Covance Management Discusses Q2 2012 Results - Earnings Call Transcript

| About: Covance Inc. (CVD)

Covance (NYSE:CVD)

Q2 2012 Earnings Call

July 26, 2012 9:00 am ET

Executives

Paul Surdez

Alison Cornell - Chief Financial Officer and Corporate Vice President

Joseph L. Herring - Chairman and Chief Executive Officer

William E. Klitgaard - Chief Information Officer, Corporate Senior Vice President and Treasurer

Analysts

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

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

Stephan Stewart - Goldman Sachs Group Inc., Research Division

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

Gregory T. Bolan - Sterne Agee & Leach Inc., Research Division

Ross Muken - ISI Group Inc., Research Division

Andrew Schenker - Morgan Stanley, Research Division

Garen Sarafian - Citigroup Inc, Research Division

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

Todd Van Fleet - First Analysis Securities Corporation, Research Division

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

Lauren Migliore - Morningstar Inc., Research Division

Douglas D. Tsao - Barclays Capital, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Covance Second Quarter 2012 Investor Conference Call. This call is being recorded.

At this time, for opening remarks and introductions, I'd like to turn the call over to the Vice President of Investor Relations, Mr. Paul Surdez.

Please go ahead, sir.

Paul Surdez

Good morning, and thank for joining us for Covance's second quarter 2012 earnings teleconference and webcast. Today, Joe Herring, Covance's Chairman and Chief Executive Officer; and Alison Cornell, Covance's Chief Financial Officer, will be presenting our second quarter financial results. Following their opening comments, we will host a Q&A session.

In addition, the press release, 20 slides corresponding to our prepared comments are available on our website at www.covance.com.

Before we begin the discussion, I would like to remind you that statements made during today's conference call 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 we consider to be outside of our normal operations. We believe that providing these measures helps investors gain a more complete understanding of our results and is consistent with how management views our financial results. For a reconciliation of GAAP to pro forma results, please refer to the supplemental schedules included in our press release issued last night.

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

Alison Cornell

Thank you, Paul, and good morning, everyone. As all of you know, I was named CFO of Covance in early May. I joined Covance back in 2004 after a 19-year career at AT&T and have worked very closely with Joe, Bill and our operational teams across the company over the course of my tenure here.

I'm very excited to be in this role at a time when I believe there are significant opportunities ahead of us. Since my appointment, I've met with a number of our shareholders and covering analysts and look forward to meeting many more of you in the coming months.

Now let's get to the detailed results. First, let me begin by talking about the special items included in our GAAP results that we have excluded in arriving at our pro forma results this quarter. First, we've excluded revenue of $4.3 million and operating losses up $3.8 million from 3 facilities we began closing. One is our Chandler, Arizona preclinical facility, which we announced during our first quarter earnings call; two is our Phase I clinic in Honolulu, Hawaii; and three

is our Phase I clinic in Basel, Switzerland pending completion of customary employee consultations.

The second special item is a $9.7 million in costs associated with the restructuring action.

The third special item is the above-the-line asset impairment charges totaling $38.7 million; $17.9 million, which relates to the write-off of goodwill associated with our Basel clinic and $20.8 million, which relates to the write-off of excess preclinical inventory resulting from a reassessment of toxicology demand in light of current and expected future market conditions.

Finally, we have written off the remaining $7.4 million book value of our investment in a toxicology research product supply company.

My commentary, which follows will focus on our pro forma results, which exclude the impact of these items. You may find the GAAP to pro forma reconciliation is in the release we issued last night and the presentation we are reviewing today.

Now for the results. Pro forma net revenue to the second quarter were $538 million, an increase of 3.9% over the second quarter of last year. On a constant exchange rate basis, year-on-year growth was 6.1%. Sequentially, the stronger U.S. dollar resulted in a $4.5 million foreign exchange translation headwind. Pro forma operating income in the second quarter was $48.3 million, resulting in a pro forma operating margin of 9%. This is a 30 basis point sequential increase although down 130 basis points year-on-year. Pro forma diluted earnings per share was $0.65, up $0.05 from last quarter and down $0.01 year-on-year. The sequential increase in earnings per share was primarily driven by the full quarter benefit of our share repurchase program. The pro forma effective tax rate for the quarter was 21.5%. We expect a similar effective tax rate as we look ahead to the rest of 2012.

