Covance's CEO Discusses Q4 2010 Results - Earnings Call Transcript

Jan.27.11 | About: Covance Inc. (CVD)

Covance (NYSE:CVD)

Q4 2010 Earnings Call

January 27, 2011 9:00 am ET

Executives

Joseph Herring - Chairman and Chief Executive Officer

William Klitgaard - Chief Financial Officer, Principal Accounting Officer, Corporate Senior Vice President and Treasurer

Paul Surdez - VP of IR

Analysts

Derik De Bruin - UBS Investment Bank

Ricky Goldwasser - Morgan Stanley

Ross Muken - Deutsche Bank AG

Alexander Draper - Raymond James & Associates

Stephen Unger - Lazard Capital Markets LLC

Douglas Tsao - Barclays Capital

Tycho Peterson - JP Morgan Chase & Co

Robert Jones - Goldman Sachs Group Inc.

John Sullivan - Leerink Swann LLC

James Kumpel - Madison Williams and Company LLC

Eric Coldwell - Robert W. Baird & Co. Incorporated

David Windley - Jefferies & Company, Inc.

John Kreger - William Blair & Company L.L.C.

Greg Bolan - Wells Fargo Securities, LLC

Todd Van Fleet - First Analysis Securities Corporation

Operator

Good day, and welcome to the Covance Fourth Quarter 2010 Investor Conference Call. [Operator Instructions] 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 fourth quarter 2010 earnings call conference and webcast. Today, Joe Herring, Covance's Chairman and Chief Executive Officer; and Bill Klitgaard, Covance's Chief Financial Officer, will be presenting our fourth quarter financial results. Following our opening comments, we will post 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 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 facts, including the ones outlined in our SEC filings.

Certain financial measures we'll discuss on this call are non-GAAP measures, which excludes the effects of events outside of our normal operations. We believe that providing these measures helps investors gain a more complete understanding of our results and is consistent with how management views our financial results.

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

William Klitgaard

Thank you, Paul, and good morning, everyone. Before I get into the detailed results, let me talk about two special items which impacted the fourth quarter. The first is $18.4 million in costs incurred in the fourth quarter relating to the restructuring activities we announced in November. Our restructuring plans remain on track, and we expect to incur approximately $18 million remaining costs in 2011.

During the fourth quarter, we also recorded an income tax benefit of $7 million resulting primarily from the favorable resolution of certain tax items. In the remarks which follow, I will refer to results on both GAAP and pro forma basis. Pro forma results exclude the third quarter asset impairment charges, fourth quarter restructuring costs and favorable income tax resolutions during the year. For a reconciliation of GAAP to pro forma, please refer to supplemental schedules included in our press release issued last night.

Now the results. Net revenue for the fourth quarter was $492 million, which is up $14 million sequentially, an increase of 1.3% over last year. Full year net revenues were $1.93 billion, which is up 3.1% from last year. Operating income on a GAAP basis in the fourth quarter was $28.9 million, and on a pro forma basis was $47.2 million or 9.6% of revenue. The GAAP figure includes $18.4 million from our fourth quarter restructuring actions, and the full year operating income on a GAAP basis was $47.5 million, and on a pro forma basis was $185.1 million or 9.6% of revenue. The GAAP figure includes $18.4 million in the fourth quarter restructuring costs and $119.2 million in third quarter asset impairment charges.

EPS on a GAAP basis for the fourth quarter was $0.45 per share and on pro a forma basis was $0.56. The GAAP figure includes $0.22 in costs from fourth quarter restructuring actions and a gain of $0.11 from the favorable conclusion of an income tax audit in the quarter. Earnings per share included $0.01 of tailwind from the accelerated share repurchase program we entered into in November, which was offset by $0.01 of headwind from foreign exchange. For the full year, EPS on a GAAP basis was $1.6 and on a pro forma basis was $2.15. The GAAP figure includes third quarter impairment of $1.15, $0.21 in costs associated with the fourth quarter restructuring and $0.27 from favorable income tax resolutions.

As you might expect, given our financial performance, 2010 results include incentive compensation accruals well below target levels. As we enter into 2011, bonus targets reset and accruals increased to a normal 1x level, which resulted in a year-on-year headwind of approximately $0.20. We continue to enjoy the benefit of a lower effective tax rate due to a higher proportion of our earnings coming from our foreign operations where tax rates are lower and from tax fine [ph] initiative we've implemented. The effective tax rate for the quarter was 23%, and we expect a similar tax rate be in effect as we look ahead in to 2011.

Now please turn to Slide 5. In the fourth quarter, Early Development contributed 45% of net revenue, and Late-Stage, 55%. I want to make a note that in 2011, as a consequence of our restructuring, our pie chart will combine the Clinical Development and Commercialization services into one bucket, that's for future reporting. In the fourth quarter, 55% of our revenue came from the U.S., 14% from Switzerland, 11% in the U.K., 8% from countries within the Eurozone and the remaining 12% from the rest of the world.

Now please turn to Page 6 to discuss segment results. In Early Development, fourth quarter net revenues grew $14 million sequentially to $221 million, an 8.6% increase year-over-year. The increase was primarily driven by the inclusion of our new sites in Alnwick, England and Porcheville, France, as well as some modest improvement in the Toxicology Services in the fourth quarter. Full year net revenue increased 6.1% to $840 million.

Fourth quarter operating income on a GAAP basis were $21.1 million, and on a pro forma basis was $26.6 million or 12% of revenue. This compares to our pro forma OM of 10.7% last quarter. The GAAP figure includes $5.4 million in costs from the fourth quarter restructuring act. Sequentially, expansion and operating income was driven primarily by results from the Alnwick and Porcheville sites and modest improvement in Toxicology Services, partially offset by a decline in Clinical Pharmacology profitability, which was impacted by sudden delays.

For the full year, on a GAAP basis, Early Development had operating loss of $32 million, which includes $119 million in the third quarter asset impairment charges, $5.4 million in fourth quarter restructuring costs and $8 million in costs associated with Q2 cost actions. Excluding those items, operating income was $100.7 million or 12% of net revenue. Note that if we transfer our Specialty Toxicology Services from Vienna to Greenfield, we will incur meaningful reductions in revenue and increase operating losses in Q1 as we wind down Vienna and transition operations to Greenfield. The operating losses will decline in the second, and more meaningfully in the third quarter, as significant costs are removed in Vienna and as we begin the ramp up operations in Greenfield.

