Why I Bought Covance (Again)

| About: Covance Inc. (CVD)

The Contract Research Organization [CRO] industry captured my attention in late 2003 when I recommended Pharmaceutical Product Development (NASDAQ:PPDI) at my former firm. At the time, I liked Covance (NYSE:CVD) (61.20, $3.9 billion) too, but opted to go with PPDI. We then added CVD at the end of 2005 as it became clear that the industry was benefiting from some very powerful secular growth drivers. CVD got ahead of itself in 2006 as the analyst community and the buy-side began to recognize that what had historically been a very cyclical industry had finally rationalized and become more of a true growth story. In what follows, I will share some background on both CVD as well as the industry and explain why I decided to reestablish a long position in my personal account on 4/18.

The CRO industry is comprised of many players, with a few significant ones including privately-held (formerly public) Quintiles, PPDI, Charles River Laboratoires (NYSE:CRL) and CVD. Some of the better-known publicly traded names include PAREXEL International (NASDAQ:PRXL), ICON(NASDAQ:ICLR) and PRA International (PRAI). Additionally, inVentiv Health Inc. (VTIV) is rapidly expanding in this area as it transforms its business model.

The industry caters to pharmaceutical companies, helping them to speed the time-line in drug development by running their clinical trials on an outsourced basis. Historically, the companies helped with overflow, but they have now become so much more integral to their customers. In fact, while most of the Big Pharma companies outsourced to some degree, it has increased. Particularly enlightening was the big move by MRK last year, as it had traditionally not been a big outsourcer.

Also, last year there was a study done that quantified the ability of the CROs to speed development. As Biotech companies have taken market share in the development of drugs from traditional pharmaceuticals, the CROs have benefited, as these companies tend to outsource fully. We all know the pressures that the industry faces and that innovation is necessary. So, the CROs should benefit from increased development, especially in the Biotech area.

Another very big driver is the concern on safety. We have learned that Pharmaceutical companies have basically ignored the FDA regarding post-marketing studies that have been mandated. With Vioxx, Tysabri and so many other issues recently, there is increasing need (and probable political intervention) to study long-term safety, which plays into the hands of the CROs. So, the industry is right in the middle of several developments that look to be drivers over the long-term.

While I don’t want to dismiss the smaller players, my focus has been on PPDI and CVD. They are the most globally integrated and offer tremendous breadth, especially CVD. PPDI is focused on “late-stage” and has a compound-partnering strategy, while CVD is focused on the whole development cycle (pre-clinical and toxicology, where it competes with CRL, all the way to Phase IV). With increasing difficulty in locating “naïve” patients for clinical trials, it is important to have operations in Latin America, Eastern Europe and Asia. PPDI and CVD both have tremendous balance sheets and strong management. CVD, by the way, came out of Corning (NYSE:GLW) (along with Quest Diagnostics (NYSE:DGX)), in December of 1996 at a value of about 23.

CVD was on my active watch-list (90 names), and it recently caught my attention from a technical standpoint. PPDI reported on 4/18, and the stock was unfairly punished (in my opinion). I have some concerns about PPDI’s management turnover (below the CEO, who is one of my favorite executives in the whole Healthcare sector), so my focus is more on CVD right now. I used the early dip in the stock price to buy. I think that the stock, about $61 at the time of my purchase, should trade to 72 sometime this year, perhaps as high as 79. The 72 target is a 23 multiple of the current 3.12 2008 estimate, while the stretch target assumes a 25 multiple on a 3.16 projection.

The company reports Q1 on 5/1, and maybe I get lucky in terms of hitting my low target quickly. The Head of IR, Paul Surdez, is extremely knowledgeable about the firm and industry should you desire more information. One of the most interesting things going on with the company right now is that customers are taking “dedicated space” contracts for toxicology. This has resulted in very strong backlog growth and should lead to less variability in earnings. One always is subject, though, to cancellations and push-outs. Don’t get stuck watching quarters (like folks did on PPDI yesterday morning)! Below are some charts that serve to support my position:

Consolidation since late Q3:

Valuation reasonable:
CVD valuation

This table shows that the increased focus on top-line growth is paying off – nice acceleration into late 2007, too:

CVD growth

Disclosure: I am currently long CVD and may add to it in the coming days.