Please turn to Slide 5 of the presentation. In the second quarter, Early Development contributed 40% of net revenues and Late-Stage contributed 60%. 52% of our revenue came from the U.S., 14% from Switzerland, 12% from the U.K., 9% from countries in the eurozone and the remaining 13% from the rest of the world.

Now to Slide 6 and 7 where I'll discuss the segment results for the quarter. In Early Development, pro forma net revenue was $215 million. This represents a $3.7 million sequential increase on a rebound in discovery support and clinical pharmacology, which more than offset a decline in research products and toxicology. Continuing operations in toxicology, it is when excluding Chandler in both periods, was up sequentially. This is a 7.1% year-on-year reduction, driven by a decline in revenues in toxicology, research products and foreign exchange headwinds as well as the exclusion of revenues from the 3 facilities for which closure activities have commenced in 2012.

Pro forma operating income was $18.7 million in the quarter, up from $11.3 million last quarter and down from $32.9 million in the second quarter of last year. Pro forma operating margin was 8.7% compared to 5.3% last quarter and 14.2% in the second quarter of 2011. Sequentially, pro forma operating income increased, primarily from a return to profitability in discovery support services from a loss last quarter, the exclusion of losses from our Chandler and Phase I facilities in Basel and Honolulu and increased profitability at our continuing toxicology operations. These increases were partially offset by a decline in research products, which was profitable in the first quarter and experienced a loss in the second quarter.

During the quarter, we divested our environmental services, a niche service line with 2011 revenues of $7.7 million for a small loss on sale.

Turning to Late-Stage Development. Net revenues were $323 million, up $4 million from the first quarter level and up 12.8% from second quarter of last year. At constant foreign exchange rates, year-on-year revenue growth was 16%. Sequential and year-on-year revenue growth were, again, driven by continued strong performance in clinical development, which more than offset the decline in market access services revenue. Central laboratories delivered a sequential revenue increase of nearly $4 million and a year-on-year revenue growth above 4% for the second consecutive quarter.

Pro forma operating margins were 21.1% compared to 22.7% last quarter and 20% in the second quarter of last year. The year-on-year increase in profitability was driven by both clinical development and central laboratories while the sequential decrease was primarily driven by hiring and staff costs in clinical development, lower profitability and market access services and increased spending on strategic IT projects. At the end of the first quarter, our market access team completed its work on 2 large multi-year projects, which was the primary driver of its sequential decline this quarter.

Turning now to Slide 8. I will recap the order and backlog information for the quarter. Adjusted net orders were $701 million, which represents an adjusted net book-to-bill of 1.3:1. Backlog at June 30 was $6.23 billion versus $6.28 billion at the end of last quarter. Foreign exchange negatively impacted backlog by $105 million sequentially.

Please turn to page 9 for a review of cash flow information. Cash and equivalents were $398 million at the end of the quarter, a $42 million decrease from the cash levels at the end of the first quarter, primarily driven by debt repayment, share repurchase and the impact of foreign exchange rates. At June 30th, our debt balance stood at $330 million, down from $340 million at the end of the first quarter.

We repurchased approximately 400,000 shares of common stock at a cost of $18 million in the quarter. Approximately $40 million of share repurchase authorization remains, which we plan to complete this year.

Free cash flow for the second quarter was negative $3 million, consisting of operating cash flow of $36 million less capital expenditures of $39 million. Our operating cash flow in the second quarter was negatively impacted by a 6-day increase in DSO from a record low levels at March 31, which negatively impacted operating cash flows by $36 million as each day of DSO represents approximately $6 million of cash flow. We continue to target year-end DSOs of approximately 40 days.

For 2012, we are slightly reducing our forecasted full year CapEx to approximately $170 million.

Corporate expenses on a pro forma basis were $38.6 million or 7.2% of net revenue within the quarter.

And finally, we ended the quarter with 11,499 employees with ongoing hiring in clinical development being more than offset by the sale of our environmental services, restructuring actions and net activity across the rest of the business.