Turning to Late-Stage Development. Net revenues in the fourth quarter were $271 million, essentially flat as expected to the third quarter levels and down 3.9% compared to the prior year. The conversion of backlog to revenue in our Central Labs and Clinical Development Services continues to be forward than we've seen historically and is a result of several of the factors we highlighted last quarter. As a reminder, these include an overall lengthening in the duration of clinical trials, a shift in mix of orders towards larger and more complex studies which take longer to initiate, a higher level of projects per production and cancelations. For Central Labs we're also being impacted by the shifts in mix of testing, as well as geographic mix of kit receipts toward locations with lower transportation revenue and expense. We expect revenue growth to continue to be affected by these factors over the next few quarters.

Late-Stage Development operating income on a GAAP basis was $47.6 million, and on a pro forma basis was $54.7 million or 20.2% of revenue. The GAAP figure includes $7.1 million in costs from the fourth quarter restructuring action. Fully operating income on a GAAP basis was $226 million, and on a pro forma basis $233 million or 21.5% of revenue. The GAAP figure includes $7.1 million cost associated with fourth quarter restructuring.

Please turn to Slide 7 to recap orders and backlog. Adjusted net orders in the fourth quarter was $603 million, which represented an adjusted net book-to-bill of 1.23:1. Not included in these figures is $125 million extension and expansion of an existing dedicated capacity cost agreement, which was awarded in December. Consistent with our practice, this award will be included in adjusted net orders as revenue from the contract is recognized over the duration of the contract.

Backlog grew 27% year-on-year to $6.19 billion at December 31 from $4.87 billion last year. Sequentially, backlog grew $176 million, including $12 million from the positive impact of foreign exchange. Due to the increasing amount of Late-Stage minimum contract obligations in our backlog, going forward, we intend to provide the consolidated adjusted book-to-bill metric. In addition, we are now referring to the guaranteed portion of our backlog as contractual minimum bond commitments instead of dedicated backlog.

Please turn to Page 8 for a review of cash flow data. We had pretty dramatic improvement in all three components of DSO, and that drove DSO to a record low of 31 days at year end, that compares to 45 days at the end of last quarter and 40 days at the end of last year. We believe some of this improvement is due to very favorable timing of cash flows, and as a result, we do not project DSO to remain at such low levels. We continue to model DSO at approximately 40 days going forward. Cash and equivalents was $377 million at the end of December, a $12 million increase compared to the end of the third quarter.

And at the end of the year, we had debt of $133 million. Both the decrease in cash and increase in debt result from the execution of a $250 million accelerated share repurchase program. Under this program, we've taken out approximately 4.75 million shares of our outstanding stock with the potential to receive additional shares when we true up with our banker on completion of the repurchase period.

Free cash flow in the fourth quarter was very robust at $119 million, consisting of operating cash flow of $145 million, that's CapEx of $26 million. Record operating cash flows were driven by a 14-day decline in DSO levels. Free cash flow for the full year was $208 million, consisting of operating cash flow of $334 million less CapEx of $126 million.

For 2011, we are expecting full year free cash flow to be approximately $100 million, consisting of operating cash flows of $240 million and CapEx of $140 million. And that assumes we return to a more normal DSO level of approximately 40 days.

Now please turn to Slide 9. This graph highlights the continued moderation of our capital spending as a percent of revenue, and on that basis, the $140 million of CapEx in 2011 comes out at approximately 7% of revenue, with $60 million of that for new IT projects, $30 million for growth and process-related investments and the remainder allocated to maintenance and other items.

Corporate expense of $33.9 million in the quarter included $5.8 million in costs associated with fourth quarter restructuring actions. On a pro forma basis, excluding those costs, corporate expense totaled $34.1 million or 6.9% of revenue, that's a 10-basis-point improvement from the end of last quarter. Going forward, we expect pro forma corporate expense as a percent of revenue to trend lower in 2011 as the savings and planned restructuring actions are realized.

Finally, we ended the quarter with 10,528 employees, an increase of 148 heads from the third quarter as additions of new employees in Alnwick and Porcheville, as well as new hires across the business more than offset the reduction in employees from the fourth quarter restructuring. Note that under our fourth quarter restructuring actions, further staff reductions will occur as we wind down the Vienna campus over the next six months and complete other restructuring projects.

And now I'd like to turn the call over to Joe for his comments.

Joseph Herring

Thank you, Bill, and good morning, everyone. The year 2010 was a challenging year for Covance. We continued to grow revenue and delivered a number of significant achievements, which helped us set up for future growth, including a restructuring action which allowed us to reduce frequent [ph] capacity and our cost structure across the company; finding the largest outsourcing contract in industry history, which drove our backlog up 27% to over $6 billion; successful implementation of several of our large enterprise IT projects; completing greater than 200 process improvement projects; reducing outstanding shares to a well-constructed accelerated share repurchase.

However, the accomplishment I'm most proud of is the further increase in our client satisfaction scores. This is especially noteworthy in our large strategic accounts, where senior leaders are volunteering to serve as references for potential new clients, as well as looking for ways to expand their current relationships with Covance.

These successes combined with our prudent track record for implementing large contract create a fertile environment for us to continue forging the new strategic partnerships with our clients. For the level of determination and commitment to excellence on client projects, I thank Covance employees around the world for their extraordinary efforts in 2010.

I'd now like to provide a brief update on the strategic actions we discussed last quarter. First, the restructuring actions form reducing our cost structure and capacity is expected to deliver $0.45 of gross EPS benefit in 2011. And in 2012, we expect further earnings improvement as we enjoy the full year benefit of these cost actions. I'm pleased to report that our restructuring actions continue on track, and we're expected to be completed in 2011.

Approximately 50 Vienna employees have accepted open positions at other Covance sites, including Madison, Wisconsin; Chandler, Arizona; Greenfield, Indiana; and Shanghai, China. This was twice the level we expected and underscores the strength of our company culture. We believe clients will value the added benefit of having experienced Covance employees assisting in bringing up GLP toxicology in Greenfield and in China.

