Covance, Inc. Q4 2007 Earnings Call Transcript

Covance, Inc. (CVD)

Q4 FY07 Earnings Call

January 31, 2008, 9:00 AM ET

Executives

Paul Surdez - VP, IR

William Klitgaard - Corporate Sr. VP and CFO

Joseph Herring - Chairman of the Board and CEO

Analysts

John Kreger - William Blair

Douglas Tsao - Lehman Brothers

David Windley - Jefferies & Company

Alejandro Alvarez - Goldman Sachs

Jon D. Wood - Banc of America Securities LLC

Eric W. Coldwell - Robert W. Baird & Company Inc.

Asher Dewhurst - FBR

Robert Gilliam - UBS (US)

Sandy Draper - Raymond James

Presentation

Operator

Good day everyone and welcome to the Covance Fourth Quarter 2007 Investor Conference Call. Just as a reminder, today's call is being recorded.

At this time for opening remarks, I would like to turn the conference over to the Vice President of Investor Relations, Mr. Paul Surdez. Please go ahead, sir.

Paul Surdez - Vice President, Investor Relations

Good morning and thank you for joining us for Covance's fourth quarter 2007 earnings teleconference and webcast. I apologize to those that have been waiting on hold to get in the queue, we had a bit of a technical difficulty with the conference call, but it looks like everything is on track now.

Today, Joe Herring, Covance's Chairman and CEO; and Bill Klitgaard, Covance's CFO will be presenting our fourth quarter financial results. Following our opening comments we will host a brief Q&A session.

In addition to the press release, 23 slides corresponding to the commentary you are about to hear are available on our website at www.covance.com. Before we begin the commentary, I would like to remind you that statements made during today's conference call and webcast, which are not historical facts, might be considered forward-looking statements. Such statements may include comments regarding future financial results and are subject to a number of risks and uncertainties, certain of which are beyond Covance's control. Actual results could differ materially from such statements due to a variety of facts including the ones outlined in our SEC filings.

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

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

Thank you, Paul and good morning everyone. Before reviewing our fourth quarter and full year results I would like to point out that year-on-year comparisons for Q4 and the full year are affected by two events; first, the sale of our Cardiac Safety business in the fourth quarter of 2007 which gave rise to a gain of $0.06 per share; and second, an income tax gain of $0.04 per share recorded in the third quarter of 2006. My discussions and comments around net income and earnings per share will be to our result excluding the impact of these two events. So please refer to the reconciliation in the slideshow on slide 15 and 16 so you get those numbers yourself.

Now please move on to the numbers here. The net revenue for the fourth quarter was $411 million, an increase of 19.8% over last year. Full year net revenues were $1.55 billion which is up 15.4% from 2006. The impact of foreign exchange on revenue growth was 3.3% for the quarter and 2.6% for the year.

Operating income in the fourth quarter was $61 million which was up 18.9% from the fourth quarter of last year. Full year operating income increased 18.3% to $229 million. Operating margin was 14.8% in the quarter versus 15% last year and a full year margins were 14.8% which is up 40 basis points year-on-year. Net income was $47 million which is up 22% up in the fourth quarter of last year. Full year net income grew to $172 million in 2007 which was up 20.5% over 2006. And finally, earnings per share were $0.72 per share in the quarter up 21.8% compared to the fourth quarter of 2006. Full year EPS was 265 which is up 20.5% over last year.

Now please turn to page 5 of the slideshow. In the fourth quarter of 2007, Early Development delivered 51% of our net revenue and late-stage development contributed 49%. On a geographic basis, the impact of our record growth outside the US is clearly evident as the rest of the world contributed 41% of our fourth quarter revenue as compared to 38% last quarter while the US contributed 59%.

Please turn to page 6 to discuss segment results. In Early Development, net revenues in the quarter were $208 million representing an exceptionally strong growth period of 24.3% over last year. Full year revenues were $778 million which is up 22.9% over last year. Operating income in the quarter was $51.5 million, an increase of 33.3% over last year, and full year operating income grew 27.6% to $196 million. Operating margin was 24.8%, that's up 170 basis points year-on-year from the 23.1% in the fourth quarter of last year. Full year operating margins were 25.2% which is up 90 basis points over last year.

I would like to make few comments about toxicology capacity expansion in 2008 in North America, and how we expect that capacity expansion to come online. We are happy to report that we completed the latest phase of our Madison toxicology expansion rightly ahead of schedule in Q4. Along with this we are taking the opportunity to renovate a similar number of older toxicology runs and we'll convert some into premium space for a rapidly growing Safety Pharmacology capacity. These runs should allow us to generate more revenue in the same amount of physical space and further accelerate our program management offering for client. We expect to bring the renovated rooms back online in April.

The net result is that there will not be a meaningful increase in net capacity in Madison until early Q2 and since we are running a near full capacity utilization, this will slightly mute to our sequential growth rate in Q1 in North American Toxicology as compared to Q4 of 2007.

Now turning to late-stage development. Net revenues in the quarter were $203 million which is up 15.6% over last year. Full year revenues grew 8.7% to $769 million. Operating income in the quarter were $32.6 million, essentially flat to the fourth quarter of last year and full year operating income was $128 million or 16.7% of revenue compared to the $123.7 million or 17.5% of revenue last year. Operating margin was 16% in the quarter as compared to 17.5% in the last quarter and 18.6% a year ago. Operating margin was impacted by an issue within a clinical development study. Excluding the impact of this mater, operating margins would have expanded on a sequential basis.

Finally during the fourth quarter, we divested our centralized ECG business. This will impact revenue comparisons throughout 2008 by approximately 350 basis points, since the result of cardiac safety will remain in our 2007 base period.

Now turn to page 7 to recap the backlog numbers. For the full year backlog increased $458 million or 21%. The FX impact on backlog growth was approximately $53 million. Net orders in the fourth quarter were $502 million or $1.99 billion for the full year.

Now please turn to page 8 for review of cash flow information. DSO at December 31 was a remarkable 36 days, an 11 day improvement over September 30th figure of 47 days and 13 days better than the fourth quarter of last year. This is the lowest level of DSO we have experienced in more than 5 years and reflects a continued focus by our finance leadership and their staff on this important metric.

