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Covance (NYSE:CVD)

Q3 2011 Earnings Call

November 03, 2011 9:00 am ET

Executives

Joseph L. Herring - Chairman and Chief Executive Officer

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

Paul Surdez - VP of IR

Analysts

Todd Van Fleet - First Analysis Securities Corporation, Research Division

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

Garen Sarafian - Citigroup Inc, Research Division

Alexander Y. Draper - Raymond James & Associates, Inc., Research Division

Stephen S. Unger - Lazard Capital Markets LLC, Research Division

Vijay Kumar - Deutsche Bank AG, Research Division

David H. Windley - Jefferies & Company, Inc., Research Division

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

Tycho W Peterson - JP Morgan Chase & Co, Research Division

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

Douglas D. Tsao - Barclays Capital, Research Division

Timothy C. Evans - Wells Fargo Securities, LLC, Research Division

Operator

Good day, everyone. Welcome to the Covance Third Quarter 2011 Investor Conference Call. Today's call is being recorded. At this time, for opening remarks, I'd like to turn the conference 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 Third Quarter 2011 Earnings Teleconference and Webcast. Today, Joe Herring, Covance's Chairman and Chief Executive Officer; and Bill Klitgaard, Covance's Chief Financial Officer, will be presenting our third quarter financial results. Following our opening comments, we will host a Q&A session.

In addition to the press release, 18 slides corresponding to the commentary you are about to hear are available on our website at www.covance.com.

Before we begin the commentary, I would like to remind you that statements made during today's conference call and webcast, which are not historical facts, might be considered forward-looking statements. Such statements may include comments regarding future financial results and are subject to a number of risks and uncertainties, certain of which are beyond Covance's control. Actual results could differ materially from such statements due to a variety of facts, including the ones outlined in our SEC filings.

Certain of the financial measures we will discuss on this call are non-GAAP measures, which exclude the effects of events outside of our normal operations, such as costs associated with restructuring or the impact of the resolution of certain income tax matters. We believe that providing these measures helps investors gain a more complete understanding of our results and is consistent with how management views our financial results. For a reconciliation of GAAP to pro forma results, please refer to the supplemental schedules included in our press release issued last night.

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

William E. Klitgaard

Thank you, Paul, and good morning, everyone. Net revenues for the third quarter were $543 million, an increase of 13.9% over the third quarter of last year. Growth was 8.7% on a constant-dollar basis. Sequentially, net revenues increased $25 million. Operating income on a GAAP basis in the third quarter was $51 million and on a pro forma basis was $56.3 million. Pro forma operating margin this quarter was 10.4% of net revenue, a 10-basis-point increase from last quarter, despite the impact of merit increases, which went into effect on July 1. EPS on a GAAP basis was $0.67 per share and on a pro forma basis was $0.71 per share. Sequentially, pro forma EPS increased $0.05. The pro forma effective tax rate for the quarter was 22.4%, and we expect our tax rate to remain in this range as we look ahead to the fourth quarter of 2011.

Now please turn to Slide 5. In the third quarter, Early Development contributed 44% of net revenue and Late-Stage contributed 56%. Also, 53% of our revenue came from the U.S., 15% from Switzerland, 11% from the U.K., 9% from countries in the eurozone and the remaining 12% from the rest of the world.

Now turn to Slide 6, please. In Early Development in the third quarter, net revenues were $240 million, a 16.3% increase year-on-year or 14.9% net of the impact of foreign exchange. The year-on-year increase was driven by the addition of our Alnwick, U.K. and Porcheville, France sites, as well as strong growth in our Clinical Pharmacology, Analytical Chemistry and North American Toxicology services. Sequentially, revenues increased $8.4 million on growth in Clinical Pharmacology, Discovery Support services and Research Products operations, partially offset by a slight decline in Toxicology.

Third quarter operating income on a GAAP basis was $33.2 million and on a pro forma basis was $35 million or 14.6% of revenue. OM increased 40 basis points sequentially on margin expansion in Discovery Support, Clinical Pharmacology and North American Toxicology services.

Turning to Late-Stage Development. Net revenues in the third quarter was $303 million, up $17 million sequentially, and up 12% from the third quarter of last year or 4%, excluding the impact of foreign exchange. Growth in both periods was driven by continued strong performance of our Clinical Development services. Late-Stage Development operating income on a GAAP basis was $56.3 million and on a pro forma basis was $58.4 million or 19.3% of revenue, and that compares to 20% last quarter and 20.4% in the prior year. The sequential decline in profitability was partly -- or primarily, actually, due to normal seasonal factors coupled with significant increases in staffing levels in Clinical Development, which offset a sequential increase in margins in Central Labs.

Now please turn to Slide 7 to recap order and backlog numbers. Adjusted net orders in the third quarter were $597 million, which represents an adjusted net book-to-bill of 1.1:0 -- 1.1:1, excuse me. Backlog on September 30 grew 1% year-on-year to $6.1 billion. Sequentially, the significant strengthening of the U.S. dollar in the back half of the third quarter decreased the value of our backlog by approximately $133 million.

Now please turn to Slide 8 for a review of cash flow data. We ended up the quarter with 38 days of DSO, which is up 7 days from the record low levels at the end of 2010 but at the same level that it was at the end of Q2. Cash and equivalents were $400 million on September 30th, and just as a reminder, approximate 90% of that cash was outside the U.S. In reported dollars, our cash balances declined $6 million from the end of last quarter. That decline includes the impact of the strengthening of the U.S. dollar during the third quarter, which negatively impacted cash balances by $21 million.

At the end of the quarter, our debt was $90 million, which is down $2.5 million from June 30 levels. Free cash flow for the quarter was $16 million consisting of operating cash flow of $52 million and CapEx of $36 million. Year-to-date, free cash flow is $55 million, consisting of operating cash flow of $141 million and capital expenditures of $86 million.

