fleet - First Analysis Securities Corporation, Research Division

Alexander Y. Draper - SunTrust Robinson Humphrey, Inc., Research Division

Sean W. Wieland - Piper Jaffray Companies, Research Division

Donald Hooker - KeyBanc Capital Markets Inc., Research Division

George Hill - Deutsche Bank AG, Research Division

Douglas D. Tsao - Barclays Capital, Research Division

Operator

Good day, and welcome to the Covance Second Quarter 2014 Investor Conference Call. This call is being recorded. At this time, for opening remarks, I would like to turn the call over to the 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 Second Quarter 2014 earnings teleconference and webcast. Today, Joe Herring, Covance's Chairman and CEO; and Alison Cornell, Covance's Chief Financial Officer, will be presenting our second quarter financial results. Following our opening comments, we will host the Q&A session. In addition to the press release, 20 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 webcast, which are not historical facts might be considered forward-looking statements. Such statements may include comments regarding future financial results that are subject to a number of risks and uncertainties, certain of which are beyond Covance's control. Actual results could differ materially from such statements due to a variety of factors, including the ones outlined in our SEC filings. 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 normal operations. We believe that providing these measures help investors gain a more helpful and 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 A. Cornell

Thank you, Paul, and good morning, everyone. Consolidated net revenues for the second quarter were $639 million, up 8% year-on-year. Foreign exchange contributed 270 basis points to this growth rate. Sequentially, revenues increased $19.4 million as revenues grew in some segments. Pro forma consolidated operating income in the second quarter was $76 million, and our operating margin was 11.9%. This is a 220-basis-point year-over-year increase and a 40-basis-point sequential increase. Pro forma diluted earnings per share in the second quarter were $0.95, up $0.17 or 21.5% from the second quarter of 2013. A better-than-expected increase in Early Development and continued strength in central labs more than offset increased IT spending and a modest sequential decline in clinical development revenues.

The pro forma effective tax rate in the second quarter was 23.7%, and this is expected to be approximately 24% in the back half of 2014. Note that our pro forma results this quarter excludes $4.2 million in costs associated with our restructuring and other cost-reduction actions, as well as $52.6 million in asset impairment charges related to the breakdown of idle properties, primarily our Chandler facility, which continues to be actively marketed for sale.

Please turn to Slide 5 of the presentation. In the second quarter, Late-Stage Development contributed 64% of net revenues, while Early Development contributed 36%. Revenue from our international operations continue to exceed our U.S. operations coming in at 54% x U.S. versus 46% U.S.

Turning now to Slides 6 and 7, where I will review the segment results. In Early Development, net revenue was $231 million in the second quarter, up 7.7% from the second quarter of last year, led by growth in clinical pharmacology and toxicology, which more than offset a decline in discovery support and the impact of the sale in the Seattle genomics laboratory. Foreign exchange contributed 250 basis points to the growth rate. Sequentially, revenues increased by $13 million on continued strength in clinical pharmacology, higher-than-anticipated growth in toxicology and an increase in pharmaceutical chemistry and discovery support. Nutritional analysis revenue was consistent with last quarter. Pro forma operating income in the second quarter was $30.8 million, up 27.1% year-on-year and a $9.7 million, or 46% increase from the seasonally weak first quarter.

The year-on-year increase in profitability was primarily driven by clinical pharmacology and pharmaceutical chemistry, while this sequential decrease was broad-based across most Early Development services.

Turning to Late-Stage Development. Net revenues in the second quarter were $408 million, an increase of 8.1% versus the second quarter of 2013. Foreign exchange contributed 270 basis points to the growth rate. Year-over-year growth was driven by an 11% increase in central laboratory's revenue. In addition, clinical development grew 4% and market access services resumed year-on-year growth, following several quarters of decline. Sequentially, revenue in the segment increased $6.4 million, with central laboratories being the primary driver of the increase. Pro forma operating income in the second quarter grew 11.5% year-over-year to $90 million. This represents an operating margin of 22.1%, which is up 70 basis points year-on-year. Sequentially, operating margin was down 110 basis points from a very strong first quarter level by greater IT spending and a decline in clinical development revenues.

Turning now to corporate expenses. On a pro forma basis, corporate expenses were $45 million or 7% of net revenue in the quarter. This is a decrease of $2.6 million year-over-year, largely reflecting the higher level of incentive compensation expense in the 2013 period, coupled with the shift of informatics expenses to the Late Stage segment. On a sequential basis, corporate costs increased $1.6 million, primarily due to an expected increase in IT spending, which we mentioned last quarter.

Please turn to Slide 8, where I will now review the order and backlog information to the quarter. Adjusted net orders in the second quarter were $773 million, or an adjusted net book-to-bill of 1.21:1. Backlog at June 30, was $6.92 billion, up $20 million from the end of last quarter. Changes to foreign exchange rates negatively impacted backlog by $23 million sequentially, while the Medaxial acquisition, which closed in May, added $2 million to backlog.

Please turn to Page 9 for a review of cash flow information. Cash, cash equivalents and short-term investments at June 30, 2014, was $648 million, down $12 million from March 31, and up $202 million from a year ago. Debt outstanding increased $40 million, as we repurchased 75 million in shares in the second quarter. We've completed our existing share repurchase authorization. We continue to evaluate future share repurchases as part of our broader capital allocation strategy.