Cash at the end of the quarter was a record $319 million which was up $60 million from last quarter and a $100 million from the end of last year. This increase reflects exceptionally strong cash generation from operations as well as $35 million in cash proceeds from the sale of our centralized ECG business.

In the fourth quarter, operating cash flow was a very strong $117 million and capital expenditures were $96 million resulting in free cash flow of $21 million. On a full year basis, operating cash flow was robust at $294 million, capital spending was $201 million resulting at a very strong free cash flow of $93 million for the year exceeding the high end of our own expectation.

Looking forward to 2008, we expect capital spending to increase to approximately $250 million as we continue to take advantage of the very favorable industry fundamentals with substantial positions... substantial portions of spending allocated to new preclinical facility we're building in Arizona, other toxicology expansions and several key IT systems projects. We expect 2008 free cash flow to be approximately $40 million. Finally corporate expenses totaled $23 million in the quarter or 5.6% of revenue.

Looking forward to 2008, we expect corporate expenses as a percent of revenue to return to the 6.5% range as we continued to make investment in infrastructure that will enhance our ability to manage future growth.

Now I'd like to turn the call over to Joe for his comments which began on page 9 of the slide show.

Joseph Herring - Chairman of the Board and Chief Executive Officer

Thank you Bill and good morning everyone. Let me start by saying how very proud I am of the 8700 Covance employees around the world who work diligently to delight our clients and deliver another year of strong financial results, including revenue growth of 15.4%, another year of increasing operating margins, excellent cash flow led by an improving DSO and a seventh consecutive year with earnings growth of at least 20%. Robust demand across our broad service portfolio allowed us to deliver another strong net order performance totaling $502 million in the fourth quarter and $1.99 billion by the full year. These result's topped our internal budget helping us drive at 21% growth in backlog to $2.7 billion and a strong net book-to-bill of 1.28:1 for the full year.

In 2007, we also delivered on a number of strategic objectives including the timely execution of our global toxicology expansion strategy in the U.S., UK and Germany. The acceleration of our program management service offering which helped deliver more than $200 million in revenues in 2007. The addition of new Covance offices around the globe which support clinical trials including our new central laboratory in Shanghai, China. The divestiture of our centralized ECG business, more than $12 million of incremental profitability from Six Sigma projects, and the planning and early implementation of several substantial IT projects designed to support Covance at 3X plus our current size.

So it's important for us to make progress against these strategic objectives in 2007 as success helped make our business model even more scalable and productive thereby enhancing our ability to capitalize on the exciting long-term growth opportunities ahead of us.

Please turn to slide 10 for a review of our Early Development results. In the fourth quarter, our Early Development team delivered exceptionally strong revenue growth of 24.3%. Operating margins expanded 170 basis points year-on-year to 24.8%. Full-year results were equally impressive with revenue growth exceeding 20% and margin expansion of 90 basis points. Excellent results were delivered across toxicology, chemistry and clinical pharmacology.

Clinical pharmacology grew sharply as the rate insights acquired in 2006 became accretive and played an important role in new business wins. Clients are now utilizing our clinical pharmacology sites more strategically and we are wining more bundled Phase I packages.

In toxicology, demand remains robust. To support this very attractive long-term growth market, we are further increasing investments in new capacity and scalable infrastructure. Construction on the remaining shell space in Madison is now complete. As Bill mentioned, we are also talking this opportunity to renovate our oldest toxicology space in Madison in order to increase the efficiency and to add capacity for our rapidly growing Safety Pharmacology offering.

In Chandler, Arizona construction is progressing as scheduled and we expect to open the initial phase and facility in the first half of 2009. In Harrogate, construction of our third large toxicology expansion this decade is well underway and we expect it to come online by the end of this year.

Finally, during the fourth quarter we purchased Eli Lilly's partially constructed manufacturing facility located on a 47 acre property in Northern Virginia for $20 million. We intend to transform this facility into an approximate 400,000 square foot state-of-the-art laboratory and transition our current Vienna, Virginia operations to this site in 2011. This will nearly double our current laboratory footprint in Northern Virginia.

Our program management offering which integrates multiple elements of our Early Development services continues to be a big success for Covance and more importantly for our clients. The number of molecules we are managing under this arrangement grew 60% in 2007 to 255. More than 100 clients are participating in Covance program management which again helped generate more than $200 million in revenues last year.

Please turn to slide 11 to discuss late-stage development. Revenue growth for late-stage development accelerated for the third consecutive quarter to 15.6%. Order growth remained strong with a book-to-bill above 1.4:1 for both the quarter and the year. However, late stage development margins in the fourth quarter were impacted by a study issue in clinical development. This resulted in the need for us to re-perform certain work on an ongoing study which negatively impacted revenues and margins in the segment.

Due to client confidentiality, I am not able to elaborate extensively on this matter. However, I will provide some color in context. First and most importantly it is isolated to a single study. Second, we discovered this matter in early November. We developed and are implementing a corrective action plan in collaboration with our client. I am pleased to report that the study was up and running again within the fourth quarter and it is performing well. Further we believe we are on-track to meet the original time lines that client set at the inception of this study. Third, we have determined that this matter arose as a result of human error and not the result of the systemic or systems problem.

During the quarter we took steps to mitigate the financial impact of this matter by closely managing discretionary spending. This is evident in the lower levels of corporate spending and general and administrative expenses which you see in the quarter.

Outside this particular study, our Phase II-III clinical development services continued to deliver impressive results with revenue growth in excess of 20% both for the fourth quarter and the full year. During the year we made solid progress toward making Phase II-III a third key growth drivers for Covance including higher levels of employee retention actually above our company historical average as well as industry rate even as the market for labor becomes more competitive.

Three new preferred provider relationships were added with large biopharmaceuticals companies. We continued strong project management as greater than 70% of our clinical programs are running on or ahead of schedule and we saw increased client satisfaction scores and repeat business.

Moving onto Central Laboratory Services, we continue to recover from the lower kit volumes experienced early last year. Fourth quarter revenue increased 11% sequentially, while year-on-year Central Lab revenue grew 21%. In the fourth quarter we continue to incur costs related to the startup of our new lab in Shanghai and the consolidation of our Australian lab in the Singapore. And from a mix perspective we continue to see a shift to emerging markets, which have greater transportation costs.