Second, we executed our $250 million share repurchase under an accelerated plan which will deliver at least $0.10 of incremental earnings in 2011. And finally, our 10-year strategic alliance with Sanofi-Aventis is set to deliver at least $0.20 of incremental earnings over 2010. The transaction closed in early November, and our new Porcheville and Alnwick sites contribute two months of revenue during the fourth quarter. We are very pleased with the management's commitments on both sites to get this alliance up and running smoothly and quickly. Both sites are off to a good start and already, two non-Sanofi clients have each placed a study in Alnwick. The staff at both Alnwick and Porcheville are working very hard to prepare their sites for third-party projects.

Now I'd like to make a couple of comments about our fourth quarter performance starting with Early Development. As Bill mentioned, Early Development revenues and operating margins increased sequentially. While two months of results from our Alnwick and Porcheville sites drove most of this improvement, we also saw modest sequential improvement in Toxicology from the depressed third quarter levels. When looking back at the main difference between our third and fourth quarter results, the short answer is that clients that placed orders with us toward the end of the year generally started their projects, which was not the case in the previous quarter. Note that the increased Toxicology revenues are not a result of extraordinary year-end volume from our dedicated capacity business, as revenues from both clients were in line with third quarter levels.

In the fourth quarter, one of our dedicated space toxicology clients, who continues to see the value of their Covance partnership, chose to renew and expand their contract with us. In order to retain their dedicated Covance team, they signed a new five-year $125 million contractual minimum volume commitment with Covance. Their original dedicated contract was about half this size and was set to expire last month. This new agreement clearly illustrates that superior client service, high-quality daily delivery and our program management skills enable Covance to secure large blocks of toxicology work with strategic relationships even during these difficult times.

This dedicated order along with fairly solid and consistent Toxicology awards over the last few months boosted our commercial results. Despite this good news, we are not yet calling it an upturn in Toxicology demand. Since we have experienced several false starts in the recent past, we continue to forecast Toxicology as sequentially flat excluding results from our Porcheville and Alnwick sites.

With respect to our Pharmaceutical Chemistry Base Services, which weren't as impacting as Toxicology in the downturn, continued to perform well with strong margin expansion over the last three quarters and we see continued growth to both revenue and margin in 2011.

Turning now to Late-Stage development. The segment had good commercial flow in the fourth quarter led by orders in Clinical Development. After higher-than-normal level of cancellations from last March through September, cancellations are bringing to more normal levels in the fourth quarter. Revenue and OM in the quarter were essentially flat from the third quarter as we are still working through the same delay, cancellation and tip [ph] mix issues that impeded our revenue conversion throughout 2010. We see these same issues impacting our revenue conversion as we enter 2011 with Central Labs being impacted somewhat more than Clinical. Therefore, we continue to forecast Late-Stage performance as flattish at least for the time being.

Please turn to Slide 10 to discuss our outlook. For 2011, Covance expects full year revenue growth to be in single digits, that is from 1% to 9% growth over 2010, mostly dependent from the levels of delay, cancellations and commercial flow and well as the shift in geographic mix in the Central Lab. Consequently, pro forma earnings per share, excluding the restructuring costs, are expected to be in the range of $2.50 to $2.90 per share with the midpoint of the range delivering over 25% earnings growth or 30% earnings growth when excluding the Vienna transition losses.

The midpoint of this range has a number of assumptions, including low double-digit revenue growth in Early Development and operating margin improvement driven both by the new work from our Sanofi-Aventis alliance, as well as the benefit of our cost action. It seems flat year-on-year revenue growth in Late-Stage as we are modeling continued slow conversion in our backlog. Keep in mind, that Sanofi-Aventis alliance does not begin to produce meaningful Late-Stage revenues until 2012.

Operating margins in Late-Stage development remain near fourth quarter 2010 levels, foreign exchange rates remain at year end 2010 levels and no volume from new strategic client agreements. While we continue to have a number of conversations regarding large new transactions, the size and timing are unpredictable. New strategic transactions could provide upside to our 2011 guidance.

As Bill reviewed, our pro forma earnings target for 2011 reflects a normalized level of incentive compensation expense accruals. This is a $0.20 per share headwind in 2011. In addition, we will also absorb approximately $0.08 of operating losses in 2011, as we transition work from Vienna to Greenfield, Indiana with approximately $0.07 of the $0.08 coming from the first half of the year.

In the first quarter of 2011, we expect a slight increase in net revenues from fourth quarter level. First quarter pro forma earnings per share are expected to be the range of $0.56 to $0.59. These results reflect incremental earnings from higher revenue levels, incremental sequential savings from fourth quarter restructuring and a fourth quarter benefit of our accelerated share repurchase. Results also reflect an increase of approximately $0.05 per share in incentive compensation accruals, as well as increased operating losses due to the wind-down of our Vienna lab and transition over to Greenfield, Indiana.

So that's the short term look. As I think about the longer term, I remain optimistic about our ability to grow our business and expand margins well into the future. I see opportunities for us to help our clients create a lower cost, more flexible R&D model and use our automation and informatics to help clients speed drug development [indiscernible]. We believe that in the next 18 to 24 months, we will see the pharmaceutical industry begin to make much bolder changes to their R&D model and accelerate outsourcing. Our current pipeline of strategic discussion is broad and very encouraging. So stay tuned. All of us at Covance are working very hard to help facilitate and drive this important transformation with our client.

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

Question-and-Answer Session

Operator

[Operator Instructions] And we'll take our question today from John Kreger with William Blair.

John Kreger - William Blair & Company L.L.C.

Joe, could you just talk a bit about your various client segments. As you look at your fourth quarter performance, did you see any change in flow from your large clients versus the smaller sort of nonrevenue-oriented clients?

Joseph Herring

Not particularly, John.

John Kreger - William Blair & Company L.L.C.

But the small client base is pretty quiet reporting [ph] cash?

Joseph Herring

Yes, I don't see a material change.

John Kreger - William Blair & Company L.L.C.

Second question, can you talk a bit about the fairly wide range in your guidance? Is there anything in particular driving that? And I guess, related to that, what's driving the ramp in the earnings growth as you move throughout the year in '11?