Free cash flow for the second quarter was $30 million, consisting of operating cash flow of $68 million, with CapEx of $38 million. Although there was $136 million improvement from a seasonally low Q1 level, Q2 was dampened by a 7-day increase in day sales outstanding, which negatively impacted operating cash flow by about $50 million.

To continue to target DSO of 40 days by the end of the year, which would help drive significantly improved operating and free cash flows, we continue to project 2014 full year CapEx of approximately $160 million and free cash flow of approximately $130 million. Finally, we ended the quarter with 12,684 employees, a net increase of 54 from last quarter end.

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

Joseph L. Herring

Thank you, Alison. Good morning, everyone. Second quarter results exceeded our expectations as more growth in clinical development was more than offset by continued strong growth in central labs and better-than-expected performance in Early Development. Year-on-year, our revenue growth was 80%, pro forma operating margins expanded to 11.9% and pro forma EPS grew greater than 20%. From a commercial front, adjusted net orders increased to $773 million, delivering an adjusted book-to-bill of 1.2:1. Strong new order flow continued in Early Development and central labs, and clinical development orders improved nicely from the lower first quarter level. Now turning to our segment results.

In Early Development, the rebound from the seemingly soft first quarter was more pronounced than we expected, leading to revenue growth of 7.7% year-over-year, despite the headwind from the sale of the Seattle genomics lab and 5.9% sequentially. Early Development pro forma operating margin also expanded sharply, up 200 basis points year-on-year and up 360 basis points sequentially to 13.3%. And orders in the segment were above our target once again, although slightly below the very high first quarter level.

In toxicology, with the market continuing to stabilize and industry capacity filling, Covance delivered 10% year-on-year revenue growth in the second quarter and our toxicology orders continued to be very strong. We posted our second-highest toxicology order performance since before the financial crisis of 2008.

In North America, we are now booking toxicology studies to our account in the fourth quarter, as our capacity continues to tighten. And for the first time in many years, we've started to double book study and had to get the cancellation risk. So far this year, we have successfully moved about $10 million of U.S. toxicology study starts to our European sites. This compares to 0 studies moved to Europe last year. These study placements in addition to an uptick in sales to European clients, led to improved capacity innovation in Europe, which is still below the North American levels.

We are also starting some new studies with increased pricing in North America, which would be a driver of margin expansion in the future, if that trend continues. Our second quarter toxicology results still reflect studies sold during the time of lower pricing. And toxicology markets remain in the single digits. There's a lot of run rate for improvement in price increases, and capacity utilization continues to go higher. Our new guidance assume these factors will help drive growth to develop operating margins to the mid-teens as we exit this year. Margins should continue to increase further in 2015 as an increasing percentage of Early Development revenue reflects improved market prices and better global capacity utilizations.

Also for 2015, keep in mind that the 5-year portion of the Sanofi alliance we signed back in 2010, that is the asset transfer agreement for the sites in the annex portion of the bill, is due to expire in November of 2015. If Sanofi were not to renew this agreement at current levels, Early Development will face a headwind exiting 2015 and heading into 2016.

Also note that the larger 10-year services agreement with Sanofi continues for 2020. The biggest year-on-year driver of growth in Early Development continues to be our clinical pharmacology business, which has shown strong and sustained financial performance for a couple of years. Our Phase I order volume remains strong with steady booking out into the fourth quarter. We continue to see increased activity for both biotech and large pharma sectors with increased demand for higher complexity Phase I and IIa studies.

After several years of outstanding performance, our nutritional chemistry services are off to a slower start this year, with revenue and earnings pulling back from last year's record performance. Operating income this year has been impacted by the softer top line performance, as well as investments we are making to expand our nutritional chemistry operations in Harrogate, Madison and Singapore. Despite longer-term growth in this important service line, we continue to evaluate acquisition targets across several geographies. Food safety testing is an issue of growing global importance.

In support of our integrated drug development strategy, we launched an innovative new service at the recent bio conference. This win-win solution and e-commerce forum, called Covance MarketPlace, is designed to give our most strategic clients visibility to the vast number of molecules we are working on in the preclinical and proof-of-concept phases, while also providing our hundreds of emerging biotech clients with increased access to those same strategic clients who are looking to source innovation and could become their future development and marketing partners. We believe Covance MarketPlace is a potential driver of market share gains in preclinical. We believe MarketPlace better positions Covance to be awarded to follow on late-stage work. And we believe MarketPlace establishes yet another reason for clients to engage in strategic [indiscernible] dialogue with Covance as we help them source new innovations. Covance MarketPlace is the best -- an excellent example of how we're using our new brand Solutions Made Real. Now let's turn to Late-Stage results.

Central laboratory continued a strong performance, with revenue up 11% year-on-year and 5% sequentially. Operating margins increased slightly on a sequential basis but were down year-on-year, reflecting the addition of staff to process the high level of expected kit volumes. In addition, we continue to roll out our new laboratory information management system, and we are already seeing a number of productivity benefits, including fewer shifts required to manage higher testing volume and workflow and automation benefits in an increasing number of our important esoteric test.