With the rolling 12-month book-to-bill in excess of 1.52:1 and a growing backlog larger than $1 billion we believe that our Central Laboratory is poised to deliver strong revenue growth and margin expansion in 2008. In Commercialization Services, new biological product launches over the past year which is a key driver for our reimbursement hotline services continues to impact revenue and margin in market access services. We remain confident that our strong market position together with the continued record funding of the Biotechnology industry and the increasing portion... proportion of biological products in Phase III pipeline will provide opportunities for market access to resume its growth trajectory in the future albeit not in the very near term.

Now please turn to slide 12 to review our investment in infrastructure. As Bill mentioned, we are stepping up our capital expenditures in 2008 in order to support the higher growth rates of Covance. We continue to have encouraging senior level client discussions regarding a broader spectrum of strategic outsourcing, including dedicated capacity in toxicology, dedicated resources in chemistry, large packages of work in clinical pharmacology, increasing levels of program management awards, fundamental changes in clinical development outsourcing and sole source contract in central laboratory.

These discussions give us increased confident to invest for the future. I have already touched on some of the large facility project and the expansion of our geographic reach to better support large global clinical trial programs. But equally important to these brick and mortar investment is the need to invest in our talent and our information technology platforms.

First let me talk about IT, our business model involves providing massive amounts of valuable, highly regulated data to our clients for submission to regulatory agency. It is essential for us to continue building more robust IT infrastructure and applications, which position us to more effectively capture, store and deliver exponentially more data in the years to come. More specifically, we have developed a systems architecture and integration road map for our key business lines and support functions including an enterprise-wide implementation of the PeopleSoft finance and accounting system, a signification upgrade to our central laboratory systems including a more flexible database, enhanced automation tools and expanded data reporting capabilities, the finial implementation phase of our upgraded pathology and toxicology system, and continued automation investments in our phase II, III service offering.

We are also adding an enterprise application integration layer which will allow us to further integrate data and the drug development process. It will bridge all of our enterprise technology and create additional flexibility when assessing information for both legacy systems and new technology deployment. We expect that these investments will make our operations more scalable, enhance delivery of data to client, help drive margin expansion, and further differentiate the Covance brand as we deliver data to our clients in a faster, more efficient and seamless manner.

Said another way, we plan to use IT systems and talent to make Covance capacity increasingly feel like our clients very own, just faster, more cost effective and more flexible. We will also continue to invest in the most important element of our infrastructure and that's our people. In particular, our multi-year focus on succession planning affords us the opportunity to fill several key management positions internally late in 2007. Most notably Wendell Barr, previously the President of Early Development, Labs North America was named Covance's Chief Operating Officer effective at the beginning of this year. Wendell has proved himself as the leader who demonstrates exemplary management skills, owns an impressive track record of accomplishments and has a strong client focus.

Over the past seven years under Wendell's leadership, Labs North America has exceeded every key financial, operational, and customer target we have set for the business including transforming our clients perception of Covance from an outsource provider to a strategic pre-clinical partner. Wendell's own success for talent development is evidenced by the promotion of exceptional internal candidates following this move including Mike Lehman the President of Labs North America, Latte [ph] and Michelle Robinson in Early Development.

We all look forward to leveraging Wendell's talent across the broad range of Covance's portfolio of services.

Please turn to slide 13 for our 2008 outlook. We see the current robust demand for outsourced drug development services continuing in 2008 and beyond. In addition, a number of Covance specific earnings drivers gives us reason for long-term optimism including expanded toxicology capacity and the client shift towards more strategic views of preclinical services, a strong demand for our clinical pharmacology and chemistry service offerings, the conversion of our $1 billion Central Lab backlog to revenue, the improving growth, particularly productivity and profitability of our clinical development segment, the continued contribution of Six Sigma benefits as is applied across our entire organization. And finally the benefits derived from our infrastructure investments in talent and information technology.

Based on these key earnings drivers, we continue to target revue growth in the low- to mid-teens range and diluted earnings per share of $3.18 in 2008. Achieving these targets would mark Covance's 8th consecutive year with EPS growth of 20% or greater.

So thank you for your time and your interest in Covance this morning. I would now like to turn the call over to the operator for a Q&A session.

Question And Answer

Operator

: Before the question and answer we will like to apologize to everyone for the long call time. [Operator Instructions]. Our first question will come from John Kreger with William Blair.

John Kreger - William Blair

Hi, thanks. Joe a question about your comments on the Phase II and III business becoming a more important growth driver, can you just give us a little bit of historical perspective, I think back several years ago which is the last slowdown in the business I think Covance talked about the fact that was not really a critical part of the strategy from your perspective what's really changed and why you think you can be more successful or more strategic in that business today?

Joseph Herring - Chairman of the Board and Chief Executive Officer

All right, John, thanks for your question. I think fundamentally if you go back to 2000, 2001, we made a commitment to our laboratory base business for preferential investment and the main reason is that the majority of the day that goes into an IND or an NDA is laboratory data and we felt that we could be the biggest, the fastest, most cost effective generator of that data in the world, and that by capitalizing on the assets that we have and improving them, we could help our clients to accelerate drug development, and certainly that was boom for our business, and at that time it was really just a priority decision. We also were concerned that the sort of lumpy nature of Phase II-III or at least of our business was a concern. It was spillover capacity from pharma companies and sometimes it was very good, sometimes it wasn't so good. And what we saw then over the next five years was an initial transformation of the market that was very positive which was the persistent funding of the biotechnology industry with ever more and more clients who could take drugs all the way through Phase III, maybe even rent a sales force and go into market launch, and so there was a wave and a continued wave of clients who do not internal capacity and relied on CROs. So we saw the demand becoming instead of lumpy to be very predictable and growing faster.

Over the last 24 months John, we have seen major pharmaceutical clients fundamentally we think Phase II-III outsourcing and looking to do it more strategically and we see larger chunks coming out. So really it's about staying close to the market, seeing the changes and now putting more investment into the Phase II-III business to add as a growth driver.