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

Joseph L. Herring

Thank you, Alison, and good morning, everyone. Let me start by summarizing 4 key second quarter results.

First, while Early Development performance improved sequentially, profitability is still well below our expectations. As a result, we are taking additional actions to reduce our capacity and cost structure across the segment.

Second, Late-Stage Development results were strong especially in clinical development, and our central lab revenue continued to increase.

Third, adjusted net orders were strong once again, exceeding $700 million for the third consecutive quarter and growing 14% year-on-year. We also signed 2 distinctive client agreements, which leverage multiple services in our portfolio.

And finally, the strategic IT projects we announced last quarter continued to proceed on time and on budget.

I'd now like to detail these results and the actions we are taking to underpin the longer-term growth and success of Covance. In Early Development, overall segment performance in the second quarter rebounded from the low levels we experienced in January and February, the levels roughly in line with those we saw in the month of March.

In toxicology, both revenue and earnings from continuing operations increased sequentially. On the commercial front, an increase in toxicology orders from our top 15 clients was offset by a decrease from orders from more transactional clients. We also continued to see solid new orders, roughly at budgeted levels, being offset by project delays and cancellations. The lumpy orders, combined with the low biotech funding, lead us to moderate the toxicology growth we expect to see in the back half of this year.

Last quarter, we mentioned a couple of pending client decisions with respect to toxicology outsourcing. One of the opportunities, an asset transfer, did not materialize as the client ultimately decided to close the site. The other opportunity is still pending, but the timing is uncertain.

In discovery support services, revenue grew sequentially as our large CMV clients placed more work in the second quarter, and we expect continued sequential discovery Services growth in the coming quarters.

In clinical pharmacology, results improved from Q1. However, since orders were short of expectations, we are predicting a sequential decline in clinical pharmacology results in Q3.

Rounding out Early Development, research products, which was profitable in the first quarter, lost money in the second quarter as product demand continues to be choppy.

Our chemistry services growth remains largely as expected.

Please turn to Slide 10 where I'll provide a quick update on the cost and capacity actions we announced last quarter. In Chandler, we are no longer initiating new studies and the facility is on target to be operationally closed by fourth quarter. We will then begin preparing the property for sale. We are seeing very high retention rates with clients -- with Chandler clients now placing their new studies in Madison.

With regard to the other Early Development cost actions announced last quarter, employees have been notified, announcements have been made and we've remained on target to realize the cost savings and capacity reductions previously identified.

Let me now describe the new cost actions we announced last night. In clinical pharmacology, we had initiated action to close our Honolulu and Basel Phase I clinics, both of which have underperformed our expectations. Employee announcements have been made in both sites and we are in the process of completing customary employee consultations in Basel. We expect both facilities to be closed by the end of 2012.

We plan to reduce our Münster toxicology facility and capacity by roughly 1/3, subject to completion of consultations with the works councils in Germany. The Münster site is expected to be profitable at this lower level of capacity. We have identified and will capture a variety of additional cost-reduction and streamlining opportunities within Early Development.

The Münster restructuring and other streamlining and cost-reduction actions are expected to yield an incremental $15 million in savings. This $15 million does not include the removal of losses from our clinic closures since those losses have been excluded from our pro forma results. When combined with the $20 million we communicated last quarter, this brings a total annualized impact of cost actions to approximately $35 million with approximately 1/3, or $12 million, to be realized in 2012. These 2012 savings are reflected in our 2012 outlook and offsets weaker-than-expected results in Early Development.

We continue to look critically at other parts of our business, including corporate spending, to identify areas where our operations and cost structure can be further streamlined. We will update you on our ongoing efforts during the third quarter call.

Let's now turn to Late-Stage Development where results were strong once again. First, our clinical development team delivered a particularly impressive performance with revenue growth in excess of 25% for the second consecutive quarter. Operating income grew strongly year-on-year, but declined slightly on a sequential basis as we added several hundred new staff. We expect to continue hiring to support the record levels of new business we're winning.

Central laboratory performance continues to improve as well. Revenues were up several million dollars on higher kit and testing volumes, more than overcoming some foreign exchange headwind. From the commercial front, cancellations, while still somewhat higher than what we'd like them to be, were lower for the second consecutive quarter, dropping to levels we've not seen since the first quarter of 2010.