Our central labs has taken market share for many years, despite some larger sponsors choosing to use lower price and lower quality competitors. History has proven that over time many of these sponsors come to realize that the lower price comes with substantial cost in the form of clinical trial delays, negative surprises, and extra cost to fix errors. In the last 6 to 9 months, we are again seeing some larger sponsors becoming less price-sensitive and looking to reengage with Covance. Recent new orders and a significant increase in proposal volumes gives us confidence in our ability to continue taking profitable market share in central labs. In clinical development, second quarter revenues declined sequentially due to slower revenue conversion on a few large projects. On the commercial front, cancellations returned to a more normal level in the quarter, and gross orders increased, driving sequentially higher net orders. Although those orders increased sequentially, they remained below the record 2013 levels. In addition, the mix of work one order will be helpful for future growth, but will not drive accelerated growth in the next quarter or 2. In response, we have taken assertive actions, including headcount reductions to align our cost structure with volume for the rest of the year. Having said that, our pipeline's total was at an all-time high at June 30, and since then, several significant new opportunities have entered the funnel. We continue to be very optimistic about the clinical development market space and our long-term growth opportunities there.

Contributing to our longer-term optimism in clinical development is the positive client response to our informatics tools. In fact, a couple of those large new proposals that came in the door already in July are directly attributable to our client's interest in Covance informatics tools, our team and our strategy. Covance is incredibly well positioned to be a leader in clinical informatics, based on our 40% market share in central lab, in addition to our global clinical organization. Just within our current Xcellerate product, we have information spanning more than 11,000 clinical protocols, 600 clinical indications, 175,000 investigators and 15 million patient visits. Over the last year, we have added sophisticated, highly experienced data scientists and engineers to harness the power of this data. They are leveraging the information technology investments that we've made across our businesses. This team is inventing new ways to leverage this data, expand it with real-world evidence from other sources and deliver it with powerful, intuitive visual analytics.

Most recently, Covance has entered into an in-kind collaboration with Novartis Institutes for Biomedical Research to accelerate the development of the state-of-the-art data warehouse. It is designed to support data integration and meta-analysis across both preclinical and clinical research. This new data warehouse will use next-generation technologies, which make it possible to integrate massive volumes of data faster and more economically. The end goal of our informatics investments, as well as our investments in technologies to support our risk-based monitoring efforts, is to significantly reduce the time and cost of clinical trials for our clients, while simultaneously improving quality. If we can help our client finish patient enrollment a year ahead of their target and we deliver that incredible milestone twice in the past 12 months, the value creation for our clients is absolutely staggering. Continued success like this, coupled with innovative services like Covance MarketPlace, positions us to win a lot more repeat business, as well as earn an opportunity for more strategic client discussions.

Finally, market access returned to growth in the second quarter. More importantly, we were recently chosen to support the launch of several new important biological medicines that have or will soon hit the market, which should drive accelerated growth in our business going forward. In addition, we continue to look for acquisitions to expand our capabilities in this growth segment, such as the recent purchase of Medaxial, which provides an important value communications services to our clients.

Now let's turn to our outlook for Covance. For 2014, we now forecast revenue growth of 6% to 8%. The midpoint of this range assumes Early Development at the lower end of that range and Late-Stage Development at the higher end. Revenue growth expectations include headwind from the sale of the genomics laboratory. We are also updating our full year pro forma diluted earnings per share to the range of $3.78 to $3.92. In terms of cycling of 2014 earnings, we expect sequential growth of a few cents in earnings in both the third and fourth quarters, which will deliver earnings at a new higher midpoint of our guidance range.

Looking further ahead, we continue to build a stronger Covance for the future, due to rise[ph] in both the depth and breadth of our portfolio and the enormous talent in our global drug development teams to create Solutions Made Real for our clients.

In closing, I'd like to thank Covance employees around the world for delivering exceptional service to our clients and help them bring their important medicines to our patients around the world. Operator, you now may open up the lines for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And we will take our first question from Robert Jones with Goldman Sachs.

Robert P. Jones - Goldman Sachs Group Inc., Research Division

I guess, the one area, Joe, that directionally wasn't where we thought it would be, given recent trends, it's clearly the clinical top line. I know you touched on this in the prepared remarks a little bit, but I was hoping you could talk about what exactly drove the conversion rate slowdown? And I guess in your view, was this kind of a timing issue? Was it very unique to Covance in some way? Just some additional thoughts around clinical in the quarter will really be helpful.

Joseph L. Herring

I guess, it was just really related to a couple of large studies that we won that are converting to revenue a little bit slower. But let me just talk more broadly about clinical, how we're looking at that, as well as some of the other drivers of our business. We're revving[ph] through a time of project cancellations and revenue converting a little slower, but we successfully navigated periods like this back in 2006 and 2010. Now on the heels of that one substantial need work, which led our clinical revenue growth to new highs in the following years. But the record level of proposals we had at the end of the quarter and the addition of these several large opportunities, we could see a significant turnaround in growth rate in this business in 2015 and beyond. And keep in mind, you have to think about the whole portfolio. In Early Development phase I continues to run strong, the investment that we've made there are paying dividends. And of course, toxicology capacity, as you know, Bob, is filling across the industry and pricing there improving and new orders continue to run strong. If these trends continue, we could see some exciting performance. In central lab, we continue to take market share. A couple of these clients drop back in and we will continue that winning streak. And you add all that, market access starting to ramp up. And when we're delivering on our cost-savings initiatives and the investments that we're making in informatics tools. Sometimes, it's easy to kind of get lost in the weeds or in the detail, but keep in mind, 2013, in an organic basis, Covance grew 10% in revenue and pro forma EPS grew 20%. And despite the headwind from the sale of the genomics lab and the clinical slowdown, this most recent quarter, we got revenue growing 8% and EPS growing 21.5%. So we're a strong and growing company, and not everything gets on every cylinder at all times, but I tell you, we like our chances.