Full year capital expenditures are now forecasted to be approximately $120 million in 2011, and we expect quarterly capital spending at or above current levels going forward as we continue to invest in new IT systems and infrastructure.

Corporate expenses on a GAAP basis were $38.4 million in the quarter, on a pro forma basis were $37.1 million or 6.8% of revenue, which is a 30-basis-point reduction from where it was last quarter.

And finally, we ended up the quarter with 11,135 employees, an increase of 325 employees from the end of the second quarter.

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

Joseph L. Herring

Thank you, Bill, and good morning, everyone. Covance delivered another strong financial performance in the third quarter with net revenues and pro forma earnings per share increasing sequentially for the fifth consecutive quarter. Consolidated margins also expanded sequentially, overcoming seasonal headwinds in Late-Stage and significant new hiring in Clinical Development.

Despite elevated cancellations in Late-Stage, adjusted net orders of approximately $600 million delivered an adjusted book-to-bill of 1.1. Central Lab adjusted net orders were at their highest levels in over a year, and we delivered a third consecutive quarter of increased Toxicology orders.

We believe our continuous commercial success is a direct reflection of our primary strategy, which is to deliver operational and service excellence on client projects. All other Covance strategies pivot off of this core service quality strategy. During the third quarter, we were pleased to see the results of 3 independent market research projects, which identified Covance as the CRO clients preferred most across discovery, preclinical, clinical and central laboratory services. We have provided links to these 3 market research projects in today's slide deck.

As further evidence of our strategy in action, third quarter orders included a $25 million rescue study in Clinical Development, and a $25 million rescue study in Central Laboratories. These 2 clients did not initially award the projects to Covance. Instead, they chose a competitor with a lower price. In both cases, the competitors failed to deliver as promised, and the clients transferred these important studies to Covance.

Now let's move on to segment results. In Early Development, our revenues grew 16% year-on-year, with growth in each major service category. Early Development revenue also grew $8.4 million sequentially. Pro forma operating margin increased 40 basis points sequentially to 14.6%. Remember that our 2011 pro forma operating margin includes the operating losses we are absorbing as we wind down our Vienna site, as well as startup losses related to the opening of new specialty Toxicology services in Greenfield and the launch of our preclinical facility in China. In total, these factors impacted margins by about 150 basis points in the third quarter.

Global Toxicology orders in Q3 were at their highest level of the year. Over the last year, we've seen a nice rebound in revenue and operating margins in our North American Toxicology services. However, our legacy European Toxicology facilities have seen revenues decline over that same period. This prompted us in early October to pursue further cost reductions in our Harrogate and Münster laboratories. We're anticipating reduction of approximately 5% of our workforce at those 2 sites, and we expect the actions to be finalized by year end.

In Chandler, revenues increased 6% over the second quarter driven by a healthy increase in volume from clients other than our historical anchor client. I would also point out that Chandler revenue from our historical anchor client, although down sequentially, was similar to the revenue levels in the third quarter of last year.

In Clinical Pharmacology, our revenue and operating income once again grew nicely both year-on-year and sequentially. We differentiate our Clinical Pharmacology capabilities by linking services across preclinical and clinical under program management, as well as integrating Phase I with biomarkers, Early Clinical and translational medicine studies.

I'd now like to comment on our Late-Stage results, where revenue grew 12% year-on-year and $17 million sequentially. Growth was led by our Clinical Development team, which posted year-on-year revenue growth of 27%.

On the commercial front, our Late-Stage team delivered their highest gross orders -- quarter of the year, led by our Central Laboratories, which posted its best order performance in 5 quarters. In Central Labs, while our constant-dollar revenues were down year-on-year due to shorter backlog conversion, we delivered sequential increases in revenue, operating margin and new orders in Central Lab. However, due to the continued elevated level of cancellations, we expect Central Lab revenue to be relatively flat for the next several quarters.

Having said that, our competitive position in Central Lab remains very strong. In fact, in a recent independent survey of 550 global investigators, Covance Central Laboratory was named the most preferred central laboratory by a wide margin. 54% of investigators named Covance as their most preferred laboratory, followed by the next closest competitors at 8%, 9% and 7%. In addition, Covance scored significantly higher across all key performance metrics, including easy-to-use laboratory kits, easiest kit ordering process and timely resupply of collection kits.

A key conclusion of this survey is that the selection of a preferred central laboratory plays a very important role with overall investigator satisfaction. Over 85% of the investigators surveyed agreed that they are more satisfied and more willing to work with a sponsor on future trials when they select their preferred central laboratory, which is usually Covance. We believe these lopsided survey results demonstrate that the extra value we provide, both to sponsors and investigators, are not easy to replicate.

Turning now to Phase II-IV services. Our Clinical Development team delivered another very strong quarter with revenue growth in excess of 25% year-on-year and 9% sequentially -- $9 million sequentially, excuse me. To accommodate this growth, we hired several hundred new staff in the third quarter, and we expect to continue hiring as we head into the fourth quarter.

I'd now like to provide an update on our ongoing information technology strategy. Our business model involves capturing, storing and reporting massive amounts of highly regulated drug safety and efficacy data to our clients. In fact, we believe we generate more drug development data for submission to global regulatory agencies than any other R&D organization in the world. And we are increasingly utilizing this data to differentiate our service offering and create value for our clients. Continuing to leverage this unique Covance strength requires robust IT systems.

Over the last several years, we've been making investments in our IT infrastructure and application portfolio. We have now successfully implemented an enterprise-wide PeopleSoft finance and accounting system, a variety of investments in Phase II-III clinical services automation, including our Xcellerate tool for investigator site selection and clinical trial forecasting; a global installation of Xybion pathology toxicology system, which standardizes our Toxicology IT footprint globally, including our most recently added sites in Alnwick, Porcheville and Shanghai; a TIBCO enterprise integration layer, which enables systems and applications to communicate with each other across our business units; refreshes of our LabLink and Study Tracker, the systems we use to provide clients with direct and near realtime access to laboratory data; and an enterprise use of salesforce.com to help drive commercial effectiveness.