Joseph Herring

John, the first of all, if you look at Late-Stage by itself for just a minute, pretty strong commercial performance. That is good solid orders over the last sort of three years. We had revenue growth in comps in dollar with approximately 12% to 15% and then followed last year with comps in dollar revenue growth of about 25%, followed with revenue shrink this year of about 3%. And the big difference is delays and cancellations and the time between when a study is awarded and when it starts and the mix in Central Lab kits coming back. The first three quarters of 2010 we had delays and cancellations at the very high end of our historical range, and we had large projects pushed out of the year. Fortunately, that turned around. It's just one quarter, but turned around in the fourth quarter to sort of the middle to lower end of our historical range, and so that's encouraging. And if that continues into 2011, then you'll see a big -- we think you'll start to see a big ramp on Late-Stage revenue growth as we enter 2012. So our range, I think has to contemplate what if we have another year of delays and cancellations like we saw this year or as many of our competitive frankly we saw in 2009. We need to contemplate that as we think about guidance. The ramp that you're describing in the back of 2011 reflects in our guidance. First of all, the operating losses in Vienna of $0.78 is in the first half, that goes away in the back half. We start to get the full benefit of restructuring charges and a couple of other items. So we think that there's support for that. I guess, thinking about Early Development, obviously, we're happy to see the new volumes in our Alnwick and Porcheville sites. We're happy to see a little bit of an increase in Toxicology and the Chemistry businesses are performing well. And should those be better than flat, we know then we'd be towards the high end of the range. It's great incremental operating margins on the upside in Early Development businesses. So I guess, if you look at our company, as well as our competitors over the last three years, it's been pretty hard to predict. So we think it's prudent at this point in time to have a wide range, and we'll update you as we progress.

Operator

And next we'll hear from Greg Bolan with Wells Fargo.

Greg Bolan - Wells Fargo Securities, LLC

Joe, with regards to the expansion of the dedicated capacity agreement, would you characterize the largest impetus to be that the sponsor is transferring more internal work to Covance or that the sponsor is simply plowing more dollars in the Tox study?

Joseph Herring

I think they're transferring more work to Covance, Greg.

Greg Bolan - Wells Fargo Securities, LLC

And then with regards to China, we now know that obviously MPI is dissolving its JV with Medicilon and Charles River is pulling its Tox services from the country. But could you share your thoughts on the market and how Covance is positioned there over the long run?

Joseph Herring

Well, Greg, I think as you well know, we've had a disciplined, long-term commitment to China and have been building slowly and carefully over time, making sure that we have local government and regulatory relationships, that we understand the culture and that we bring the right types of people to our company and building facilities and having instrumentation of the exact same quality that we have in the Western world. So first of all starting with the businesses that are already there, Greg, our Clinical business is growing very nicely, very profitable, and the clients absolutely love the quality of our work, and we continue to help the industry build new investigator sites who are capable of doing work that would be accepted as part of the global submission. Our Central Lab, we started out a partnership with Huashan Hospital, learned the turf and then built our Central Lab. It is growing very rapidly. It's profitable, and the clients are very happy with that. Several years ago, we decided that Chemistry was going to go faster than Biology, so we put our biology and chemistry lab in place. Starting November and December, that is now profitable and has a nice ramp of growth for next year. So if you add those pieces up, the compound annual growth rate over the last three years is between 80% and 100%, and it's all profitable, and the quality and client satisfaction is high. So that leaves us then to Toxicology, certainly weren't the first in. We haven't made a huge dent, but our belief is that primarily clients, as they continue to invest in discovery in China, are going to be looking for a non-GLP and the GLP work and you want to be there with them. And we are very happy to have that facility now open and qualify. We expect to get -- we have our ALAC approval, we expect to get our OECD approval and to be able to do at least China while the GLP work towards the middle of this year. And frankly, with the competitive moves, we'll be the only western company, I believe, to have a Toxicology footprint in China. We don't have massive numbers in there in our forecast for 2011, but we think did the right size at the right time.

Greg Bolan - Wells Fargo Securities, LLC

Bill, can you quantify the impact of a one-day change in DSOs in operating cash flows? So just thinking about your cash flow guidance for 2011 and obviously you're exiting at a very low DSO level in 2010, expecting that to kind of trend upwards in 2011. So just kind of give us a sense around that sensitivity, if you could.

William Klitgaard

The math is pretty clear. It's the revenue level divided by 365, that's what a day is, about $5.5 million. Going from 31 to 40 days would be roughly a $50 million bad guy, if you will, in 2011 relative toward the end of the year. We do it here year-on-year going from 40 days down to 31 days, that was a $50 million good guy in 2010, so that's really $100 million swing year-on-year if you look at it that way.

Operator

We'll take out next question from Robert Jones with Goldman Sachs.

Robert Jones - Goldman Sachs Group Inc.

Just on the Early Development revenue guidance for the low double-digit growth, Joe, I was wondering if you parse out maybe for us your expectations for the legacy Covance business. So if we back out what are expecting to gain from the Sanofi business in Early Development, I know sequentially you said flat, but can you maybe just tell us what's baked in for the full year?

Joseph Herring

Most of the growth, Bob, is really the Sanofi Aventis projection that we've included. Low single-digit is kind of what we're thinking for the organic, if you will.

Robert Jones - Goldman Sachs Group Inc.

On the Late-Stage specifically, the operating margin obviously, expectation there is for it to be flat to 4Q. Again, how does the incremental Sanofi Lab business play into that margin? Does weigh on it? Does it actually help it? I guess, are there other factors that are keeping the operating margins flat in the guidance?

Joseph Herring

Most of Sanofi is in Early Development, I think it's 85% of our 2011 is in Early. So it really doesn't effect the Late-Stage margin very much. I think there's a lot of challenges we face in terms of delays and cancellations and conversion of backlog to revenue, which are flowing through Late-Stage, and it's a competitive landscape out there. So our margin assumptions are pretty modest with respect to future expectation.

Robert Jones - Goldman Sachs Group Inc.

So it's the same things, we've kind of saw the last couple of quarters then.

Joseph Herring

Right. Of course, remember we have the one exponent issue which we highlighted as well.

Operator

[Operator Instructions] And we'll now hear from Tycho Peterson with JP Morgan.

Tycho Peterson - JP Morgan Chase & Co

Maybe, Joe, just kind of following up on your comments on Tox, understanding you don't necessarily want to call a rebound here yet. But can you just talk qualitatively about what you're hearing from customers? And how sustainable some of the trends you saw coming out of the fourth quarter might be?