Operator

We will now take our next question from Jeffrey Bailin with Crédit Suisse.

Jeffrey Bailin - Crédit Suisse AG, Research Division

Joe, on the toxicology front end of the capacity continues to fill up Covance some likely some of your competitors. How much runway do you have to light up dark wings and flex capacities at current facilities before you or -- it appears you might have to start to consider meaningful facility expansion, reopening some of these sort of facilities? And would you wait on that until we see price coming back in a more meaningful fashion?

Joseph L. Herring

Well, I tell you, the welts are still on my back, so I would say that the first data point is, we could probably grow 10% over the next 2 to 3 years within our clearance footprints. And then obviously, we would manage capacity with price, which we did very successfully from 2003 or '04 to 2008. The big difference between now and when we were making significant investments in capacity is that there are a number of facilities that are available. And should we have extraordinary growth beyond the upper end of our cone of uncertainty, there are a number of very cost-effective basic capacity that we could bring on very quickly, particularly leveraging the investments we made in IT infrastructure and preclinical systems, which would allow us to take a facility and convert it quickly into -- much more quickly and historically, to revenue and margin generation. So from your lips to God's ears, it would be high-class problem to have.

Operator

[Operator Instructions] We will now take our next question from Greg Bolan with Sterne Agee.

Michael P. Ward - Sterne Agee & Leach Inc., Research Division

This is Mike Ward in for Greg. This question was for Joe. Is there any appetite that you can comment on where you are in terms of the pipeline of opportunity of kind of mega alliances like those of the Lillys and the Sanofis of the world, now kind of versus this time last year?

Joseph L. Herring

Yes. We don't comment on sort of stuff that's in the funnel and really never have, and we tend to wait until we have something definitive. But having said that, there is a lot of turmoil in our large client organizations. In particular, there seems to be rolling announcements of their need to reduce overall cost, as well as R&D cost and improving efficiency. And that's why we're working on solutions such as helping them access more innovative molecules and making investments in technology that allow us to complete clinical trials and drug development projects faster, less expensively, while improving quality. So a lot of those, I guess, the drivers of client needs, creates opportunity for us and we stay actively engaged in those, and just try to bring as much heart[ph] as we can. But I don't have anything specifically to announce exactly.

Operator

And we'll now take our next question from John Kreger with William Blair.

John Kreger - William Blair & Company L.L.C., Research Division

Joe, could you just expand a bit on the informatics slide in your deck? It seems like you're definitely starting to get some benefits now from all those investments. How do you think that'll show up over the next year or 2? Is that, do you think, a shared driver or more of an efficiency tool that could drive improved margins? And is there one part of your business that you think should benefit, in particular, such as clinical? Or do you think it would be broad-based?

Joseph L. Herring

John, I definitely think it makes us more efficient and I definitely believe that it's an enabler of market share gains. Frankly, I think the CRO industry is maturing and there are several companies that are developing tools and capabilities that clients always wanted, but tended to struggle to develop internally. And then, with the extreme pressure on R&D spending, CIOs, the RV organizations they're having same kind of budget cuts as others. So I see the whole data and informatics as a major driver of industry growth over the next several years. And with the combination of the data, the investments we made in the infrastructure and systems and the talented people that are literally racing to our company to help leverage that, as well as external data, I think puts us in a position to really take significant time and cost to our drug development and improve it along the way. So stay tuned, we're going to continue to, I think, have some exciting comments to make.

Operator

And our next question is from Steven Valiquette with UBS.

Steven Valiquette - UBS Investment Bank, Research Division

So I got up a couple of minutes late, but just a question I have is, is there any sense that the slower revenue conversion on a few large projects within Late Stage, is that related to client M&A activity in any way? Or can we check the box and clarify that it specifically had nothing to do with that? I guess, clarity either way would be helpful.

Joseph L. Herring

To the best of my knowledge, it has absolutely nothing to do with that.

Steven Valiquette - UBS Investment Bank, Research Division

Okay. And then also just to be clear, it's not cancellations we're talking about here, it's just slower decisions, that's the right way to think about that. Is that also correct?

Joseph L. Herring

Yes, well we -- Steven, we had a chance of high level of cancellations for several orders and that's all well documented. Cancellations moderated now and orders actually picked up. But it's the time when cancellations sort of have a sustained impact, especially if a couple of studies are a little slower to ramp up. But I mean, again, we think the clinical market is very healthy. If you look at the 5-year period ending in December 2013, Covance's clinical business was the fastest-growing major clinical company in the industry and had the highest book-to-bill over that same time period. Again, we have similar things like this, very similar things happened like this in 2006 and 2010, and we recovered from that when we worked and punched through new highs in terms of revenue growth, margin expansion and market share gains. And I think we have a funnel to do that right now. So there's really nothing that hasn't happened to us and other competitors in clinical development from time to time. It's just part of the normal ebbing and flowing. And again, we really like our chances going forward.

Operator

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

Eric W. Coldwell - Robert W. Baird & Co. Incorporated, Research Division

John actually covered most of my topic on informatics. I guess, I just maybe would add on, are there any early anecdotive [ph] solutions, specific solutions that clients are interested in? You talked about some of these larger R&D[ph] opportunities coming in to the pipeline very recently. And some of those were based on discussions about your informatics capabilities. I'm curious if there's any one specific area or 2 specific areas that you're talking about with clients today, in terms of engendering interest in coming to Covance as opposed to another solution, based on what you're doing with informatics here early on.