Deployment of our new central laboratory backbone system based on the industry-leading labware platform is now beginning with implementation to occur during 2012 and 2013. In total, this system implementation will add approximately $10 million of incremental costs in 2012, consisting of a step-up in depreciation, system maintenance and increased labor associated with deployment activities. Once it's fully implemented, the new Central Lab system will make our service offering even more flexible for clients, provide better reporting capabilities, speed our processes and make our business more profitable and scalable.

Beyond what we've achieved so far, we see future opportunities for leveraging information technology to accelerate the drug development process, reduce our cost structure, further differentiate our service offering and enhance competitive advantage for Covance. We will evaluate these multi-year IT systems with an eye on achieving our ultimate goal, which is being valued by our clients as the best drug development partner in the world.

I'd now like to review our outlook for the remainder of 2011. On a segment basis, we continue to expect sequential growth in our Early Development revenue and pro forma operating margin during the fourth quarter. In Late-Stage Development, we expect revenues to be relatively flat as we move from the third to the fourth quarter, primarily because foreign exchange rates, at least at this point in time, seem likely to offset continued sequential growth in clinical development.

The continued shift in service mix, foreign exchange headwind and continued hiring in clinical development will likely translate into somewhat lower Late-Stage pro forma operating margin in the fourth quarter.

On a consolidated basis, we forecast sequential growth in revenues in the fourth quarter, as well as margin expansion on a pro forma basis. We expect this to translate into full year pro forma earnings per share of $2.70, which is right in the midpoint of our previous range, or approximately $0.73 in the fourth quarter.

I want to close by thanking our employees for delivering on their commitments to our clients, and thanking our clients for selecting Covance as their CRO partner of choice.

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

Question-and-Answer Session

Operator

[Operator Instructions] We'll go first to Robert Jones with Goldman Sachs.

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

Joe, I believe you mentioned in your comments that Central Lab was expected to be flat for the next several quarters. Are there levers you can pull in Lab to drive margins, or should we be thinking about just holding the line on margins until the revenue comes back?

Joseph L. Herring

I would say hold the margins in the short term, although the IT systems that we're talking about are to address, structurally, our cost structure and our ability to provide services, high-quality services, at a net lower cost. But I'd say in the short term, flat to slightly down.

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

Okay, that's helpful. And then just my follow-up on the preclinical side. Seems to be a little bit of a discrepancy in some of the market commentary we're getting from you versus your largest competitor. I was just curious, are you seeing more RFPs, or is your win rate going up? Just any kind of insight you can give us to maybe give us a better sense of what's going on with the market.

Joseph L. Herring

I think there are a couple of things that really make up our approach to this market. One is developing strategic partnerships with clients, and I think there's ample evidence of that in our results. I think the second thing is that we have focused intently, not only on service delivery in terms of quality, but also the scientific content. We have upped our market share clearly in specialty Toxicology. And while they're smaller in size, we've had quite a number of rescue studies in Toxicology and clients wanting sort of to come back to Covance. And I guess the final thing, I think you know, Bob, that over 40% of our preclinical revenue, Toxicology revenue, is wrapped up into program management where we've given the client a comprehensive solution, and we think a lower net delivered cost on an IND enabling our proof of concept package. So I think it's hard to put a finger right on it, but suffice to say, we're glad to see our toxicology businesses growing again and expanding margins.

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

So you'd say -- I know you mentioned specialty, say, on general tox, seems like maybe there is some share gains going on in your favor?

Joseph L. Herring

Well, the numbers might suggest that.

Operator

We'll go next to Ross Muken with Deutsche Bank.

Vijay Kumar - Deutsche Bank AG, Research Division

This is Vijay in for Ross. I just had a quick question on sort of some of the opportunities that you're seeing on strategic partnerships, and could you comment on some of the discussions that you've been having?

Joseph L. Herring

Well, obviously, it would be unfair and inappropriate to be discussing discussions that we're currently having. Suffice to say, though, I think if you look at the pharmaceutical industry, I think more and more you're hearing from the executives in the industry that they need to address the high fixed cost infrastructure they have in R&D, as well as improve the productivity. They all sort of have a different way of getting after that. We preferentially target clients who like to think of a strategic approach to that, where they think about value creation and value delivered. Others think about it as "How do we take pricing out of the CRO industry?" We tend to shy away from those. But there are a lot of conversations going. The timing of those are very difficult to predict. Over the last couple of years, we had a few that we thought were right on the edge, and the company was sold or it had a change in executive leadership. We've had strategic discussions flip into more price oriented, and we also have a lot of new discussions going on with clients want to really want to talk about creating true value. And I guess from a client perspective, I think it's really interesting if they took all the profit margins of the top CROs, completely into their coffers, it would barely move the needle. However, if they can leverage the cost structure and efficiency of the CROs and keep them healthy and profitable, it gives them a huge lever, short-, medium- and long-term. And we think they're still sort of in the early days of learning how to strategically outsource, and we hope that over time that they will see the entirety [ph] of industry as an important variable cost structure, and one that can speed development timelines. And so those are the kind of discussions we've try to stay in. But suffice to say, there's a lot of conversations going on in the industry right now for us, as well as with our competitors.

Vijay Kumar - Deutsche Bank AG, Research Division

Sure. And maybe switching gears to Central Labs. You did mention that orders were the highest in -- over the last year. Could you comment on the mix and sort of what you're seeing out there? I know that you had some seasonality sort of impacting on the lab side?