Looking ahead, we normally expect a moderation of kit volumes in the summer months. Following that, we expect to see volumes increase in the fourth quarter, and assuming cancellations remain at current levels, continued growth trajectory for central labs into 2013.

I'd now like to comment on our business development activity. We recently signed 2 exciting client agreements that are expected to help drive future orders. First, as Bayer recently announced, we formalized our collaborative working relationship by signing a long-term agreement. Over the last several years, we have worked very closely with Bayer having been 1 of 2 clinical preferred providers as well as managing approximately 1/3 of the central laboratory support of their clinical trials. We work very effectively with their clinical teams, and together, we have consistently delivered timely results of quality and high satisfaction scores. It is very gratifying to be named Bayer's primary provider for Phase II to IV clinical, and we expect to be awarded more than 3 quarters of their outsourced projects over the course of the partnership. In addition, our agreement with Bayer also designates Covance as there primarily central lab supplier. We expect to win even higher portion of project awards there.

This agreement also opens the door for evaluating how several of our other service offerings that help Bayer reduce the time and costs of drug development. As our project portfolio broadens with Bayer, we believe the relationship should add well over $100 million of annual incremental revenue over the next several years.

In addition, I'm also pleased to announce that we've entered into a broad-based 3-year alliance with a fast-growing mid-tier biopharmaceutical company, a company with an R&D budget in excess of $1 billion annually. This is a relatively new client for us, and we began the relationship by solving some of their complex drug development challenges with our genomics service offering. We quickly expanded to biomarkers services that had been a preclinical and clinical pharmacology work. The working relationship developed rapidly from that point.

Under the agreement, Covance will automatically be included in 90% of all bid requests for central labs, toxicology, clinical pharmacology, DMPK, genomics and biomarkers. The intent is to consolidate as much work as possible with Covance as their primary provider for these services. This agreement should ramp to $75 million to $100 million annually over the coming years.

Both of these agreements were made possible by the successful execution of our 3 core strategies: operational and service excellence, integrated services and building strategic partnerships with our clients.

Before I my closing remarks, I'd like to turn the call over to our CIO, Bill Klitgaard, for a review of our IT projects. Bill?

William E. Klitgaard

Thank you, Joe. Our 3 IT initiatives continue to run on time and on budget. The first initiative, an upgrade of our clinical systems, will allow our clinical team do their work more quickly and efficiently. We're moving to a world-class standard in terms of system that support trial execution, data analysis, reporting and client connectivity. Combined with our investments and predictive analytics through Xcellerate, it positions our business for future growth based on high-quality delivery and provide compelling reasons for our clients to select Covance as a partner. We expect to roll out the first release of these new tools in the coming months.

The second initiative, our investment in data center consolidation, is going very well and we expect this to deliver meaningful cost savings and performance improvements to the company over time. This is a reminder when we are done, we will have consolidated for more than 30 data centers scattered across our company to 2 modern, highly scalable, highly virtualized data centers. We expect to feel the benefits of this more efficient footprint beginning in 2014 and savings in the future state to ramp up over time, achieving a 20% or greater improvement relative to our prior environment. This program has already delivered some modest savings in network costs even at this early stage.

Our European data center, we have begun the migration of applications into the new architecture and expect completion of migration to happen before year end. And in the North American data center, we are provisioning the physical environment and anticipate we will be moving application migration beginning next year.

Third, the investment in our new lab information management system in central labs continues to move forward as we replaced our legacy system with an improved single-instance database. The existing system supports thousands of multi-year ongoing trials at 5 locations. Replacement is a process that we will handle exceptionally carefully over the coming months. Once in place, the new system will provide a more efficient means to capture, analyze, present and report data to improve the flow of valued information to customers.

Covance is more than just a service provider. We are a data company. Over time, our goal is to provide both exceptional real-time reporting capabilities and enhance this by offering valuable insights and predictions that help clients make more informed judgments about their development programs. We are investing in collaborations with external parties who have large complementary data sets or who have unique data analysis capabilities in order to enhance our predictive analytics. We expect that these will generate meaningful additions to our Xcellerate offering, and we will keep you posted on new developments as they arise.