Joseph L. Herring

Yes, Eric, thank you so much for that question. One for sure is the innovative approach that we have taken to risk-based monitoring. And we haven't rolled it out broadly, we are rolling it out to strategic clients and having them involved in the beta testing and the early work. Most of the algorithms and the logic behind our approach to risk-based monitoring, we can do manually and have been doing manually, and now it's a matter of putting in an automated system, and we've made substantial progress on that. And clients really, really like the elegance of that tool. The second thing, Eric, as you well know, our accelerated tool has really helped our competitive position. But it's largely been manual calculation that we've used only for strategic clients. And leveraging our IT investments and even more sophisticated algorithms, it's becoming a more automated tool that we're using in more trials. And the fact that we can sit here and say 2 major pivotal clinical trials finished enrollment a year early is a stunning proclamation to be able to make. And it's delivered by our ability to drill into our data that we have and use both analytics and foreign algorithms to pick the right size, predict enrollment, and to give other resource information that help our clients be more efficient. And I can tell you, the project teams, when they go back to procurement, to executive management and talk about who's going to do the next big trial, they talk about what happened with Covance. The quality of the team, the quality of tools, and the Xcellerate piece. Another element that we're starting to show clients is this data visualization capability that we think is industry-leading. So again, we sit with clients, say here's how you're currently doing it, here's how we've historically have done it with you, choose now, the visibility you're going to have to your current enrollment, site performance, data queries, all the things that are important along the way, and how we predict that over the next 3 to 6 to 9 to 12 months, stuff that you can play in your resource needs, whether it's data management, data reviews, medical reviews or whatever. And it just keeps rolling from there, Eric. Every time we sit with clients and show these tools, they go, "What about this?" or "What about that?" And they want to find ways to work more closely with Covance. And frankly, I think it's going to lead to more and more companies exiting IT in a larger way because of our network and data centers capabilities, well, some of our key competitors, and some of these tools and the lack of their ability to gain funding to build these. And frankly, why would they ever do it anyway? Because we do more clinical research than any of them, as well as some of our competitors. I just think it sets up a very, very interesting dynamic, and Covance is determined to be both an innovator and a leader in that regard.

Operator

And our next question is from Ricky Goldwasser with Morgan Stanley.

Ricky Goldwasser - Morgan Stanley, Research Division

Can you talk a little bit about, on the clinical side, what do you think is a reasonable organic growth rate for the business? What do you think the market is growing at? And also, if you could talk a little bit about your longer-term margin expectation for that segment.

Joseph L. Herring

You know, Ricky, I think we struggle to call the clinical growth market. There's a number of variables. First of all, the top 5, 8 companies continue to take share from the smaller companies, so you got a share grant that drives, molecules continue to grow, outsourcing continues to expand. But the biotech funding and friendlier capital environment, they're more midsized companies that are taking their drugs either directly or through partners to go further in development. And there's not an IMS-type database you can go to, to know this number absolutely. But I think it would be safe to say the clinical market is growing faster than we would have guessed. And I think you'll see that in the results of some of our competitors who've not had some unexpected cancellations. The fact they have a number on that stays something in the highest single digits and maybe 5% to 10%.

Ricky Goldwasser - Morgan Stanley, Research Division

Okay. And on the margin side, as you think about the segment?

Joseph L. Herring

Our margins are strong and our consolidated late stage margins, we continue to see sort of its current levels going forward. But obviously, we are going to continue to be bringing automation and technology to try to improve that and pass along some of that, we're just making it more competitive, but we sort of see it in pretty good shape right now. I guess, Ricky, we're looking for company-wide margin expansion than coming more from Early Development and continue successfully with our cost reduction and corporate expenses.

Operator

And our next question is from Garen Sarafian with Citi.

Garen Sarafian - Citigroup Inc, Research Division

I guess, I wanted to use my one question just to get some clarity on the clinical development portion. So hopped on a little late, but it sounds like it was due to a couple of clients and conversion rate slowdowns. So if it's these couple of large clients and you guys aren't expecting it in the next couple of quarters, will this be a tailwind then? Is it going to follow through early next year? Or because it's not a cancellation, then it should flow through unless there's sort of a strategic partnership who went to another, the other vendor, for some reason. So I guess if you could just provide some clarity there, that would be great.

Joseph L. Herring

Yes, well, I think, Garen, I think you've accurately characterized it. I hesitate to predict too much on the go-forward basis because it's slower from what we expected and -- but you're right. If those projects pick up, and it's likely that they do, then we'll have revenue growth accelerate. It's a tremendous funnel that we have. A few of those projects are ready to go. They went from somewhere in the client's pipeline to a very top priority, and they wanted to go very quickly, even looking for rollover teams. So you have to factor a whole bunch of different things in there. And right now, I would say it's a little -- I don't want to call it too quickly, but again, I think there's a -- we will recover from the slowdown.

Operator

Our next question is from Tycho Peterson with JPMorgan.

Tejas Savant - JP Morgan Chase & Co, Research Division

This is Tejas for Tycho. Just sticking with margins here. Can you help us think through the cadence of IT spending in terms of the Late-Stage business? Obviously, it was a little lower than 1Q, a little higher in the second quarter. How do you see that sort of trending forward? And then in Early Development, as well, can you help us dimension how much of the sequential improvement was weather versus study mix and other drivers?