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

And John if I could just talk in one more comment on that. I think we have also seen our own management team become much more focused in this business and execute better and that's reflected in client satisfaction scores that we monitor as well as the financial performance of that part of our business.

John Kreger - William Blair

: Great, thanks. Just a couple of other questions. As you talk to your clients especially in the large pharma side. I think as we look back to '07, that industry turned out to have a very challenging year probably worse than what a lot of people expected. How are you seeing that translated into changes and behavior if any as they think about their R&D spend and what they are outsourcing?

Joseph Herring - Chairman of the Board and Chief Executive Officer

Well I think, John, patent expirations has everyone thinking longer term. We do have several clients who really aren't facing that until 2011, 2012, 2013 but they see the broader industry and say hey let's... while times are pretty good, let's think about how we make our infrastructure more flexible so that if we aren't successful with new product development over the next several years that we will be able to take cost down and match revenues with expenses more easily. And so for those clients it's a very strategic approach. What they would have done historically is continue to pour capital into pre-clinical facilities as they in-license that molecule; this maybe out there historical therapeutic strength they would hire bunch of medics and build a therapeutic capability of maybe up to 1000 people. And as you look at patient accrual in emerging markets they will be piling people into China, India and Brazil and Eastern Europe. And what they are saying is, we really don't want do that, and so they are saying rather than building a new per-clinical facility maybe this dedicated capacity thing you are talking about makes a lot of sense or we have a big bolus cardiovascular samples that need to be tested rather than us expanding our footprint. Can you give us some interim facility and dedicated staff. It has several of those which are very interesting.

Our clients are very worried about Phase II right now. How do you more rapidly determine whether you have a drugable compound before you go into a Phase III study and so they are looking for faster action, early proof of that efficacy in Phase II. And again are they going out building Phase I facilities or are they building centers to do Phase II more rapidly, generally not.

And then the other side, John, of course are companies that are in real trouble right now and I think there has been 50,000 layoffs in the last 12 months and more and more of that is creping into R&D. And so whether you had a clinical development or pre-clinical or clin pharm, you are... almost at any company, you have either flat headcount or you got a trip [ph] headcount or you've got a sliced headcount. And... but the back pressure is, we got more molecules because of end-licensing and we've got lot of work to do. And then the second item is that capital spending I think you have seen these trends John have gone down, down, down for, I think, the fourth consecutive year. And so the ability to add staff and add new capital had somewhat been curtailed.

All of those events helped the CRO industry and keep in mind the umbrella that we are under is that we haven't seen 2007 numbers but it will be somewhere in $65 billion or $70 billion spent in R&D, up somewhere in the high single-digits growth rate, only $15 billion is outsourced and Covance below $1.5 billion. All of these, I think, spell continued robust growth for the CRO industry. Not that our clients are having the greatest time of all ever, but they need help and we need to be positioned with our company, our portfolio, and future investment to help to make their costs more flexible.

John Kreger - William Blair

That's very helpful. And then just one last question. The... curious of how you would help us to suggest how we think about your bookings numbers, I think your total company book-to-bill is a little under 1.2, your later-stage development over 1.4, so doing the simple math that would suggest the Early Development bookings, book-to-bill was more like one. But I know that's not a particularly relevant metric in the Early Development side. Would you suggest people focus more on the clinical bookings ratios and is that a statistic you will be giving us in the future?

Joseph Herring - Chairman of the Board and Chief Executive Officer

We hit that almost every quarter, but in reality we don't think that backlog or even book-to-bill is anything more than a blunt indicator. I mean if you looked at our Early Development business, John, book-to-bill has been around 1.0 for the last year and yet we drove greater than 20% revenue growth and accelerated throughout the year 24% in the fourth quarter. And so when you take that 1.0 and say, well, that's not that good from a book-to-bill or a backlog growth standpoint, but revenue's smoking. And then you match that up with late stage at 1.4... it has been 1.4, 1.5 for 10, 12, 14 quarters in a row, Central Labs' been over 1.5 quite a bit and you go alarmed [ph], why isn't your revenue going 30% to 40%. Well there is... this year we elongated clinical trial. And so I think it's more about executable backlog, it's length of trial, it's how exciting is the compound in terms of is it novel, and so patient accrual ramps rapidly, or is it the fifth DPP-4 inhibitor that's being brought into geography and it's going to be slow.

I think all of those numbers are blunt instruments and I wouldn't get too carried away. But having said that a good solid book-to-bill of us at 1.15 to 1.2 maybe to 1.25 is very good news. And is it a blow out, we are not looking for a blow out. Our target is low to mid-teen revenue growth and 20% earnings growth, we can do that with high quality delighting our clients and financial control; it fits our capital structure and hopefully over the long haul provides great return for our shareholders.

John Kreger - William Blair

Thanks very much.

Joseph Herring - Chairman of the Board and Chief Executive Officer

Thank you, John.

Operator

And our next question will come from the Douglas Tsao with Lehman Brothers.

Douglas Tsao - Lehman Brothers

Hi. Good morning. Joe you referenced the impact of transportation cost on the Central ad business and I was just wondering how you were thinking about that because obviously in the past incremental margin have been very, very good in that business. Is this something where you might further expand the lab geographically and you obviously just entered China but would you consider new locations or does that mean that you might place greater emphasis on the Covance local lab server?

Joseph Herring - Chairman of the Board and Chief Executive Officer

Well Doug yes, yes and yes. We continue to expand it to address the transportation issue and might there be another location... there are a couple of places where transportation costs are very high and while it's not a meaningful percentage of our business today, it's growing rapidly and we'll continue to monitor that. The local lab business had a very, very good year topped off by a very strong fourth quarter and we're thrilled that even that we have that opportunity and certainly the local lab capability was a home run for us and for our clients during the Russian embargo last year we were able to keep trail going and testing within specification for those sample. But we always continue to monitor it Doug, and again despite the transportation issue we expect margin expansion in 2008. We did take some extra costs in 2004 as we said related to the close down in Australia and moving that business into Singapore as well as the ramp up of hiring and the depreciation and all the expenses we're setting up the facility in Shanghai. But right now it's not a huge portion of our business but we'll continue to monitor it.