Joe?

Joseph L. Herring

Thank you, Bill. We expect these IT investments to make us even more competitive in the marketplace, enhance employee productivity and engagement, feed drug development for our clients and support the longer-term growth and success of Covance.

Now a comment on our outlook. Over the next 2 quarters, we expect Early Development revenue to increase sequentially as volume increases under our CMV contracts. Operating margins are also expected to improve largely from our cost actions albeit at a slower rate than we originally expected as demand continues to be lumpy.

In Late-Stage Development, normal seasonality is expected to result in revenues being roughly flat with Q2 levels, while margins are expected to decline as spending increases on our strategic IT projects, hiring continues in clinical development and we face headwinds from the stronger U.S. dollar.

In the third quarter, we expect our pro forma revenue and EPS to be slightly higher than the second quarter level.

For the full year, we are revising our revenue growth forecast to the low to mid-single-digit range, primarily reflecting FX headwinds and the more modest sequential growth in Early Development. We now expect pro forma EPS to be in the range of $2.50 to $2.70 based on June 30 foreign exchange rates.

Let me close by summarizing our view of the road ahead. The strategies and investments we made in our clinical business are paying visible dividends and our clinical teams are well-positioned to drive sustained, profitable growth in the future. Our investments in central lab automation have allowed us to deliver solid margins even during the downturn we experienced, and volumes are now steadily increasing with nice incremental margins.

Early Development market conditions remain challenging, and we continue to take significant cost actions in order to better align supply and demand. Beyond the actions we announced today, we are looking at other areas of cost reduction including corporate spending and we'll provide an update during our third quarter call.

Our consistently strong order performance set Covance up for growth, especially in our late develop -- Late-Stage services, which now represents 60% of our revenue and more than 3 quarters of our profit.

Our investments in IT will help increase our competitiveness and are expected to be a strong lever for earnings growth beginning in 2014.

Finally, we continue to differentiate Covance as a company that formulates innovative R&D alliances that benefit both us and our clients. We will continue to build upon our strong service and quality reputation at a time when clients are looking to more aggressively than ever outsource R&D activities. We believe they will continue to look to a trusted, global and broad-based partner like Covance.

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

Paul Surdez

Operator, we can begin the Q&A session.

Question-and-Answer Session

Operator

[Operator Instructions] And we'll hear first from John Kreger with William Blair.

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

Joe, can you just -- as you look across the breadth of your service offerings, how do you feel about the pipeline flow of drugs as they -- as you see them move from kind of out of the discovery lab into safety talks and then into first-in-man studies. And what I'm really getting at is are you comfortable with the stability of the pipeline development from your clients? Or are you worried at all about some of the softness that you're seeing in clinical pharmacology rolling into your Later-Stage business looking out over the next couple of years?

Joseph L. Herring

John, overwhelmingly, I think what our clients are trying to do is improve success rates. As we talked about in the last couple of calls, more shots on goal did not bolster the pipelines in clinical development like they had hoped. And so they changed the incentives and instead of being incented to put 20 or 30 new candidates into development irrespective of the quality of those candidates, they're highly incented now to have candidates actually make it through proof-of-concept and into patients. And so every company has a different theory about how to get this done. But some of the things that we've seen changed pretty dramatically over the last several years is many times historically they would have a lead compound, a couple of backups and they would do full development programs on all 3. But the lead compound had some safety efficacy issue, manufacturing issue, they would click -- quickly flip to a backup molecule and it would basically be on the same pace. And they're no longer doing that. So that's a major change. The second thing is that they are working much more diligently to look at early efficacy even in non-human models and so that slows down the pipe a little bit. But the theory of the case is that if you clearly characterize safety and you have early efficacy indicators, then you really have a drug-able target and they're looking to rapidly accelerate that development. And then finally, I guess the notion of running a lot of studies so that you never lose pace is being replaced by sort of cost-reduction initiatives and certain projects like maybe a big infusion study or carcinogenicity studies that become much later developed historically. They're just not doing those and picking them up only on the successful molecules. And then, of course, setting aside big pharma, the lack of biotech funding and the restructuring of how new biologicals are being funded obviously makes that pretty choppy. So I think where we come out in the other end of this is a continued lower level of volume in the preclinical area. We think demand, in total, both price and volume is down 40-ish percent over the last 4 years. We've developed higher potential molecules for clinical development. And obviously, you can tell by looking at across our industry, clients are disproportionately spending their money in Late-Stage Development.