Joseph L. Herring

Well, seasonality really doesn't that have much to do with orders. Seasonality effect is around the globe. People take vacations during July and August. The patients don't come in generally and participate in the trial, and they -- therefore, kits coming in tends to slow down. I think the second comment I'd make along this is that Central Lab gross orders have remained very solid during this whole sort of downturn. The issue is that we touch almost 40% of all clinical trials with our Central Lab. As you see, portfolio revaluations, the financial pressures, the mergers and consolidations, clients have taken a much starker view of Phase III compounds. They may award them and then there's an executive meeting saying we can't afford to have 3 CETP inhibitor studies. We're going to do the best one and delay the other 2. So maybe we've received the award, we had counted it as an order, probably haven't even started the study, and it gets pushed and delayed or we're mid-flight and they decide that interim data is not what they would like, or they have a backup compound that they like better, and they will cancel that study. We also have clients who have historically run companion studies and a very similar clinical trial and decide halfway through that one has a better outcome. And historically, they would just let it run and now they pull those back. So we disproportionately sort of participate in all that. Our hope and our view is that once the whole sort of industry pipeline is purged and cancellations go back to a normal range, then the gross orders that we've been enjoying over the last six quarters will be a little bit more obvious to investors and start to flow through as revenue. And when we have a couple of quarters of lower cancellations and stronger net orders, we'll start signaling something other than sort of flat revenue growth aided by an FX tailwind.

Operator

We'll move now to John Kreger with William Blair.

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

Joe, could you give us an update on the pricing trends you're seeing across your various business units? Are you seeing any increase in perhaps client budget sensitivity or any changes in competitor pricing patterns?

Joseph L. Herring

John, pricing is a very, very difficult thing to speak to with great specificity. So it's a different dynamic in Clinical versus Central Lab versus Toxicology. I think the thing that people talk a lot about is really toxicology pricing. The question is, is it -- what's the geography? Is it a dark study, an infusion study or general tox? Is it with a client who values speed and integrated services, or is it a bottom feeder on price? So it's really difficult to just make a simple statement say, "this is where pricing is". I do believe that the lower tier that we dearly [ph] don't play in, which is sort of the bottom feeder, pricing seems to be even more difficult. There are times when we have used -- dipping into that pool to fill slack capacity, and we've seen that it's very difficult there. But overall, I think our results show that pricing is pretty stable for our book of business. And so it's a very competitive industry, always has been, but feels relatively stable for us. In Clinical Development, sort of the same thing. There have been very visible sort of books at work that are extremely price competitive. We tend not to do very well there. And -- but there's other factors that you don't see. If there's a study that has a huge fixed-price gain, we take that into our P&L and had the same net effect of higher pricing, because we earned it. In the case of Central Labs, if we negotiate much, much better freight carrier rates, our prices may go down 5%, but our margin doesn't change. All we've done is become more competitive in the market. People may be squawking about our Central Lab prices that had nothing to do with our margin. It's being more competitive and working hard to create more value for the client by having lower transportation rates. So again, I think it's hard to make a blanket simple statement about pricing, but I think, John, you well know we focus on clients that value what we do. And I think our results reflect the fact that we understand the price volume ratio pretty well.

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

Great. That's helpful. And my quick follow-up, just to clarify your comment about how you see the lab business trending in the coming quarters. The cancellations you're seeing, are those reductions in scope but the trials still continue, or are you seeing full cancellations generally?

Joseph L. Herring

John, I would say it's a bit of both.

Operator

We'll go now to Garen Sarafian with Citi.

Garen Sarafian - Citigroup Inc, Research Division

First, I wanted to just discuss the smaller end of the market. We all try to track funding -- biotech funding, and you guys have a very interesting slide on the appendix also tracking it. And it seems that in Q3, it's going back to early '09, late '08 types of numbers, financing total near the bottom, partnering and cash on hand at or below 2008 levels. So especially given what one of your peers said earlier this week, can you just discuss how funding levels are impacting your biotech customer base? And if you could just remind us what percent of your current revenues and backlog are most impacted by this space as well?

Joseph L. Herring

Well, honestly, we included the slide, and biotech funding is down for the quarter. I think that's a macro indicator, and you have to be really careful how you interpret that. Generally, biotech funding goes down, we don't necessarily see immediate impact. We may not see impact at all. It depends on the clients. In our sort of the portfolio, if they remain well funded, then we sort of stay through that. Again, I think there's evidence that our teams are very competitive in winning at least our fair share. And I do not have the current percentage of our portfolio that is sort of unfunded biotech that's waiting on cash cycles, but it is much lower than it was. Back in 2008, we made a conscious decision to build a stronger book of business with fully funded R&D organizations, and I think our results show that we're benefiting from that right now.

Garen Sarafian - Citigroup Inc, Research Division

Got it. But you're not seeing any sort of softening of demand in that segment of the market due to some funding issues?

Joseph L. Herring

In our commentary, we said strong order, stronger revenue, margin expansion. And I guess the facility that sees a chunk of that is Chandler, and they're up 6% sequentially and doing quite well. So I'm not saying we're immune, but we're just not seeing it at this point in time.

Garen Sarafian - Citigroup Inc, Research Division

Got it. Great. And just as a follow-up, just a macro question. Just wondering, one of your peers that's currently in the process of going private also reported solid results yesterday, and it also had some new solid business authorization backlog numbers. I'm just wondering, how is the environment now impacting your ability to win new business in your clinical businesses? Is it helping you guys get more business because people want to deal with public companies, or can you just elaborate on what you're seeing?

Joseph L. Herring

Wow, I'm not sure public or private has that much to do about it. I'm speculating. I don't know for sure. I think it has a lot more to do with service quality. The easiest way to win a big clinical trial is having done good work for the client before, having a great medical team, regulatory team, a great project leader that they highly value. We think it's great when you build a strategic partnership with the client or you're 1 of 2, or 1 of 3 or have CMV backlog commitments from that client and you deliver on those. But whether you're public or private, I'm not sure. I think anytime there's a change in ownership of any company in a service industry or changes in ownership or executive management, particularly, if there's client relationships involved, I think people question and pull back and ask a few more questions than they normally would. But I guess 27% revenue growth for our clinical business was -- I think speaks volumes.