Joseph Herring

Tycho, I hate to make -- try and represent customer comments because frankly, every company has a different view. And prior to, say, 2008, ahead of global safety assessment or drug disposition, those folks so sort of control their world and they could give you a forecast and be pretty confident in that. I think with the changes in the pharmaceutical industry, a lot of decisions are out of their hand. And executive management is more involved in dividing the spend between Early and Late-Stage. There's more in licensing than ever. And that sort of an unknown. And so frankly, they struggled to know their own budgets and give us a lot of clarity. And we read the same things, Tycho, that you read from industry experts who are saying the industry needs to flip back to spending in preclinical and an earlier in their pipeline to build Late-Stage assets down the road. We have seen biotech funding strengthened, it hasn't really turned in to spending all that much now but we certainly expect that to be a good guide. I can come up with some good guides and some bad guides but at least for now, we'll just call it flattish.

Tycho Peterson - JP Morgan Chase & Co

With regards to strategic deals you've always been a little bit open-minded than some our your peers strategic deals and asset transfers. Are we at the point now where you think the pace of some of those decisions by pharma is going to accelerate? You had talked about, I mean, obviously you're not committing to another asset transfer but that could be one of the drivers for upside this year, if you were to do another strategic deal. I guess what's your view on how many opportunities are being shopped around? And are we at the point where that process is accelerating as pharma gets closer to [indiscernible] and has to make some difficult decisions here?

Joseph Herring

I'm not sure I want to comment specifically about asset transfer, but I think it'd be safe to say that the client interest and strategic discussions with CRO is at an all-time high, whether it means transferring staff or reducing suppliers from eight or 10 to two or maybe three, you have to consolidate their volume. They want to make their fixed cost infrastructure lower and more variable. And so I'd say there's a wide-ranging of discussions going on right now in terms of how they do that. And like I said, we are very encouraged by that, and frankly we think it has to happen in the industry.

Tycho Peterson - JP Morgan Chase & Co

Can you just talk about the transitioning customers from Vienna to Greenfield? How you're managing that process? Is there any risk that competitors try to step in and capture some of the business?

Joseph Herring

Well, I'm sure they will. Any time you take a campus of that size, then try to move the business to multiple locations, there's certainly that opportunity. I would say there are client discussions have been pretty positive. Had this happened maybe in 2005 or 2006, it sort of headline news across the industry. Today with pharma downsizing, our competitors downsizing, moving things around, I think clients are very understanding. One of the things that gives us great confidence is having 50 employees that the clients know and respect and have a lot of experience being in these other locations. I think that helps a lot. Having said all that, Tycho, we have made very modest assumptions on the amount of revenue that will transition initially and even over time, and I think that's prudent and if we do better than that, then that will be great. And our numbers is a very conservative view of that.

Operator

And will now hear from Dave Windley with Jefferies & Co.

David Windley - Jefferies & Company, Inc.

Joe, on this expanded and extended dedicated agreement, I wondered if you could characterize the pricing. In that agreement just broadly speaking, and some of your competitors have talked about broader agreements, repricing or rolling over and renewing at lower rates. And I wondered if you could maybe compare or contrast to that?

Joseph Herring

We don't like to comment on specific client agreements pricing for competitive reasons. But just generally speaking, if you're going to put that much more volume, the purchasing people want to get a little bit better [ph] dividend. So I think in the direction of that but not some new pricing in a big way.

David Windley - Jefferies & Company, Inc.

Could you compare maybe to current spot rates, call it current rates of just tactical business?

Joseph Herring

I prefer not to, Dave.

David Windley - Jefferies & Company, Inc.

Second question then is around CapEx, the prepared remarks commented about some large IT projects coming to conclusion in 2010. And I think there were some facility projects that did the same. I was a little surprised that CapEx grew or at least the guidance is slightly higher than 2010. Could you call out any timing shifts or perhaps new projects that are embedded in that guidance?

Joseph Herring

Well I think, Dave, in the history of Covance as a public company, we've never spent at our CapEx target including the most recent year and the most recent quarter. As you know, we run a portfolio of drug development businesses that use a wide range of instrumentation, over 2,500 different IT applications. Rolling it all up with great precision is very, very difficult. And one of the biggest challenge is actually the do-ability of those numbers of capital projects, and it's very challenging for Bill and I speaking [ph] as a team and to get that precisely correct. Having said that, we were not metering out capital in 2010. Our underspend in our capital is more the do-ability, or things that change in the market where we didn't have to build something from scratch. We could just refurbish say renovate something say in Greenfield or in Madison rather than build de novo. Again, as we look at 2011, let's be cautious. Let's put a number out there that you think that we might spend and certainly if we don't, that would improve free cash flow. And the same thing with DSO. I mean it would be great to maintain a DSO of 31 days. I argued with Bill, let's not go 40, let's go lower than that. But what we'll say on a normal basis looking over time with a 40-day DSO is prudent then if we beat that, and we'll have a better cash flow and everybody will be happy.

David Windley - Jefferies & Company, Inc.

Can you just give some color on the $30 million growth capital. You already kind of know two those things. One of them relates to Alnwick and Porcheville sites and sort of adding equipment to services there. And then the other relates to the transition of work from Vienna to Greenfield, there's some building improvements we're going to have to make over there. So a good chunk of that $30 million relates to those two particular sites.

Operator

We'll now hear from Eric Coldwell with Robert W. Baird.

Eric Coldwell - Robert W. Baird & Co. Incorporated

On Central Lab, you've been very consistent in your commentary about the mix shift and the geographic shift and I think we have a good idea of what's going on there. But I was hoping that you could provide some specifics on this call in terms of which geographies are relatively strong, which are relatively weak. And maybe some specific examples of the types of kits that you're seeing now compared to in the recent past would be helpful.