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

That's very helpful. A quick follow-up. Again, if -- to the extent you can tell what your competitors are doing, what's your sense about pricing dynamics right now? Are you seeing price roll over anymore, particularly in some of the areas where you've seen softer demand like regulatory tox?

Joseph L. Herring

Well, it's always been an incredibly priced competitive market and there are different niches and tiers in that market. But compared to last quarter or last year, I would say generally stable.

Operator

And we'll now hear from Tim Evans with Wells Fargo.

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

Just a quick housekeeping one first. Wondered how much FX headwind is in your guidance relative to last quarter? EPS guidance.

Joseph L. Herring

Roughly $0.05.

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

Great, all right. And then going to your corporate overhead comment, there was one point where you talked about that going up in 2012 and 2013 and then a secondary comment when you're talking about potential reductions there. Could you just kind of square that circle for us?

Joseph L. Herring

Well, we have these strategic IT projects, which are a big part of having that pickup because a big portion of our IT spend is in corporate and so that's been a driver of that. I think that causes us now to look at other corporate spending and saying, what could we push off or delay for a later time to allow us to get these IT projects done and work a scenario we can return to earnings growth even during the investment period.

Operator

[Operator Instructions] And we'll go on to Robert Jones with Goldman Sachs.

Stephan Stewart - Goldman Sachs Group Inc., Research Division

It's Stephan calling for Bob. Just wanted to follow up on the FX question. I know you didn't give guidance to '13, but just thinking about the first half of the year. I'm doing quick math here, shows that we could see probably 100 basis points of impact as well, so I need to confirm that or are we thinking about that wrong?

Alison Cornell

No, I think that's about right.

Stephan Stewart - Goldman Sachs Group Inc., Research Division

Great. And on Lilly, a big client of yours, they've had some recent comments on reduction in R&D. Can you remind us of the contractual relationship there, and then more broadly what your perspective is on big pharmas' R&D spending over the next couple of years?

Joseph L. Herring

Well, I guess, our partnership with Lilly is an important part of their ongoing efforts to drive R&D productivity improvements. It's structured as a minimum value -- volume contractual guaranteed through 2018 at approximately $160 million a year and they remain right on track to achieve those targets this year. More recently, we were beginning to win important new projects from Lilly in clinical development, which are set up to drive growth in the partnership next year and beyond. And you probably saw recently they announced the opening of a major R&D effort in China, particularly around diabetes where they, again, are utilizing Covance as a strategy laboratory in that geography. So that new relationship or that new partnership will bring new work to the Covance-Lilly agreement. But keep in mind that the Lilly contractual minimum volume commitment to Covance is approximately $160 million a year out of their $5 billion in R&D spend. And at the most senior levels of both of our organizations, we continue to discuss new business opportunities that can grow our relationship by creating innovative and cost-effective R&D solutions that benefit both of our companies. More broadly, thinking about R&D spending in big pharma, I would maybe reflect the Sanofi announcements over the last couple of years that R&D spending was coming down in total and as a percentage of revenue. Yet by striking an innovative deal that help them accelerate productivity and cost savings, we signed a $2.2 billion 10-year deal with a client we were doing very little work with. So I think the more serious large pharmaceutical companies get about making their R&D spend lower, more flexible, the better it is for well-positioned CRO like Covance. As I meet with senior executives in the industry, I challenge them to think about instead of having 15,000 people in R&D, maybe have 10% of that, 20% of that; 1,500, 2,000, 2,500 of the best drug development and regulatory minds in the industry and then have all of the handle-turning and I don't want to under-call it, this is very high science, but sample analysis, clinical trial recruitment, toxicology services by the set when needed instead of having to continue to maintaining the large platforms across a broad range of therapeutic areas. And so continued pressure on R&D spending is actually helping us.

Operator

We'll continue on with Tycho Peterson with JPMorgan.