Operator

And Eric Coldwell with Baird has our next question.

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

Guys, did I hear you right that the combination of the investments in China, Vienna and Greenfield were 150 bps of Early Development operating margin drag, which would translate to $0.04 to $0.05?

William E. Klitgaard

Right. I mean, we called this out last quarter, so this quarter, it was about 150 basis points between Vienna closure, the Greenfield startup and China. Last quarter it was about 200 bps.

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

Okay. And do you have a target on where that trends over the next one quarter and then maybe into next year? Are you going to get to a point relatively soon where the Vienna transition is complete?

William E. Klitgaard

Well, I mean, we expect Vienna to wind down, so the drag there will be decreasing. Greenfield is still in startup mode, same thing for China. So it's kind of hard to take a blend of that and really make long-term predictions. Frankly, we're just in the midst of putting together our budget for next year. So I don't want to give forward guidance till we have that process complete.

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

On the cost actions in Harrogate and Münster, what would be the expected charge in the fourth quarter?

William E. Klitgaard

Probably in the range of $2 million or $3 million for that.

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

And the expected cost savings from that action?

William E. Klitgaard

On an annualized basis, we'd like to get to a $4 million run rate.

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

Great. And then final question. When you look at the overall toxicology market, notwithstanding your own performance, do you see a dramatic shift from out of GLP tox studies into discovery, simply think that one area might be growing faster than the other? What's your perspective in terms of the mix of work that's occurring in the market overall?

Joseph L. Herring

Eric, I'm not sure we see a dramatic change. I think what we do see is there are more clients who are now looking back into discovery, which is much less outsourced than regulated work, as you well know, and saying, can we outsource more? And obviously, we're benefiting from that in our Greenfield, our Seattle location, as well as starting to in our Alnwick and Porcheville sites providing some Discovery Services. So I do think that, that market is picking up. I do think that clients are a little more hesitant to do regulatory work until they absolutely have to. If they can push it later in the cycle, then they will. But our results and our continued new orders suggest that there's plenty of juice in the GLP market, and we're enjoying some upside there.

Operator

We'll move now to Tycho Peterson with JPMorgan.

Tycho W Peterson - JP Morgan Chase & Co, Research Division

First question, we've obviously seen a lot of news out of pharma about the accelerating R&D cuts, and one of your strategic partners has been -- Sanofi has been pretty vocal this week about some of the cost cuts. I guess, first question there is, because you have a relationship with them, do you get first look at some of the outsourcing, and how much of that potential would go through your existing facility that you bought from them a few years ago?

Joseph L. Herring

Well, we have a very well-defined and active governance [ph] structure and executive steering committee that meets about every 60 to 90 days, depending on calendars. And so we do get early views into what they're thinking and how they -- actions they want take to reduce their R&D cost structure, but at the same time, accelerate a very exciting portfolio. If you look at the legacy Sanofi, as well as the Genzyme and other partners and relationships that they've developed to beef up their portfolio, we're in all those discussions. And we feel very buoyant about where we are and how it looks going to 2012 and 2013. Remember that the biggest bolus of work in the first year was from the 2 sites, but the overwhelming size and value of that contract is in winning Late-Stage work that's starting to come in, and we expect to ramp pretty significantly over the next several years.

Tycho W Peterson - JP Morgan Chase & Co, Research Division

Okay. And then the second question, I guess, as we think about what you're doing from an IT perspective, can you just comment on, I guess, some of what you expect to get out of this? I mean, do you potentially get better visibility and traction with clients, and is there an opportunity to extract better pricing if you've got better granular data around projects with some of your partners?

Joseph L. Herring

I think it's multi-factorial, Tycho. I think the first comment I would make is that we see increasing evidence that pharmaceutical companies are no longer making new investments in IT systems or R&D. If you think about the [indiscernible] system providers, as I meet with them, they're not landing new work from pharma clients. When you look at EDC vendors or you look at kind of clinical trial management system or drug safety system providers, Oracle, Argus, those type of providers, you're not hearing any more about big installations in pharma. And we hear clients asking us, can you take over a part of our IT infrastructure in this particular service category? Well, we need to come audit your system because we're sort of winding ours down as we outsource more. So I think -- if you think at the big play for Covance is to be a major partner as outsourcing goes from the 40%, 50% range to 70% or 80% range. And to be able to handle that type of transformation, I think you have to have a global infrastructure that is small, probably a combination of a private and public cloud that is low cost and very fast on a global basis, and sitting on top of that, robust, state-of-the-art backbone operations for your business, integration layers and ability to report that data, and you can envision a point in time where a client can get more data faster and better decision support from Covance than they ever got out of their own systems as part of their R&D organization. And that would be a beautiful thing in terms of competitive advantage, switching costs and our ability to fully integrate and be a seamless partner with our clients. We also think from a competitive position that there aren't very many companies that have the wherewithal or even the knowledge to run this kind of an IT strategic play. It will take CapEx over time and cost over time to make that happen. In the case of Central Labs, for next year and part of the following year, we're going to have to have duplicate workforces, one serving the client and another one bringing up the new system, and winding down projects on the old system, winding up new projects on the new system and training on the new system. So it creates the $10 million that we called out. But on the backside, a much, much nimbler Central Lab, which we think a lower cost structure, faster and richer data. So I do look back over the last couple of years and look at the number of enterprise applications and systems that we have put into this company on time and on budget, as compared to other companies in other industries, and our IT team and our business leaders, linked arm in arm, getting those projects done is one heck of an accomplishment. And it gives me confidence as I look forward to what we're going to do next year and some of the things we're thinking about more strategically, and gives me confidence that we can build IT into an offensive weapon and a competitive advantage for Covance. And again, in a service business as complex as ours, building strategic partnerships with clients to have high value adds and high switching costs, I think bodes well for us.