Alison A. Cornell

Sure, this is Alison. So from an IT spend perspective, the IT in late stage should increase second half of the year. And that's really project-based. From a corporate perspective, we see our corporate expenses staying around the low 7% range for the second half that was in the corporate expenses, which IT got half of it. You'll see a little tick-up in the second half, as I said. From an Early Development perspective, what you see pulling through is a trace of our second half orders after next year. It was -- we had about $1 million worth of impact that was weather-related in the first quarter, that we spoke about, and that we had to deal with utility spend in the building that are -- had regulated temperature control. But beyond that, what we see in the second quarter in terms of the significant increase, sequential increase is really operational strength.

Operator

Our next question is from Ross Muken with ISI Group.

Ross Muken - ISI Group Inc., Research Division

So maybe I thought, Joe, you gave us some color on the lab. What's interesting to me is it's sort of a unusual year, and then it's sort of in line with kind of your target growth. Usually the lab has sort of been up significantly or has had challenges. Could you maybe talk a bit about some of the -- a little more -- could you talk some of the underlying dynamics? It seemed like some of your commentary suggested pricing maybe getting a bit better. So how are we thinking about sort of general market, volume versus price, versus share in terms of adding up to the kind of the results there?

Joseph L. Herring

Yes, Ross, I think our central lab performance is really about continued market share gains and continued increases in complexity of the clinical trial testing. I've said this before, it's probably been a couple of years, but 90% of what goes into an NDA filing, or frankly, mostly regulatory filing, is laboratory data. But it's only 5% to 10% of the cost of the trial. So if you think about Covance performing at a greater than Six Sigma level of quality, when taking the most frozen and ambient samples out of clinical investigator slides in 130 countries around the world, and sort of unparallel quality and speed, I don't know why a client would ever use anything other than central lab -- than Covance's central lab. And we're not sitting on our laurels. We were putting in more automation, more systems, better data reporting capabilities, so that clients can benefit from slicing and dicing it any way that they want. And so a combination of that is some clients being -- I mean, there's some really ugly stories coming out the market over the last 6 months where clients have had major studies put in jeopardy because of another central lab provider. So as much as we hate that for the client, it tends to send them our way and then they come visit our site. And compared to what they've seen in a low-cost competitor, and it's whole new cow. So we plan to keep leveraging that. In terms of price, this is a very competitive market and pricing has been under a lot of pressure. I think with our cost programs, we've been able to weather most of that. And it's not in our models to have prices go up, but should that happen, that would be a good guide. So that, and we continue to add more esoteric testings that brings more of the work in-house rather than us having to outsource it. So unless you have a follow up question, that's my story and I'm sticking to it.

Ross Muken - ISI Group Inc., Research Division

That's super helpful. And maybe just a big picture one. I know you talked a lot about sort of the clinical market. I mean, just looking at your results and some of your peers, it just does feel like there's been a little bit of moderation in our fees or in just total conversion growth. We're just trying to get a sense for, as the year has played out, you talked to the funnel improving in Q3. What do you think is driving some of the seasonality that I don't recall happening in the last couple of years? And what do you think is sort of new or different big picture-wise relative to maybe the medium term, the 2-year outlook than where you were 3 or 6 months ago?

Joseph L. Herring

Ross, don't let our revenue growth color either Covance or the markets. This is just a luck in the draw that we had this period of cancellation. Again, the funnel for us at the end of the quarter was all-time record proposals and several very, very significant items rolling in the door, better than ever. And I think when it's all done at the end of the reporting season, and you look at all the clinical companies, my guess, and I haven't seen their results, but my guess is you're going to see a good or better-than-expected performance and pretty positive commentary. Keep in mind, there are a lot of these midsized clients. They're very well funded and have very exciting model tools, and we're winning more of that work. I think our competitors are, too. And we have large pharma clients that are desperate to replace revenue loss to [indiscernible] and they're pushing really, really hard. And we have that sort of interesting backdrop, which is they can't act fast. They can't stand and they can't do that and that's reason to utilizing CROs. So I don't see the market being softer, and just our short- to medium-term performance is less than we would like, but I think longer term, we feel very confident.

Operator

Next question is from Rafael Tejada with Bank of America Merrill Lynch.

Rafael Tejada - BofA Merrill Lynch, Research Division

Just wanted to switch gears a little bit and talk a bit about the nutritional business. Can you remind us what percent of total sales that is? And sort of what the margin profile is at? Or how it relates to the overall business? And can you comment just a little bit about the, I guess, the initiatives, being taking a sort of reaccelerate growth there?

Joseph L. Herring

Well, it's less than 5% of revenues and the profile is that for most of my 18 years with the company, it has grown faster than the rest of the company, been more profitable than the rest of the company, had a higher return on capital than the rest of the company. And in terms of the premium space, has, we think, the highest market share, very, very strong performing business. There's a subsegment, a couple of subsegments to that business related to crop biotech[ph] and some other subsegments where the clients had just sort of had a slowdown. Frankly, if you look at the results of most large global food companies, it's not exactly a great time for them. So pressure on them to do less testing and less product development, that type of thing. Having said that, hardly a week goes by where food safety testing or nutritional analysis is not somehow in the news either as an opportunity or as a regulatory trend or however you want to characterize it. And our business is very, very well positioned. We're investing to expand our capacity capabilities in 3 different locations. We're evaluating a number of acquisitions. We are very committed with this business. It leverages a lot of the tools, instrumentation, scientific talents that we have in pharmaceutical chemistry. We have a very strong team and we feel very good about the forward outlook. 2013 was truly a spectacular year for this business. And revenue is down just a little bit year-on-year. It's not a disaster. It's a bit of a slowdown. And again, we're going to continue investing and grow that business.