Douglas Tsao - Lehman Brothers

Okay, great. And then turning to the preclinical business. You referenced that there is going to be some renovation of older rooms at the Madison facility. I was just wondering if you could provide a little more detail around the new capabilities that this will give that space. I mean, is this sort of improving in our ability to work and use the... and new models and if they are not in the climate or is it still beyond that?

Joseph Herring - Chairman of the Board and Chief Executive Officer

Well a couple of things. One is you've been to our Madison facility and when you are building contiguous space or you are building on top of space then a bunch of things come into play like what are you doing with the air handling and if you already working contagious too, the only remaining space in the facilities that value the venue or newly renovated, why not take advantage of the opportunity and do that.

So that was a part of the rationales to bring it up to sort of 2008 standards. The bigger driver though Doug is really Safety Pharmacology and Safety Pharmacology is largely related to cardiac safety testing in pre-clinical or monitoring. And that has been sort of an on and off specialty cost business over the years but it became part of the core ICH battery. The demand for that business is skyrocketing and it generates far more revenue in the given room than general toxicology space. We have built a world class Scientific and Regulatory Organization under the leader of Dr. Dusty Sarazan and clients are very anxious to grow their relationship with Covance as it relates to Safety Pharmacology.

So again this gave us an opportunity to update space and converted a fairly large chunk of that to really one of the fastest growing segments that we have. Because of the contiguous nature of this and the fact that we are doing... finishing this other work, what ends up being is just a 3-month delay in this new capacity coming online and let me just elaborate there a little bit more.

We have been saying that the third component of the Madison shelf space was going to come on in early 2008. In fact our team finished that early and that sort of gave us this opportunity. So we took the work in that old space and put it in the new shelf space and then with that old shelf space is being renovated converting to Safety Pharmacology. And so the ramp up will occur in those space as is completed and I will be on the ramp that we were predicting. But it's about a 90-day project and if we stay right on track that we will see that uptick in the second quarter.

Douglas Tsao - Lehman Brothers

Okay, great. And then just final quick question on... in term of Harrogate, you continue to expand there and obviously you have expanded the Munster facility as well. I was wondering have you considered adding an additional per-clinical facility in Europe, just sort of based on the thinking that perhaps there's other buildings are maxed out in terms of the capacity could be added there.

Joseph Herring - Chairman of the Board and Chief Executive Officer

Well Doug when your preclinical revenue is really 24% you have to consider all sorts of things. We know that Greenfield is a very expensive way to add toxicology capacity and were it not for some of the dedicated space contracts that we have, we would have been lot more nervous about pulling the trigger in Chandler. So our model is still to grow in the space where you have strong management control, strong security, strong oversight and I think we are going to find ways to continue to build in Harrogate. We have a great team there that delivers strong consistent performance and so right now I don't see anything on the near-term horizon.

Douglas Tsao - Lehman Brothers

Okay. Very good. Thank you very much.

Joseph Herring - Chairman of the Board and Chief Executive Officer

Thanks Doug.

Operator

And our next question will come from Greg Boland [ph] with Jefferies & Company.

David Windley - Jefferies & Company

It's Dave Windley, can you guys hear me okay.

Joseph Herring - Chairman of the Board and Chief Executive Officer

Yes, Dave.

David Windley - Jefferies & Company

Okay. I have couple of question here. First of all, Joe you talked about and went through the variety of investments that you are making, investment facility in IT and retention and things of that sort. In the fourth quarter your corporate overhead number dropped by, I think, couple of million dollars at least and jumped around a little bit during 2007. I guess I was hoping can you give us a sense of where the base case is on that number and I guess tell us why the fourth quarter number's not a paired back number to make the EPS number in the quarter?

Joseph Herring - Chairman of the Board and Chief Executive Officer

I'll have Bill grab that one.

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

I think the answer there is some flexibility in terms of our spending here and we mentioned this clinical issue we had to deal with in the quarter and that impacted us a little bit. So we found other ways to... in essence take a holiday for a certain spending elements that we had in our midst and our capability to control it and deliver the quarter.

David Windley - Jefferies & Company

Does that mean that number will then have to jump back up in the first half of 2008?

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

I think what we have given you is both in the earnings release and our comments that we expected to come back to 6.5% range plus or minus and we've always indicated for last year or so, that's kind of the range we're comfortable in 6.5% of revenue plus or minus 50 basis points. We expect that kind of go back towards those levels in 2008.

Joseph Herring - Chairman of the Board and Chief Executive Officer

David there are also some natural thing that occur when you have a no win hit like we did related to this study, it impacts compensation. So you automatically have a compensation calculation that takes expenses down. The second thing that may be helpful to you is we have five large IT projects going on right now at Covance and we have been very... I think very thoughtful in how these projects have been planned. We start out with 100% assumptions that we are buying commercial off the shelf and once we go through a process and identify what system best fits then we go through a complete fit gap analysis and determine what if any configuration needs to be done. We have been to a conference room pilot where we take actual employees offline and have them run studies and then dummy projects on that system to determine whether our fit gap analysis was correct. Then we hire a systems integration organization external to the company which drives the change management piece. We make the final configuration changes and then we start rolling it out business unit by business unit.

We don't just approve a $20 million IT project and push the button, and so when you have 5 of those running simultaneously there is some discretion as to they will use the term holiday which I think is a good one its just say we are going to take a holiday on the change management piece or the conference room pilot that we are going to run, we are going to delay it for some period of time and so that gives us some flexibility.

Earlier in the year we actually accelerated many of those projects because we were running ahead. And in fact as we look at 2008 to the extent that we create upside we are going to be looking to accelerate those projects as well. And the reason why is because the faster that we can get these done and in place the better for Covance, the better for our clients, the better for our employees and better for our shareholders.

David Windley - Jefferies & Company

Okay, that's helpful. Well, Bill on the below-the-line FX gain number in the quarter was sequentially quite a bit higher and I want to understand which currency movement was the primary driver of that and what line items are the primary driver of that I assume that comes from balance sheet adjustment?

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

Dave, it's actually... what we are trying to do is marry up payables and receivables potentially and we don't go out and do FX hedging explicitly we are trying to do internal matching of those long and short position in a sense to various currencies. During the fourth quarter we had a couple of situations where we had receivables, essentially long positions that were hard to match up against offsetting payable position. One of those was a Euro exposure on a U.K. balance sheet, another one was a Swiss counter exposure on U.S. balance sheet.