Tycho W Peterson - JP Morgan Chase & Co, Research Division

And then one last quick one. There was news recently on a lawsuit, I think [indiscernible] I mean, I assume these things happen quite often, but anything we should read into this? I mean, they seem fairly small and seem to be fairly litigious, but just wondering what your thoughts are and just the general dynamic with clients. Are they getting more proactive about pressing forward lawsuits if issues come up?

Joseph L. Herring

No, I don't think so. We did have a contractual disagreement with a client and for a very small deductible on our insurance, we were able to quickly put the dispute behind us. And I think we feel that the quality of our clinical research services, as the surveys that we highlighted today indicate, is very good, and the sponsors view our clinical business in the very highest regard. So I see it as a de minimis event.

Operator

We'll hear now from Todd Van Fleet with First Analysis.

Todd Van Fleet - First Analysis Securities Corporation, Research Division

On the Late-Stage Development margin. Is 20% still the bogey there that you guys are shooting for over the longer term? And I guess, the commentary that you've given us today suggests that perhaps we could see the margin for Central Labs maybe dip a little bit further here for maybe the next couple of quarters or maybe the next 12 months. And it would seem that in order for the aggregate Late-Stage Development margin to get back to kind of that 20% bogey, that it would have to be due to the strength of the Clinical Development business. Is that the right way to think about what's going on in that segment?

William E. Klitgaard

So Todd, let me start off, and I'll let Joe comment on that. I think -- the way I think about it is that historically, and probably on a prospective basis, Clinical and Central Labs have slightly different margins. Central Labs typically has a higher operating margin, and because clinical is growing faster, you would see some mix impact on operating margins in Late-Stage just by itself. Secondly, as Joe mentioned, we have about $10 million of incremental costs coming in next year. That, by itself, on CLS is 150 basis points or so, maybe a little bit more than that in terms of their margins. So both of those factors should lead to somewhat lower margins in late stage looking forward.

Todd Van Fleet - First Analysis Securities Corporation, Research Division

Right, but is 20% still the bogey, Bill, that you guys are thinking about for that volume?

William E. Klitgaard

I think it's volumes, and they obviously is -- the nice thing is those volumes come back to Central Labs as nice incremental drop-through, so that should be a positive factor. As Joe said, once the cancellation trend in Central Labs abate, and volumes start to come back to Central Labs, then you would like to go back to the 20% level, absolutely.

Todd Van Fleet - First Analysis Securities Corporation, Research Division

Okay. And then just to try to calibrate the model then for that $10 million of investment. I mean, you said depreciation, a few other elements, is that primarily depreciation in SG&A that are receiving on that or is it COGs?

William E. Klitgaard

It's depreciation, it's support costs and it's also, as Joe mentioned, some of the duplicate expense you have while you're bringing the system up and validating it and training your staff. If you put all those together, you're in the $10 million range.

Todd Van Fleet - First Analysis Securities Corporation, Research Division

Right. But I'm just thinking about the line items, Bill. So again, just trying to calibrate the model here a little bit.

William E. Klitgaard

Yes, it's kind of across all of it. So it's across both COGs...

Joseph L. Herring

[indiscernible] step up in depreciation by half. And the others are split between the 2.

Operator

Going next to Dave Windley with Jefferies & Company.

David H. Windley - Jefferies & Company, Inc., Research Division

I wanted to follow-up on one of Tycho's questions about Big Pharma. Joe, I was curious if the Sanofi agreement, you mentioned the governance and the pretty clear visibility. Does an announcement like they made this week accelerate your penetration into the incremental billion dollars? I wondered, we haven't heard a lot about that incremental opportunity and if that's becoming available to you?

Joseph L. Herring

You know, Dave, I sort of learned to refrain from predicting the future on some of these types of things. I'd rather show it to you in the P&L than forecast it in advance. And as you know, we've become extremely timid about announcing strategic partnerships, because I think they're widely misunderstood in the marketplace, and we really only announced them or make any comment when the client really wants to. I mean, we had some nice expansion of a current partnership in this quarter, which feels good, but we also know that clients have delays and cancellations and all sorts of things happen along the way. So I'd say that the trend bias is up with both of our strategic clients that are named, but we'd rather show it to you in the P&L than comment today.

David H. Windley - Jefferies & Company, Inc., Research Division

Okay. Understood. Is it right to assume -- to think that the revenue that you're recognizing so far from Sanofi is within the CMV portion of that contract?

Joseph L. Herring

Yes.

David H. Windley - Jefferies & Company, Inc., Research Division

Okay. In the cancellation discussion, it does sound like the majority of that is coming on the Central Lab side, if you could confirm that, that's correct. And then also in your comments about those returning to a more normal level, I guess I'm -- we see some elevation in cancellations from some of the peers as seemingly as client relationships get more strategic and you get more ingrained in their organic flow of R&D. I guess I'm wondering if a higher level of cancellations has become the new normal.

Joseph L. Herring

Our cancellations, I think the -- it's fair to say that cancellations are at the upper end of our historical range for Late-Stage, and -- but it's true that for Central Labs, they're larger than they are for Clinical. I wouldn't want to just paint it as just Central Labs. I think we have it as part of the world we live in now.

Operator

And Tim Evans with Wells Fargo has our next question.

Timothy C. Evans - Wells Fargo Securities, LLC, Research Division

Joe, in the past, you've given us the number of non-anchor clients in your various facilities. I was wondering if you'd be willing to update that number for Chandler, Greenfield and the new European sites?

Joseph L. Herring

I guess we're out of that business for the quarter. We didn't prepare that. I would sort of guide you back to the numbers we gave last quarter, and it would be something similar to that. I guess our reason in giving those numbers early on is to show you that clients are coming to those facilities. But at some point in time, I think it becomes less meaningful, particularly if the sites are profitable and growing and winning new work. Again, I think I'd rather show it to you in the P&L with revenue growth, new orders and margin expansion than counting noses.