William Klitgaard

Eric, I think the way to think about it is that clinical trials for a long time have been shifting towards more emerging geographies and that those geographies can be further away from Central Labs, they're harder to arrange transportation for. And so we had pretty dramatic growth over an extended period of time. I think what's happened now is that we see a shift back towards the western markets a little bit in terms of clinical trials. And so the distribution of where the kits are coming from includes less transportation in terms of on year-to-year changes. We do see a little bit of increase in Asia Pacific, a little bit decline in Europe and more flat in North America on a steady state basis right now. But what we're indicating is that there was an point in time when prices like Russia, for example, had a lot of clinical trials. As Russia comes down, that huge transportation costs to get the kits back will lapse there and that will impact the transportation mix.

Eric Coldwell - Robert W. Baird & Co. Incorporated

And then on the nature of the kits themselves?

William Klitgaard

Obviously, there's a lot of different test. Every single trial has its own characteristic set of tests. Some tests like Genomics tests are very high-priced. And so the richness of the kit, if you will, when you have that kind of work being done, is high. Right now, it's kind of coming back to something where the testing is more normal. We've have had spikes in the past of more expanded test, for example, so the richness of the kits were higher in times gone by. So when we do a comparison from period-to-period, we're seeing some effect of that.

Eric Coldwell - Robert W. Baird & Co. Incorporated

Shifting gears, could you give me your basic share count at the end of the year. So I'm not looking for the quarterly weighted average that was reported today but the year-end basic share count.

Joseph Herring

Let me try and answer that in a different way, and give you the share account that we would model for Q1. I think that's probably a better way to go. I think we're looking at something like 60 million, 60.6 million, 60.7 million shares in Q1, that's kind of the number.

Eric Coldwell - Robert W. Baird & Co. Incorporated

And that's on a diluted basis, correct?

Joseph Herring

Fully diluted, yes, correct.

Eric Coldwell - Robert W. Baird & Co. Incorporated

In the past you've given some interesting comments on Greenfield and the number of non-Lilly clients working, placing studies in Greenfield. I was hoping if we can get an update on that. And if there need be a caveat around that, any work that has already transitioned from Vienna? But just interested in your diversification strategy in Greenfield.

Joseph Herring

We have over 50 non-Lilly client placing, working in Greenfield right now. In terms of the transition of work from Vienna, the DART facility, the facility that we're retrofitting for DART is not done yet nor is the space that we're retrofitting for the Genetic Toxicology business. So there's no new revenue there at that point in time. But the Greenfield acquisition really put us into the Discovery Support business. I wouldn't want to say that we're in the true bench discovery amateur chemistry kind of work. Our discovery work I would say, is in the later phase of discovery. And as you know, we pick up some very talented folks and some very interesting capabilities there. And we now have it led by a GM that also pulls in our Genomics business that we acquired from Merck, as well as our Proteomics relationships, as well as our antibody businesses that historically sat in Research Products. And the combination of those businesses is actually performing very well. We had $50 million in work in those facilities from non-Lilly non-Merck clients, so that's really starting to gain traction. And frankly, we believe that late discovery is going to be a faster growing market than actually the regulatory driven toxicology work in preclinical both in terms of raw spending by clients, as well as the percentage of outsourcing, we think is going to grow up. So still early days on the transition work from Vienna. But overall, the Greenfield business is performing very well, and the Lilly satisfaction with that whole transaction is very high.

William Klitgaard

In specific color-by-color commentary there, Eric, we've actually have some number of different service lines out there, about the only business that's there right now is our Clinical business and we've expanded almost every other service line into that site taking advantage of the footprint that's there.

Operator

[Operator Instructions] We'll now move on to Ross Muken with Deutsche Bank.

Ross Muken - Deutsche Bank AG

Joe, I want to touch upon what Tycho's talking about from a sort of strategic transaction perspective. Obviously, Sanofi was quite a good deal for you guys and was sort of the second marquee one we saw an industry. And looking back at the Pharma industry historically, whenever we've seen a trend among some of the large players whether it's acquiring biotechs or restructuring the cost base or looking at sort of improving ROIC on the R&D front, we've started with one, then we've seen two and then there's been a series of others. And so I guess what I'm curious on to ask Tycho's question maybe a different way is, is the conversations you're having whether it's at the C suite with procurement organizations, with heads of R&D, the level of activity that you're seeing and the type of dialogue that you're having, how is this sort of evolved pre- and post-Sanofi? And have we seen any of the other companies that are currently undergoing restructurings involve you in a process or reach out maybe more proactively or maybe in another fashion to kind of see what you can bring to the table?

Joseph Herring

Well, Ross, I think if you sort of go back to what's driving all of this, what's really driving all this is thick [indiscernible] coming, pipelines that maybe don't feel as good as they have felt in the past, higher regulatory hurdles, bigger worry about comparative effectiveness. So maybe this drug is terrific, but if it fits the market, what's going to be the reimbursement for that. So all of those worries, I think, give our clients pause and they're thinking about their revenue growth being sort of flattish maybe to down a percentage to compound growth rate on a go-forward basis. And so in that environment, if they're going to remain profitable and they have any earnings growth whatsoever, we've got to dramatically attack their cost structure. And as you well know, a lot of that has happened on the commercial side, in the SG&A and now R&D has something that they're going to have to get after. To me, I think the changes that I see, first of all, is I think every C suite executive in the top 30 pharma clients now knows and understands what CROs are. I think they're understanding that the CRO industry has eclipsed their internal capabilities in terms of size, growth, geographic reach, a lot of times, tools, and systems and speed. I think that's well known. I think they see that the asset transfers that everyone knows about and certainly as it relates to our company, Lilly, Sanofi, they see that they employ with the new company, stayed with the new company. The executives in those companies seem to be very happy with the deal. And so I think it just creates an environment where people go, we're going to have to get after this. Everyone of them has a different view of how to do it and what the timing is. But suffice to say, it is on everyone's agenda and the conversations I would say are increasingly encouraging whether they're going to be in the form of asset transfer or staff transfer or whatever. I think each and every one would be very different. I think the industry maybe is a little surprised that more of the facilities that they were shopping over the last year weren't taken on by someone and more of them are now actually being closed. But I think if you're in the C suite, you're really balancing if I close this facility and irritate the governments of this country and I get thrown off the formulary, or I lose my R&D tax credits or on and on and on, that's probably not a good outcome. And I think that drives some of the asset transfer deals. So we'll see. I guess, Ross, I'll just close by saying I think it's going to be an easy year to 18 months, not necessarily Covance but just across the industry. I think it's going to be a very easy year and I think it had to happen. Actually it had to happen.