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

With regards to the new deal that you're talking about here, can you talk about your capacity to take on the additional work for the Bayer deal? Should we expect a margin hit? And talk about maybe the pacing of that work, how you think about that coming on?

Joseph L. Herring

Well, Tycho, I think you know the Covance drumbeat. We tell you about it or we can show it to you in the P&L. And the rapid reality is that Bayer's been ramping over the last several years and is accelerating now with this new relationship. But we're not taking time out, we are -- having to add extra employees in that part of the prepared comments, but we see this as very good news. It's happening now. The projects are being awarded. There's more coming, and we see it as a net positive.

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

Okay. With regards to tox here, a little bit cautious here in the back half of the year here. Can you -- are you still expecting tox to grow in the back half of the year, or I mean how are you thinking about the trends?

Joseph L. Herring

Yes. As you know, we have CMV agreements with a number of clients. And what's happened in the last several years is that it tends to ramp towards end of year, so that they get to their contractual minimum volume commitments to Covance. We did say in our prepared comments that we expected to grow sequentially throughout the back half of the year. Having said that, keep in mind that this is a short-cycle business and we had extraordinary delays and cancellations over the last several months, which causes the down dial. But that could quickly flip and the incremental margins had been stunning over the last couple of years when we do get additional revenue growth. Or it could flip the other way and we could have the summer doldrums. So we're being cautious because historical -- the historical evidence suggests that we should be. But we're selling our socks off to try to ramp in the back half of the year and of course that's supported by that CMV contracts that we have in place.

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

And then the last one would be facility closures you talked about at Basel and Hawaii. I mean those are Phase I facilities. You've talked about divesting the environmental services business. How much of the changes we're seeing are a function of reshuffling the portfolio in terms of the services offered versus obviously there's excess capacity problem. But can you just talk to the degree to which you're reevaluating the overall service offering? And are there new services you're looking at adding on as you get rid of things like environmental services?

Joseph L. Herring

Yes. Well, there are -- there's some noncore services that we divested slowly but surely over time, sort of right time and we have the right sort of a buyer. And the environmental services was a small business and it's not a terribly large strategic decision. It was really de minimis in size. With respect to the closure of the clinics, that's strictly a function of we've got way more supply than there is demand in the marketplace and you've seen that reflected across our competitors as well. And we are absolutely determined to get our Early Development business profitable at the new normal lower levels and then hopefully grow from there. And we were more modest earlier in the downturn, but we are aggressive at this point in time because we're doing no one any good by hanging onto capacity, hoping and wishing.

Operator

We'll continue on to Greg Bolan with Sterne Agee.

Gregory T. Bolan - Sterne Agee & Leach Inc., Research Division

Can you quantify the contribution of toxicology to Early Development revenues and operating profit and I'm really just thinking about regulated tox, but whatever you can comment on would be helpful.

Joseph L. Herring

Greg, I think we're sort of scratching our head. We're not -- as percentage of -- what is tox as a percentage of revenue?

Gregory T. Bolan - Sterne Agee & Leach Inc., Research Division

Correct, so just thinking -- percentage of Early Development revenues. So do you couple between nutritional chemistry, analytical chemistry, tox, discovery services. I mean I guess really just kind of isolate -- I'm just trying to isolate on if you do have these numbers like GLP tox, regulated toxicology.

Joseph L. Herring

Yes, roughly 1/3. Greg, 1/3, call it, of revenues directly to toxicology. But there's chemistry services that we're not maybe including in that, research products that we're not including in that. So maybe if you build all those up, maybe it gets as high to a 1/2 perhaps.

Gregory T. Bolan - Sterne Agee & Leach Inc., Research Division

And then just contribution to profit, operating profit, or that segment profit, I should say.

Joseph L. Herring

That part, we don't break out.

Gregory T. Bolan - Sterne Agee & Leach Inc., Research Division

Okay. And then Joe, it looks like you are planning to nearly double headcount at Greenfield over the several years. Can you talk about the largest drivers for this plan? Is it Lilly or is it non-Lilly clients? And what services appear to be the strongest out at the site right now?