Timothy C. Evans - Wells Fargo Securities, LLC, Research Division

Maybe try a different way, can you -- of the clients that you had in there, I think you said 22 in your European facilities last quarter. Have those grown as far as the amount of work that they're doing?

Joseph L. Herring

I would say a little, but it's not a big enough number where we're going to crow about it all that much. The significant thing is that we've proven to ourselves that this historical Big Pharma facility was quickly converted into a standalone CRO, and was able to get I think we said 40-something client visits and 20-something placing small orders, pilot orders, and starting to build revenue. And that's the big story. Whether it gets to some huge number, it's too early to say, but the fact that they're coming and they're visiting and they're placing work, I think that's good news for the longer-term.

Timothy C. Evans - Wells Fargo Securities, LLC, Research Division

Let me sneak one in on the IT as well. Can you talk about how the client-facing portions of your IT strategy might be differentiated from your peers? I mean, I think a number of people have various IT strategies going on. I'm just trying to get a sense for what you might be doing that's different, not as far as your internal facing, PeopleSoft-type things are concerned, but as far as your external client-facing IT strategy?

Joseph L. Herring

Well, our clinical team had a dynamite meeting with a new client, actually done work for them in the past. They were kind of a lapsed client, and they narrowed their providers and chose us. This is not something that's been announced. But they have a very, very important clinical trial, and as kind of a new partner, they wanted us to come in and hear what we had to say about the classic compound and the competitive situation and clinical trial design. And using Xcellerate along with our analysis, we blew the client away. We showed them how they performed on previous trials in this general category, we showed them how competitors were performing, and a combination of the data, the forecasting and the medical, scientific and regulatory input blew this client away. And so I guess that's how we're using it to help win work, and then obviously, being able to provide the data that shows how a trial is enrolling and how much data management work, how many pages are coming and when, allows them to better determine resources and whether they need to outsource or whether they need some variable costs in there, and also knowing how many monitoring visits are required, particularly if you think about risk-based monitoring. It's better to make those decisions with facts and data. And we don't know of any organization that has a richer data set for analyzing and making such a decision than a client of Covance, because you're literally peering into over 40% of the entire market. And then I mentioned briefly, LabLink and Study Tracker, that's our near-realtime data access in preclinical as well as Central Labs. We think ours was the first and still the best. And you can pull that data anywhere, anytime, anyhow as long as you can link into the Internet.

William E. Klitgaard

I guess if I could add 2 comments. One is, as Joe just mentioned, as part of the customer experience, IT is becoming much for important in terms of how you deliver your services and how you're perceived by the customer, as well as being a way to enable more efficient operations for your company over time. So that's both the internal and external aspects, and I wouldn't want to just point to one. I think they're both important.

Operator

We'll go next to Steve Unger with Lazard Capital Markets.

Stephen S. Unger - Lazard Capital Markets LLC, Research Division

Just a couple of quick questions, I guess, that are bundled on Clinical Development. The growth there has been pretty strong the last couple of quarters. I was just curious if you could be able to tease out the constant-dollar revenue growth for that part of the business, and does clinical benefit from the CMV relationships that you have? And does -- do they -- does clinical still have sort of suboptimal margins? I know that's an area that you've been investing in.

Joseph L. Herring

Wow. Clinical's had tremendous margin expansion and, from a competitive standpoint, is close to the top of the heap. In terms of CMV, I think we're starting to see some ramp up from clients who have a CMV, including Clinical Development. Those things don't happen at the snap of a finger, particularly where they had existing relationships and that type of thing. But I would say the CMV part was not really much of a contributor to our story this quarter. But we see it playing an increasingly important role on a go-forward basis.

William E. Klitgaard

And in terms of foreign exchange, Steve, just a couple of comments. Obviously, the biggest single factor in foreign exchange is the Central Laboratory in Geneva where we have exposure to Swiss francs, which has been incredibly volatile, as you know. If you look at clinical by itself, roughly $3 million of growth or 3% of growth is exchange.

Stephen S. Unger - Lazard Capital Markets LLC, Research Division

Okay. So then as far as going -- looking forward, I know it's still early to talk about 2012, but clinical is your most visible business as far as giving you confidence in being able to grow. Is that a double digit, top line growth business for you next year, even -- because the currency -- especially with this currency impact not being that significant? Could you just comment on clinical, I guess, as to how that growth outlook looks?

Joseph L. Herring

Steve, we're right in the middle of our budget process, and this is a complex business with a lot of moving parts and a lot of assumptions. And we've got more information to go before we make a call on that. Having said that, if you look at the trend lines over the last 2 years in our clinical business, we had a couple of very large delays and cancellations that slowed the revenue growth for a period of time, but even if you look back over the last 6 years and draw a line through it, I think it's clear that Covance is very competitive, winning in clinical, and taking market share, and we like where we are.

Stephen S. Unger - Lazard Capital Markets LLC, Research Division

Got you. Okay. And then just one quick one on the IT, the $10 million of incremental expenses, how does that roll out next year? Is that straight line $2.5 million a quarter, or is it ramped to get to $10 million?

Joseph L. Herring

Well again, we're in the middle of the budgeting process, and so I don't really want to say with great definition at this point in time.

Operator

We'll go next to Sandy Draper with Raymond James.

Alexander Y. Draper - Raymond James & Associates, Inc., Research Division

Pretty much all my questions have been asked. Maybe just this one question on the tax rate. You gave the comments for the fourth quarter. Any thoughts -- and again, not trying to get guidance for 2012, but just longer term, do you have thoughts on the trend line for taxes, are these new lower rates sustainable, things that may push that up or down? Any thoughts that you can give us there would be helpful.

William E. Klitgaard

Well, again, I think we haven't done the budget, but I don't think it changes right now in terms of the forward look. It will always depend upon the mix of earnings and where it's coming from. And we'll have more clarity to that once the budget process is complete.

Operator

And Douglas Tsao of Barclays Capital has our next question.