Rafael Tejada - BofA Merrill Lynch, Research Division

And just one clarification. Is that business mostly U.S. or is it a fairly global business? I guess, where I'm getting at is you need to add, do you need to expand your footprint into Europe and Asia Pacific?

Joseph L. Herring

Yes, I think I actually mentioned that in my prepared comments. But firstly, building out and opening this capability in Harrogate that will get us in to the European market. We're expanding in Singapore and then looking at acquisitions in Latin America, as well as either buy or build in a couple of other Asian markets. So we're definitely going global in this business, but trying to do it in a smart and thoughtful, high-quality way and in a responsible way. We believe, really, our outstanding attributes in this business is our quality reputation, and we are a reference laboratory for a number of regulatory agencies in the U.S., and we want to go global with that. So thanks for your questions.

Operator

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

Todd Van Fleet - First Analysis Securities Corporation, Research Division

Just looking for perhaps a bit of an elaboration on the IT investment, surrounding late-stage business and the informatics. I mean, are there any of these -- how much of these investments are kind of onetime in nature that hits the P&L today? And maybe could you talk about -- maybe parse that out a little bit more for us? That would be helpful.

Joseph L. Herring

I think a lot of it's tied is really OpEx in nature. And so, yes, it has a P&L. And as we develop the systems or integrate the systems or whatever, it should drive -- it should go away over some reasonable amount of time. That's how I'd characterize it. There will be some depreciation of some CapEx, but it's more OpEx than CapEx.

Todd Van Fleet - First Analysis Securities Corporation, Research Division

Just, Joe, on that, is that over the next couple of quarters or remainder of 2014? Is it $5 million to $10 million? Any more specificity you can offer there?

Joseph L. Herring

Well, for competitive reasons, we're not characterizing it. But we're eating[ph] it as we go, and it's reflected largely in late stage. I don't want to put a time frame on it, because, as I said in an earlier comment, the more the clients see and the more intrigued they are, sort of the more they want. And we sort of like that economic model that they eventually will be paying for data and paying for knowledge information systems, as well as give us more work that would fund this development. In the case of this Novartis Institutes for Biomedical Research, we're [indiscernible] investments and co-developing. So I don't necessarily want to put an end time frame on it. But because it's -- I think it's really transformational for the industry. But keep in mind, in total, Todd, IT is growing slower than revenue at Covance. It was last year, will next year and we're really leveraging a lot of investments to create the opportunity to build value-added systems.

Operator

[Operator Instructions] Our next question is from Sandy Draper with SunTrust.

Alexander Y. Draper - SunTrust Robinson Humphrey, Inc., Research Division

A question, I guess, harking back to some of the -- one of the early questions, Joe, around the sort of what's going on in terms of band of talks in the business in your comments about starting to double a little bit. One of the things, just looking at the numbers of that the CMD backlog has been trending down by about $100 million or so, roughly, a quarter burning off some sort of legacy contracts. Over time, is that something eventually, you think just goes down to 0 and you don't really have much of that? Or do you think at some point over the next year or 2, you would be interested and maybe more importantly, do you think clients will be interested in going back to those type of deals? Is demand significant enough to even start to think about that type of scenario?

Joseph L. Herring

Yes, I think you're right. Without jumping in new work, CMD burns overtime, that's exactly right. And in our backlog chart, you could see that we separate regular backlog from CMD backlog and that bar continues to shrink. We'll see. I mean, there are a number of interesting opportunities out there that could add to that, but time will tell.

Operator

The next question is from Sean Wieland with Piper Jaffray.

Sean W. Wieland - Piper Jaffray Companies, Research Division

So pharma companies are also embracing greater data transparency. So my question is, how does your informatics business fit into pharma's desire to open assets to their data. And how do you think this increased trend towards data transparency changes your business in the coming years?

Joseph L. Herring

Yes, well, I mean, first of all, the clients own a lot of that data and how transparent they plan to be through a number of different programs, where there's datasphere or other things, is really their call. Our data, largely what we're doing right now, is data around clinical trial productivity and efficiency. And -- but it's not going to be too long to -- we are in some of the areas that may be you're suggesting. And we'll cross that bridge when we come to it. But I think there is a tremendous opportunity before we get to the point where we're worrying about if and when and how we share that data.

Operator

The next question is from Donald Hooker with KeyBanc.

Donald Hooker - KeyBanc Capital Markets Inc., Research Division

I just -- it seems like CROs, and Covance included, are sort of incrementally investing a lot in data as we talked about a lot in market access and observational research. Now I'm just curious if you see sort of an increasing relationship between the CRO industry, including Covance, and some of the more provider-facing vendors of software, like electronic health records and population health and how Covance fits in that?

Joseph L. Herring

Yes, I think absolutely, and I serve on the Board of Directors of that CRO [ph] and we've had a number of discussions that the government organizations, as well as some of these software providers, and how we could potentially provide valuable input of how to code patients, how that data is entered so that it can be used for clinical trial purposes, so as to identify more patients that fit a protocol better, as well as engage more physicians in clinical research because it's a part of their system. So I feel that it's being ultimately very complementary, but it's going to take quite a while. I think there are many priorities for electronic health record companies that will drive investments before they get to clinical trials.