Ross Muken - Deutsche Bank AG

If you think about the context of the competitive landscape in these areas, competitors in the businesses you touched sort of had different views on the type of transactions you've embarked on in sort of these strategic relationships as a whole. As you think about going forward, your ability to do Lilly, Sanofi-type deals, I mean, have you seen the competitors reorganize or reapproach, sorted that effort differently now that you've had not just one, but two? And what do you think is on sort of their top of mind in terms of understanding kind of how you can sort of differentiate yourself on a go-forward basis versus what they're doing?

Joseph Herring

Well, Ross, obviously, I can't guess what our competitors are thinking. I would say that if you look back 10 years ago, I think a lot of people looked at Covance and saying, "Wow, they're too broad. How can you manage all these different businesses?" They all look in that differently. And mostly our competitors focus on a core business, whether it's clinical or preclinical or research model or whatever that is and trying to optimize that. We took a longer-term approach and said we want to be a drug development company, a company that expand development, help clients, speed timelines and reduce cost strategically over time, and it has taken up a long time to be in position to do the two deals that you talked about. And so I think if you started today, thinking, "Hey, I need to roll off of this, get ahead of that," [ph] good luck because these businesses are difficult to manage simultaneously. Different cultures, different economic and financial drivers for those business models. And to build the company culture, well, you think across these business lines. I think if you look when the Lilly deal was struck, there a lot of people laughing in the industry. Covance has stepped too far. No one's ever done anything like this, they're going to fail. And I think if you look back to what Lilly says and what we say, what our financial results say, it was a very bold, very creative deal. But it's worked extremely well for both companies. As Bill mentioned, in addition to good, solid, profitable growth in what we have, we put a repository there. We've launched our Biotech Safety business there. And both of those at a fraction of what it would've cost us before. Reimbursement hot lines are there. We moved Nutritional Chemistry footprint there, and it's doing very well. Now we got DART genetic Tox coming there. If we've been doing all that Greenfield, we'd still be on the capital spend you saw several years ago. In the case of Sanofi, we don't know the exact number, but we think shot for 30 companies. 25 said no way, no how; five showed up and looked; four said no way, no how; and one company found the way to do it. We found a way to do it because we have a broad portfolio, a creative team, and we know how to help clients solve their problems. I think the net-net is it's a fabulous deal for us and Sanofi. And so today when people start thinking about these things, they think about calling Covance. They've read about our deals. They've inspected the deal. They asked us about how we got it done. We tell them the best we can within the limits of confidentiality. And if nothing else, people say, "I know Covance can do this." And they also know that because of the breadth of our portfolio, we have many cards in our hands to solve the riddle. And I like our chances.

Operator

And we'll next hear from Todd Van Fleet with First Analysis.

Todd Van Fleet - First Analysis Securities Corporation

About the middle of last year, I think you guys had talked about three different Clinical Development projects that were either delayed or there were some issues surrounding the timing by which you're going to receive revenue and they started to get pushed a little bit. And I'm wondering if you can update us on the progress of those three particular projects and whether that played into your thinking on the outlook for Clinical Development or maybe broadly speaking Late-Stage development for 2011?

Joseph Herring

All three of those projects have started on the track that we spoke about last time. One started a little late but ramped up. One was downsized scope but started about midyear, and the third one that was scheduled to start early this year is on track to start. Those three trials had a very substantial impact on our 2010 revenue and again, that's why we're factoring in the low end of our range pretty healthy delays and cancellations in case it happens again.

Operator

We'll now hear from Ricky Goldwasser from Morgan Stanley.

Ricky Goldwasser - Morgan Stanley

If you look at 2011, Early Development revenues with fee 2008 levels but the implied margins that we calculate are lower by about 900 basis points. So as we model the out years, given your new customer mix and the greater emphasis on strategic partnerships, what is the new run rate of revenue that you need to achieve for margin and the preclinical in Early Stage business to get closer to historical level?

Joseph Herring

Keep in mind, Ricky, we've said that the bonus accruals go back to normal levels. Let me just digress there for just a second. I mean, in 2009, bonuses were sort of artifact [ph] for the corporate staff before the Early Development bonuses were at the floor is never such a [indiscernible] the clinical had fantastically so they had maximum bonuses. And so the bonus recalibration for 2010 wasn't as big. It's bigger going into 2011 because basically all businesses were at the floor. So you have to factor that in. We also talked about the operating losses in Vienna in the first six months of the year in addition to the cost that we pro forma'd out. Their operating losses as we wind down in Vienna and expand ahead in Greenfield, the revenue building up there. But we do not see the margin for the year now [ph] having anything to do with strategic partnerships. I think if you've given enough information, you can sort of estimate the margins on our deals in specific areas [ph].

William Klitgaard

I'd just add on to that, the toxicology market, we've talked extensively about that, but we've gone through a tough couple of years. The margins there were in at all-time peak in 2008 and single digits actually in 2010. That said, I think there's a been a lot of rationalization in the industry. We've rationalized out footprint. We've taken cost actions to get our competitive footprint in a better place, so on a looking-forward basis we're -- add plus the Sanoki-Aventis line and things like that and focusing on different service lines, different profitability, I think there's ways to be optimistic about Early Development and Toxicology specifically, as we look forward.

Operator

We'll now hear from Douglas Tsao with Barclays Capital.

Douglas Tsao - Barclays Capital

I was just curious in terms of the level of net orders we've seen. They've been a little below the level we saw last year in 2009. Is that largely a reflection of the cancellation and the down-scoping that you guys have talked about?

Joseph Herring

Absolutely.

Douglas Tsao - Barclays Capital

And so if we're to sort -- just as a quick follow up on this route, think about things on a growth level they would be probably more consistent with what we saw last year.

Joseph Herring

Doug, I don't have those numbers at my fingertips but suffice to say, the cancellation -- the way we count orders, the cancellation offsets orders and report the adjusted net orders as well. So as an example, we capped a $125 million dedicated capacity contract in the orders that we reported. But frankly, exiting the year with a fixed [ph] handle felt really good.

Operator

And will now hear from Stephen Unger with Lazard Capital Markets.

Stephen Unger - Lazard Capital Markets LLC

On the revenue implications for the Vienna transition, could you give us maybe some color as to how meaningful that is?