Douglas D. Tsao - Barclays Capital, Research Division

Bill, I was just hoping you could sort of walk through the FX impact on earnings. Because I know you're largely naturally hedged. But does that -- does the incremental revenue flow all the way through to the bottom line?

William E. Klitgaard

Yes, I think it depends upon -- I guess, what I'm trying to do is to understand exactly your question. If you look at -- let me try and do it this way. Q3, we talked about Q3 relative to the June 30 rates, and the actual rates came out pretty much in line with that. It wasn't that much impact on Q3. If you look forward now into Q4 and you kind of apply either the June 30 rates or the average rates from the end of Q3, we'd probably have some headwind, maybe $0.02 of headwind looking at Q4. But to your point, I think FX is something that we try to match up payables and receivables basically as much as we can through natural hedging. And so it tends to flow through the P&L straight through.

Douglas D. Tsao - Barclays Capital, Research Division

Okay. And then in terms of the Sanofi contract, in terms of the revenue ramp in the Early Development side, is that fully mature at that point? Or is there continued opportunity for growth there? And was there much sequential growth from the second quarter? In Early Development, in particular.

William E. Klitgaard

Yes, I don't think it was sequential growth in the quarter. But there's is substantial growth over the life of the contract.

Operator

And we'll take a follow-up from Dave Windley.

David H. Windley - Jefferies & Company, Inc., Research Division

Joe, I was hoping to follow up on the IT discussion and to get your perspective on what sounds like a business where you're getting very high marks from clients and surveys and so pleasing them quite well. And then contrasting that with pretty significant investments in IT to -- and then I'm filling in the blank -- to keep the business, to be able to maintain a premium price, to take market share? I'm wanting to -- I'm hoping you could peel the onion back on where you see the ROI playing out from the IT systems investments in the various areas. That would be great.

Joseph L. Herring

Well, Dave, you did a great job, so the answer is yes. I don't mean to be cute about it, but it really is all of those. Bill is licking his chops because he thinks 2, 3 years down the road, our cost structure is lower and faster. It also adds, I think, a competitive advantage, So I think it will impact our win rate, particularly as you think about the higher outsourcing penetration goes, the tougher the next chunks are. And to the extent that a part of the value proposition is the client can shut down internal IT systems, I think that's part of the value proposition. Switching costs. I mean, I've been in service businesses in my entire life and have many examples. If you can drive up switching costs and you deliver good quality, the client will not leave you. And you'll get through all sorts of difficult things that happen in the normal course of business. Clinical trials are getting much more complex, and so doing things manually are going to be a thing of the past. And finally, we want to be seen as the company that is the most flexible in terms of helping the client get to their goals and objectives for their R&D. So it's multi-factorial, but again, I don't think a lot of companies are going to be positioned to do this. And I think on the backside, we are in a much stronger competitive position, and ability to drive incremental margins through efficiencies.

David H. Windley - Jefferies & Company, Inc., Research Division

Super. So is your current view that several years out, that there comes a point where you've kind of built the fortress and your maintenance of those systems will -- the cost of maintenance of those systems will decline fairly substantially, or is this an industry with the complexities and demands that where you think the investment in IT will kind of be somewhat of a perpetual, continual improvement-type process?

William E. Klitgaard

Well, from your lips to God's ears in terms of it being over. But I think the reality is IT systems, there are new releases that come, there's maintenance of that, there's value-add capabilities that you put on top of a commercial off-the-shelf system. There's a whole life-cycle management of IT systems. So I think a big chunk of that for us will be done in a 2- to 3-year time frame, we believe. But it won't be de minimis and then ratchet down for a 10 year timeframe. But the biggest bite will be the next couple of years, in our opinion, because if you look at the progress we've made so far, we've taken a big bite and have done it successfully.

Operator

And our final question today will come from a follow-up from Ross Muken.

Vijay Kumar - Deutsche Bank AG, Research Division

A quick follow-up on to the 2 rescue studies. I was just wondering, were these studies that you had originally bid for, and how did your conversations with these clients sort of changed? What was the main difference with respect to those conversations that you've been having with other...

Joseph L. Herring

I'm sorry, I can't hear you at all.

William E. Klitgaard

Vijay, you're speaking about the rescue wins. And the rest of the question was?

Vijay Kumar - Deutsche Bank AG, Research Division

Yes. On the rescue studies, so were these studies that you had originally bid for, and how did your conversations this time around change, I guess?

William E. Klitgaard

We have a hard time following you. I guess the reality is that the rescue studies are evidence of the fact that it's not about price, it's about the quality. And I think that's the point that Joe was trying to make is that sometimes you have customers switch over to someone else because they think the price is a little bit better and then they get over there and they're disappointed. And that when you really invest in operational service excellence, you can delight the client and maintain clients and you -- often your clients come back to you. I think that's the point.

Joseph L. Herring

At times, our relentless focus on service quality, we make it look too easy for clients. And they take something that is unbelievably complex, like a global Central Lab study and think anybody can do it because they have a Toshiba or a Roche platform. But it's really logistics and the project management and the IT -- the database that you build and the flags you put in system and the kit we supply and the kit design and all of that. And the good news is that for these Central Lab studies, when we get a rescue, it's normally early on, it's not mid-flight. And that's the case with this study. They awarded the study and a month later, they came back and said, "Boys, we really got into implementing the study. There's no way this competitor could do that." So it's just -- I don't know. It was a real boost for our team that fought really hard to win it on the front end and because of pricing kind of thrown out and then have it come back was pretty rewarding. Okay. So thank you, all, for your time and attention this morning. I have one final comment, and I apologize in advance for my lack of restraint, but go Tigers, beat Alabama. Thank you.

Paul Surdez

Thank you, everybody. I'll be available for the remainder of the day if you should have follow-up questions. This will end up the call.

Operator

That concludes today's conference. Thank you all for joining us.

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