Largely those two exposures which combined 70% of the FX impact in the quarter have come down, we have received receivables largely and so it's nothing that we expect to repeat. Again we try to match up receivables and payables and not have FX to be a meaningful driver of earnings. This quarter was a good portion to have penny a share come through that way but that for me that's worth repeating.

David Windley - Jefferies & Company

Okay. Just going back a little bit looking at the bigger picture of client spends, and as all my checks have come back, I am very positive about the demand in the channel but there has been some suggestion recently that pharma maybe pulling back in a couple of the previous companies are seeing some soft spending. And what's your view on that and what are clients telling you and is there... you have some concerns that there maybe some spending sensitivity negatively impact RFP flows or backlog growth as you move into 2008?

Joseph Herring - Chairman of the Board and Chief Executive Officer

Dave, that's not what we are seeing, that's not what we are hearing. They may be having a conversation like that internally, but what that translates into generally as we got to find a way to outsource more and outsource more strategically and they are asking us to bring any and all solutions that we can think of.

David Windley - Jefferies & Company

Okay. And then you mentioned you added a few preferred providers in Phase II-III and in your comments you've talked about pharma, fundamentally rethinking, I think that was mainly the answer to the first question, but fundamentally are we thinking the way they are doing these things, how is Covance's Phase II-III business in particular position should you compete for these larger chunks of business as those come out, I mean, to the tune of $50 million to $100 million is what we are starting to hear becoming surprisingly common.

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

Well, obviously we are not the largest Phase II-III provider and nor has it been our goal to be. Our goal is to be a solid full service global provider of Phase II-III services and in fact our headcount is equivalent to the Phase II-III clinical organizations inside of most of the top 20 pharmaceutical companies. Obviously there are few that are larger. We continue to disproportionately invest in emerging markets in terms of adding headcount, we continue to bring process improvement through Six Sigma projects as well as some of these IT investment. And in fact we have been running several projects that have $50 million, $60 million, $70 million in size.

So, we clearly have the capability of running a large Phase III clinical study. Can we run 15 at one time, not at this point but we are trying to build a more automated and more scaleable business so that we can in the future. And again Dave you know our story well what really drives our company as our laboratory footprint and we have done that there and we are able to capture the upside opportunity and drive margin expansion. And what we are trying to do is Phase II-III is to build the capability to add a third earnings driver we don't need it next week or next month, but a year from now we will be much stronger and two years from now we will be much stronger. I don't think top five pharma companies are going to shutdown their internal clinical development organization and give it to Covance, but we don't need that. So, I think we are positioned very well.

David Windley - Jefferies & Company

Thanks for that. I guess some other way to ask the question would be, are there top 10 or top 15 wherever you want to cut it off, key clients with the pipelines if there is such a thing and a lot of potential for repeat business in the clinical space where you are not on the preferred list and would like to be and need to be or had gone through a preferred provider agreement bakeoff that have not been selected. I mean are there satiations like that that still need to be overcome?

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

Well there have been a number of bakeoffs and fortunately three clients liked our cupcake very well. And if these clients deliver the kind of volume that they are talking about we will have all the business we need in Phase II-III for the next several years. So, we don't need to win a whole bunch more, we don't have the capability to win a whole bunch more, it's more providing high quality services and continues to stay on this track record. We developed over the last several years which has been a big part of our success which is running 70% plus of our trails on time and running a whole bunch of them way ahead of time and beating the client stretch goal. So, we are very happy with where we are sitting.

David Windley - Jefferies & Company

Very good, thank you for the answers. Good luck with that.

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

Thanks David.

Operator

Our question will come from Goldman Sachs, Alejandro Alvarez.

Alejandro Alvarez - Goldman Sachs

Hi, good morning. Bill there was a spike in direct cost that we at least weren't expecting. Can you just walk through some of the factors that drove that increase and how much of it was related to the out real work that you mentioned you had outperformed? And then secondly if you would expect the gross margins to come back to a more normalized level in the first half of the year.

Joseph Herring - Chairman of the Board and Chief Executive Officer

Alejandro, there is a lot of factors that go through this, I think the gross margin impact between Q3 and Q4 was about 150 basis point decline. There is some volatility in here from quarter-to-quarter, so I will sort of caution it that way. The answer to the part of this was as we mentioned earlier, having to grow our... sort of manage our cost closely during the quarter to do what we believe we are committed to. So, I look at it sort of a one quarter kind of situation, I wouldn't interpret from this a long-term trend, I just think it's something we have to manage from quarter-to-quarter and there's volatility built in here. Not any one particular fact of points, there are a lot of different factors. As Joe mentioned bonuses we talked about our corporate expenses, otherwise we sort of look at this and a lot of factors that go into the mix.

Alejandro Alvarez - Goldman Sachs

And then, Joe, you obviously mentioned some of the need to invest in people. With the Wendell's promotions here, is this in anyway an indication that you might need to bring on some additional folks to the senior management team or how do you fill up the team right now that's in place and its ability to continue to drive the growth that you are expecting over the next couple of years.

Joseph Herring - Chairman of the Board and Chief Executive Officer

Alex, I am thrilled with our senior executive team at Covance. We have extraordinarily high retention of the key executives in the team over the last seven years. We've continued to selectively add key talent to that organization like Dr. Nigel Brown, Dr. Hongjiang Bi [ph] in China, and we... as I mentioned in our script, we have worked very hard on succession planning and so I think for us it's a combination of continuing to develop and promote internal candidate. I got to tell you, having a guy like Mike Lehman step up to be President of Labs North America after having years of experience he know Six Sigma, he knows our culture, he's learned toxicology and chemistry as opposed to bringing somebody from the outside that either knows clinical development but not pre-clinical whether from outside the industry. When I was promoted to Chief Operating Officer everything that I thought that business could become, Wendell took it and surpassed, and our hope is now that when Wendell steps up, Mike will take everything Wendell was doing and surpass even Wendell's milestone.

So I think this stability, the succession planning and the leadership development we have is really a core strength of the Company.

Alejandro Alvarez - Goldman Sachs

That's great. Thank you.