Operator

Our next question is from George Hill with Deutsche Bank.

George Hill - Deutsche Bank AG, Research Division

Joe, maybe just a quick comment. If you look at the decline in the discovery support business, maybe if you look over the longer term history of the business, if I think of slower spending in discovery, does it -- is there ever -- does it ever spill over into other portions of the early-stage business? And what tends to be the time lag between a slowdown in discovery and whether or not it hits kind of other portions of the business?

Joseph L. Herring

Well, that's the famous "pig in the python" argument. And I think if you look at the literal collapse of preclinicals for about a 4-year time period and you look at clinical and say, "Is clinical collapsing?" The answer is no. And I think the reason is because literally, you go back into discovery, you're talking about millions of molecules. And very few of them actually make it through. So a very, very slight change in the success rate, our clients willing to fund molecules, overwhelms any of that effect. And frankly, from a Covance perspective, the amount of work we do in relation to the entire industry in the discovery services is less than a head of a needle. And so I wouldn't extrapolate from that at all. So I think it's really hard to make that correlation.

George Hill - Deutsche Bank AG, Research Division

Okay. Just wanted to make sure that holds up. And then maybe just a quick follow up. As you talk about share aggregating towards the largest CROs, does it change the company's outlook at all for M&A? And I guess, are you seeing any kind of -- any increased value of scale for scale's sake? And I'll hop back in.

Joseph L. Herring

But if it was around, consolidated in Phase III for the sake of size. I think that's something that we talked about over a long period of time, that we don't see as working, and then we could kind of point to our clinical development revenue growth over the last 5 or 10 years of double digit and not having to do M&A to get there all organic. We would point to as another reason where doing something large scale doesn't make as much sense there.

Operator

Our next question is from Douglas Tsao with Barclays.

Douglas D. Tsao - Barclays Capital, Research Division

Joe, you referenced the fixed portion of the Sanofi contract sort of ending in November of 2015. Just curious, at what point you expect to get some visibility on the continuation of that relationship and at what level? And then a quick follow-up, just in terms of your book-to-bill and the strength of performance in bookings for clinical, how much was coming from your existing sort of large strategic lines versus sort of from small midsized clients?

Joseph L. Herring

Yes, first, from a booking standpoint, broad-based, we're not particularly focused on any particular client or any particular segment. So with respect to the Sanofi agreement, let me just start by saying the alliance has been a huge value accretive for Covance and for shareholders, too. If you remember, before we entered into the agreement, we had about $35 million revenue with them, and that was primarily central labs. And today, we're doing about $250 million worth of business across our pool portfolio. About $180 million of that is under the services agreement, which has 6 years remaining and $70 million is on the asset transfer agreement for the portion of building the annex sites, and that has about 15 months remaining. Just setting -- just the [indiscernible] aside, having 5x more revenue on the service agreements is one of the world's largest pharma companies. It's a great place to be in and we're thrilled to have Sanofi as one of our top clients. And then more specifically, regarding the asset transfer agreement, there's a range of possible outcomes next year from the commitment at one or both of those sites being extended in full or in part to Sanofi, not extending its commitment and volumes that the sites being insufficient to keep them open. And then with respect to the financial contribution of CMD for, again, $70 million a year, and we have some revenue coming from other clients. Operating margin at those sites is above the segment average. But as you know, Doug, a lot happened in macro environment as the last couple of years as well as our client's pipeline and their geographic and site strategy, particularly in Europe. The work at the sites have been -- based on that is below the CMD level, but they've been fulfilling their annual take-or-pay commitment to Covance. It would be unfair for us to comment on their pipeline especially as we had, or speculate on that. But there's not a lot else I can share with you at this time, and we'll update you as things become clearer in 2015.

Operator

We also have a follow-up question from Greg Bolan with Sterne Agee.

Michael P. Ward - Sterne Agee & Leach Inc., Research Division

This is Mike Ward again in for Greg. This is kind of about market access. So is this a subsegment that we should really be keeping an eye on in terms of the revenue opportunity going forward, and kind of its ability to drive noticeably additive revenue growth to clinical services segment?

Joseph L. Herring

It's still a smaller percentage of our revenue. It's less than 5%. And we probably wouldn't have called it out, but it's just that we called it out as a drag more than not over the last number of years. And we're just really proud of our team's effort to take the feedback, become more competitive, and win some very significant projects in support of a commercial launch, as well as their creative ability to go out and find some really interesting acquisition candidates like the Medaxial. So I think, looking at the broader industry, I think pharma companies are looking at how they improve launch uptake, advance them to peak sales, competitive effectiveness, how to improve their value communication, how to target payers, how to target patients. And frankly, I think that's the new growth segment for all CROs and people who either are fringe competitors. And I think we just figured out some ways to be more competitive. So I would have looked for a lot more commentary. It's not like it's going to drive clinical development, but we are focused on making some preferential investments in that over the next couple of years.

Operator

And there are no further questions at this time. Mr. Surdez, I would like to turn the conference back to you for any closing remarks.

Paul Surdez

Thank you, operator, and thank you, everyone, for participating in today's call. I'll be available via e-mail or phone if you have any more follow-up questions. Thanks, and have a great day.

Operator

This concludes today's conference. Thank you for your participation.

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Source: Covance's (CVD) CEO Joseph Herring on Q2 2014 Results - Earnings Call Transcript
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