Joseph Herring

Probably in the $30 million-ish range, I would guess.

Stephen Unger - Lazard Capital Markets LLC

So as far as the reduction in revenues that you're expecting in the first quarter associated with the transition...

Stephen Unger - Lazard Capital Markets LLC

I guess, year-on-year it's going to be somewhere at this [ph]. So year-on-year probably dealt us around $25 million.

Operator

We'll now hear from James Kumpel with Madison Williams.

James Kumpel - Madison Williams and Company LLC

Joe, at the recent JP Morgan conference, I think, you basically said that you're reasonably confident that the cancellations and trial delays were moderating towards the end of the fourth quarter. Which means that on average, your cancellations and delays were probably higher than how you exited the year but you're still basically using the fourth quarter average as it were as sort of the guidepost for margin guidance and revenue outlook for the rest of the year. Can you give us sort of a sense of whether you think there was some one-time items that may have improved cancellations and delays or if you think if they start of a good trend.

Joseph Herring

First of all, let me just make sure that we were clear. The fourth quarter cancellations reverted back down towards the average, maybe a little less than historical average for the full quarter. There were no one-time items that I can think of that impacted that at all. So again that was one quarter of sort of an average levels or historic levels, preceded by three quarters -- particularly two quarters at the very high end of the historical range. We struggled to make a prediction for 2011. I mean, we would hope that a lot of the portfolio rationalization, the declines went through and the mergers and all that, that sort of washed through. Again I think if you looked at our competitors, they have borne the brunt of that in 2009. At 2009 our cost of dollar revenue growth across Late-Stage was 25%. So we weren't in that bathwater. We got ours in 2009, if that moderates in 2011 then we should be exiting 2011 with a significantly higher ramp in Late-Stage revenues setting up 2012, as long as we continue to win new work at the levels that we've won over the last number of years.

James Kumpel - Madison Williams and Company LLC

But basically the guidance you've given is partly related to the difficulties of 2010 predicting. So you're taking a very conservative approach at least to start the year right?

Joseph Herring

I would say that we're taking a cautiously wide view.

Operator

And we'll now hear from Derik De Bruin with UBS.

Derik De Bruin - UBS Investment Bank

How much excess capacity do you think there is in the preclinical space and in the Tox space. I mean, there's been a lot of rationalization, but how much more do you think needs to come out?

Joseph Herring

Well, Derik, we measure capacity two ways. One is actual animal rooms and the other staff. [indiscernible] start, new work. We think the CRO industry capacity is down somewhere in the neighborhood of 35%. On a room basis, it's less than that. I don't have that number at my fingertips. Is it enough? I don't know. We believe that we put our capacity at a level that if preclinical grows in the 10% to 15% range over the next three years, we will be able to accommodate that without having to add up capacity. That would be very meaningful earnings on the upside, if that space fills. If it goes beyond that, I think we have ample opportunity to take facilities that clients would like to give us today or ones that closes down. So I think there's ways to get after that potential revenue in a more capital-friendly manner than historically. The reason why we're saying that it's flattish is we think we can get there and we're not going to be more bold at this point in time.

Derik De Bruin - UBS Investment Bank

You've been very successful at filling or getting additional clients in to your Greenfield facility that are not Lilly. Have you had some success with doing more clients or doing some of the Merck business in Genomics? Are you doing more Hemokinesis, Genomics works along those lines for our non-Merck clients?

Joseph Herring

The non-Merck client totaling placing studies there is 15 and growing nicely and I'd say the commercial team is getting more and more clients in there looking at it. It's sort of a classic, sort of pharma capability, highly specialized, very expensive that use some of the time. So buying the gene expression, the gene sequencing by the step is definitely a way to go, as well as a whole bunch of other services that are still inside pharma and I think they're going to have to learn how to buy it by the step with partners who they can trust and certainly that will be a great outcome for us. But just to complete the answer for our Genomics facility, all major pharma companies have now business with that site.

William Klitgaard

If I could there's been -- Paul's kind of asking me to clarify the $25 million delta for Greenfield and Madison -- in Vienna rather. Let me do that and normally we wouldn't talk about site-specific revenue in such detail but I want to clarify before you guys get off the phone. Vienna this year is going to be something in the range of $37 million of revenue, and as we wind it down, it'll be somewhere in the $10 million to $11 million range in 2011. But we'll see Greenfields starting to come up. It's going to be pretty late in the year. That's going to be about $2 million so the net of $37 million going to $13 million is $24 million -- the $25 million that I was referring to. Hope that helps.

Operator

We'll take our next question from John Sullivan with Leerink Swann.

John Sullivan - Leerink Swann LLC

I hear you regarding the incentive comp pull up perspectively in 2011. Away from that, are your concerned about labor cost? In situations where you still want to hire -- are you seeing the type of labor pool that you want at the prices at which you want it?

Joseph Herring

Absolutely. I mean, if you think about the number of layoffs in the pharmaceutical industry over the last several years, I think it's approaching 225,000 as well as the broader economic conditions. I think our ability to find staff and find staff for reasonable salary globally is very good.

Operator

And our last question today will come from Sandy Draper with Raymond James.

Alexander Draper - Raymond James & Associates

On the incentive comp, is there a way to break out how much is cash versus potential stock? And what I'm thinking is if you're at the low end of your range and the business doesn't come through, is there a chance that the costs come in below because you're obviously have to accrue upfront and then the obvious goal would be obviously to pay as much as you can because then the business is better. Just talk on the cash stock mix and then the variability of it coming in lower if the business doesn't come in.

Joseph Herring

It's all cash. There's the FAS 123 R amount, which is the stock-based compensation but the cash component is the bonus we're talking about.

Alexander Draper - Raymond James & Associates

That is a 100% cash number?

William Klitgaard

Yes, that's correct. Obviously, Sandy, it's something more like 250, and there would be some offset because we wouldn't be paying those level of bonuses. At that point we're starting to do feathering and at this point in the year it seems -- it's a little early to do that.

Joseph Herring

Thank you, everyone, for your time this morning. I'll be available for follow-up questions throughout the day. And operator, you may end the call now. Thanks.

Operator

Thank you, ladies and gentlemen. That does conclude our conference for today. We thank you for your participation.

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