Operator

And our next question will come from Jon Wood with Banc of America Securities.

Jon D. Wood - Banc of America Securities LLC

Okay thanks. Bill the trend in the unearned revenue metric has been improving consistently. Is that a function of business mix. Are you exhibiting more success in negotiating the same contract terms or what are the other drivers to that trend?

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

Well I think we saw improvement in all three elements of DSO, so I wouldn't just hang in out to one thing first of all. Clearly we had better receivables, better contract management is reflected in both a level of un-billed receivable which is basically how long you are between being able to issue the invoice as opposed to recording [ph] the revenue. And then client advance is another indication of closer working relationships with sponsors. The idea here and what we would like to work with our sponsors about is being cash neutral. We are not trying to be a bank to fund their molecular development. We are trying to make sure that what we do gets paid for in timely fashion. And if you approach that in a constructive way trying to talk with your clients on a rationale basis about what our goal is as a company providing service and not to be a banker for their molecules, that could become something that is less confrontational and leads to the kind of performance we've seen over the last year or two particularly in the client advance account as you mentioned.

Jon D. Wood - Banc of America Securities LLC

So we should view that as a bundle on all the different balance sheet accounts rather than a specific trend going on within one specific account?

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

Right. I think there are two elements to that. One is closed management of receivables. The second is getting involved in negotiation of contracts. So the contract terms reflect a more cash neutral positioning during the study conduct.

Jon D. Wood - Banc of America Securities LLC

Okay, great. And then Joe what do you see as Covance's fastest growing businesses in 2008?

Joseph Herring - Chairman of the Board and Chief Executive Officer

Well Jon we don't forecast at that level. But I do see a solid growth opportunity certainly in Early Development in toxicology as we bring more new capacity. [Technical difficulty] our chemistry business has had a fantastic year. Our food business continues to expand not only in the current footprint but now we are open for business in Singapore. The Central Lab still a backlog of over $1.1 billion and the clinical as I talked about when I was answering Dave Windley's question.

So, in Early Development I think you know Jon we burn our backlog about every 60 or 90 days. And so given a point landing of what that looks like in the third or fourth quarter is little bit difficult but we feel very good.

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

Jon there's one thing I would add there, we have a lot of irons in the fire and there is a lot of different aspects each one of our business that can in fact grow. So we feel pretty bullish about our future and we have given you guidance of low- to mid-teens growth for the corporation. We think that's consistent with a number of different opportunities for delivering growth for the future.

Joseph Herring - Chairman of the Board and Chief Executive Officer

And Jon as you well know our executive team is paid on disproportionately on return on assets. We are not piling in this CapEx for fun just to see what's going to happen and we are investing because we think we have a strong line of side. And the headline on our press release we issued last night, 15% revenue growth in seven consecutive year of EPS growth of 20% or better we want to be able to cut and paste that next year, the next year, and the next year and we always do that, we got to invest but we've also got to manage carefully so that we drive return on asset and give investors a return on those assets we invest.

Jon D. Wood - Banc of America Securities LLC

Okay, great. Thanks a lot for the comments.

Joseph Herring - Chairman of the Board and Chief Executive Officer

Thank Jon.

Operator

Our next question will come from Eric Coldwell with Baird.

Eric W. Coldwell - Robert W. Baird & Company Inc.

Thank and good morning. Joe without breaking client confidentiality, is it possible to define what type of human error occurred on this clinical project and then also could you more specifically quantify the additional gross cost on that rework?

Joseph Herring - Chairman of the Board and Chief Executive Officer

Actually we can't Eric, I will say that client confidentiality is core as you well know to any CRO in client relationship and we don't want to say anything that may give a pharma analyst a reason to speculate to try to name a client or the project and make any kind of judgment about this particular study. Now we will say this is exciting project with a strong compound, there's lot of investigator interest, a lot of patient interest and what we are focused on and have been focused on is taking advantage of that to get the project back on track quickly and substantially new to any client impact. And I would say that our client appreciates the candor and the quick action we took to get the contract back on-track. There are a few elements that we provided in the release and objective, Bill will review here with you in a minute that will help you estimate that size. But again we took actions in the fourth quarter to meet that affect and to deliver to our target and based on that our guidance for 08 remains unchanged.

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

And Eric, I guess, I would just say that look at the press release. We did mention in there... I mentioned it also during my comments that we... the margins would have expanded sequentially from Q3 to Q4 absent this. So, still give an algebra exercise for you but I am sure you can try and get it on approximately what the number was based on that.

Eric W. Coldwell - Robert W. Baird & Company Inc.

Of course and a minimum of $3 million, what I am trying to figure out is would the margin have been 17.6 or 18.5, and I am... that kind of color would help me get a sense on what we can be looking for in late-stage moving into the first half of 08.

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

The thing I've also mentioned is it's not as simple as one project because bonus gets impacted other costs get impacted your rate of spending, we talked about control, over spending. So it's not quite as clean as that. There are a lot of different moving parts. And what the margins would have been is multi-factorial. So, I am not going to be more specific than what we have already including in the guidance but I think you got a good enough handle on what it was, but the meaning of that was for the quarter.

Eric W. Coldwell - Robert W. Baird & Company Inc.

Good enough. On Madison, also I am just trying to get a better sense on the commentary about the renovation and how that will slightly tamper your growth out of Madison or dramatically tamper the growth out of Madison for the first quarter. Is Covance still looking for sequential gains in Early Development q-on-q for total revenue? If so can you give some sense... I mean the last four quarters your lowest sequential growth has been about $8.5 million directionally. Can we get a sense on what you are looking at for Q1 growth for the total segment?

Joseph Herring - Chairman of the Board and Chief Executive Officer

First of all Eric, your term dramatic is dramatic. What we talked about was a portion of Early Development being Labs North America toxicology and we're hinting towards sort of flattish in the first quarter. But there are other businesses in Madison in Early Development and in North America in Early Development. And so I think you might be over-thinking this just a little bit. Bill?

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

Well one of things, Eric, we don't provide revenue guidance and we don't... except for these low- to mid-teens growth for the corporation, we don't provide it by business or by quarter. So part of your job as an analyst, I guess is sort of try and read the tea leaves there and make up your own mind. And as Joe mentioned, it's part of our toxicology capacity, not all of it and toxicology is a part of our Early Development revenue. So, we expect it to lead somewhat our growth, but I would be surprised if we didn't have growth between Q4 and Q1 in early development revenue.

Eric W. Coldwell - Robert W. Baird & Company Inc.

Early Development operating margin was certainly in line with the average you have seen over the last two years at 24.8%. But it was down sequentially and it was below at least what I was looking for. Is there something that could be attributed to that, whether it would be mix shift issues in Covance research products which weren't mentioned specifically in the press release as an area of strength on the top line anyway foreign currency impact, what color can you give us on operating margin in Early Development?

Joseph Herring - Chairman of the Board and Chief Executive Officer

Yes. Let me kind of look at Q3 and Q4 with you and look back over the last few years maybe this trend will help you with it. Going back to say 2002, Q3 to Q4 was 130 basis point decline; 2003, 70 basis point decline; 2004, 100 basis points; 2005, 110 basis points; 2006, 100 basis points; 2007 120 basis points. All of those in the kind of more or less 100 basis point range, I don't think there is anything unusual or noteworthy in Q3 to Q4 this year or 2007. I think there is a bit of a seasonal pattern and just try and win a lot of all the different pieces behind that, I think it's just consistent with historical trends and nothing unusual, nothing to be alarmed about.

Eric W. Coldwell - Robert W. Baird & Company Inc.

Okay, thank you.

Operator

Our next question comes from Asher Dewhurst with FBR.

Asher Dewhurst - FBR

Good morning. Earlier this year we had an issue with the Central Lab kit returns and can you just address the... what rate they are being returned?

Joseph Herring - Chairman of the Board and Chief Executive Officer

As you pointed out, actually we had 11% sequential increase from Q4 over Q3 and 20% revenue growth for the full year in Central Labs. So the fundamental issue of elongation of clinical trials and then moving to emerging market has not changed the crowded therapeutic categories that we mentioned in the past that has not changed but what we are seeing is a gradual and continued recovery in Central Labs and you know and we expect them to have a very strong year in 2008.

Asher Dewhurst - FBR

Great thanks. And also on the international business it looks like you guys are doing pretty well what were some of the issue or what were some of the items that were really not going to cover up the ball?

Joseph Herring - Chairman of the Board and Chief Executive Officer

Central Labs and Phase II-III clinical.

Asher Dewhurst - FBR

Okay. Thank you very much.

Joseph Herring - Chairman of the Board and Chief Executive Officer

Okay Asher.

Operator

And our next question will come from Robert Gilliam with UBS.

Robert Gilliam - UBS (US)

Hi good morning, thanks for taking the question, and I apologize if you addressed this earlier but I had a little bit of trouble getting on the call. So I guess just the first question here, I think last conference call you kind of indicated toxicology, pointing to the strength of the market indicated that you were kind of turning away business and I guess the first question is that still... does that still hold true?

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

While you see 24% Early Development revenue growth you would sort of scratch your head but believe it or not we still are and that's the reason why we are continuing to add in Madison, can't wait to get Chandler open. Early in the year we approved further expansion in Harrogate and obviously a big decision to purchase the manufacturing facility in Northern Virginia. Again if you drive this car looking at the rear view mirror we wish we would add more capacity faster for seven consecutive years at one level, but on the other level growing revenue and toxicology 20% plus is more than just rooms, it's really about talent and training and that many of the elements that go into the business. So, we are really at the top end of our range but we do have a longer-term facility plan, Rob, that will allow us to sustain a good strong growth.

Robert Gilliam - UBS (US)

Okay. And just give us a little more detail, as far as the 24% growth, I mean is toxicology growing at about 24% a little bit faster, a little bit slower than that, are you willing to give a little more detail?

Joseph Herring - Chairman of the Board and Chief Executive Officer

It's board based across clin pharm chemistry and toxicology. So all in that high range.

Robert Gilliam - UBS (US)

Okay. And then I guess just as far as the timing of brining down some rooms in the first quarter, I mean, just as far as the timing of that, I mean with all the demand this year, I mean is this something that you felt couldn't wait and this was just kind of like the right time to do it or I mean I was just trying to... there's not any deeper meaning here as far as like a temporary goal in toxicology or anything like that or maybe you can just kind of address that?

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

Rob if you look at the transcript because I've talked about this quite a bit earlier and I don't want to be redundant trying to squeeze in maybe another question or two, but simply stated as we open up the new shell space it gave us an opportunity because it's relatively contiguous. To renovate the last portion of the Madison clinic that is not either brand new or newly renovated but even the bigger driver from that is that the fastest growing part of our toxicology business right now is Safety Pharmacology which is now a part of the ICH Battery and we have built a powerful scientific and management organization is running that business and we are converting a chunk of this block of rooms into Safety Pharmacology space which is a different room configuration and different requirements than a standard toxicology room. And so it's a 90-day sort of breather if it will in terms of this capacity addition that we may but for the longer-term we believe it will be a home run for us.

Robert Gilliam - UBS (US)

Okay, thanks a lot guys. I appreciate it.

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

Okay, Robert.

Operator

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

Sandy Draper - Raymond James

Thanks. Most of my questions have been asked and answered, but maybe just one different way, Joe, to talk about the issue and I also had a little bit trouble getting on so you may have commented on this. Did you say whether there was an issue that came up because of trials going [ph] on or something from the client or was it an issue that something happened on the Covance side? Thanks.

Joseph Herring - Chairman of the Board and Chief Executive Officer

Yes Sandy, we weren't that specific and I think the combination of our prepared comments in the earlier questions, I think, will get you to your answer. And if you have a follow-up question obviously Paul Surdez' number and he will be happy to try to help you through it.

Sandy Draper - Raymond James

Okay, thanks.

Joseph Herring - Chairman of the Board and Chief Executive Officer

I think that was our last question. Again we apologize for the late start, but hope by going over now 12 or 13 minutes, we answered most of the questions. Paul is obviously available. So, thanks for hanging in there with us this morning and with that I'll turn it back over to the operator.

Operator

Thank you. That does conclude our teleconference for today. We would like to thank everyone for your participation, and have a wonderful day.

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