Joseph L. Herring

Yes. Well, we don't have plans to double the headcount at Greenfield anytime soon. There was a news recently about some tax incentives that we were negotiating there in Greenfield and Hancock County. And a part of that process is to estimate over the next 5 to 10 years what could happen to headcount on the site, job creation, and we made some rough estimates, but there are no immediate plans to do anything more than the normal growth rate that we're seeing in the business. Now, we have taken advantage of very favorable acquisition terms for that site, and we put -- reimbursed hotline employees there. We've got a nutritional chemistry lab there. We made a biotech investment. We built a fantastic sample storage facility there for central labs. And so our headcount continues to grow and obviously, we have a very, very strong discovery and translational services team there that are primarily former Lilly employees, and as I said in my prepared comments, that business is growing. So I think the current rate, we're looking at probably adding 50 or 100 employees a year. There's a couple of pieces of business we're looking at that could accelerate that, but they're speculative at this point. So headcount adds would be based on new business that we win. But there's -- at this point in time, there's no immediate plans to ramp to some extraordinary number.

Operator

We'll now take a question from Ross Muken with ISI Group.

Ross Muken - ISI Group Inc., Research Division

I have a specific question in a bigger picture. In terms of the guidance or how we should think about retention rates on the business, the closed facilities and how that flows through in terms of the net savings, how are you thinking or how should we model for those specific areas? What portion actually gets capped? What portion moves out of house? And is there sort of any historical kind of basis for how we should think about that?

Alison Cornell

So Ross, we have experienced, based on our Vienna site closures, they gave us confidence that the majority of the work was going to move to our Chandler site. Given our experience with Vienna, and I'd say Chandler more so, what we found was that proximity to the client site didn't really matter at the end of the day. And the clients who are doing business with us in Chandler actually had done work in Madison before. And so I'd say with the exception of one that we know about, all the clients' work had moved to Madison other than the work that's being completed given studies that already started in Chandler. That work will complete there. Everything else is moved with the exception of one study.

Joseph L. Herring

One small client with one study.

Alison Cornell

Right. One small client with one study. And so I'd say we're very, very confident about our ability to move that work. And in fact, the way that, that's factored into our financials is once that work moves, it will go to Madison that has a higher utilization and with a higher contribution margin and will improve from of our bottom line perspective.

Ross Muken - ISI Group Inc., Research Division

Okay. And then a bigger picture kind of conceptual question. I mean, one of the things the investment community is actually starting to focus more on is that pharma pipelines actually the first time in maybe 5, 10 years start to look a bit more encouraging as you start to look out. We're getting kind of through the dire years in the generic wave. I mean as you think about that and how you want your business position longer term, you've done incredibly well in the Late-Stage businesses. The lab has started to turn and that's clearly a great business. I mean how do you think about your positioning or your presence broadly in some of the discovery and early phase markets given what we've seen and given some of the recent decisions even in the context of this sort of pharma not looking to do asset transfers in certain cases and not really giving you a kind of clarity on sort of when that portion in the business theoretically could see some upward pressure?

Joseph L. Herring

Yes, I guess, Ross, our point of view on that is that we routinely have opportunities to take over for free facilities across discovery, CMC, toxicology, Phase I, you name it. And these facilities are not being generally sold or repurposed. They are just sort of sitting there. Some of the IT investments that we're making we think sets us up to be a very strong platform. We could snap acquired businesses into what we're doing and so a combination of the physical capacity laying around in the IT investments, we think we are positioned to ramp capacity faster than we did in the past and dramatically more cost effectively than we did in the past. But frankly, we still have enough Early Development capacity that if rolled back, we would grab a big chunk of that at stunning margins. So it would be a high-class problem to have.

Ross Muken - ISI Group Inc., Research Division

I guess, I'm actually going more, Joe, in the context if you're doing so well in the late phase side of the business and the profit you're able to sort of generate and grow there has been quite good relative to your peers as well as just broadly the market. And so at what point on the early phase side do you start to say, look, maybe does it make sense to have a presence in all the places we sit today. And as we see this opportunity set and maybe more of it's skewed to the development side of things, maybe not, but do we need to be in as many areas in Early Stage? What's the leverage are we getting there? And what value is the street ascribing to that vis a vis kind of the rest of the portfolio, which is actually looking quite healthy? I mean what is your and sort of the board's sort of view on sort of the asset mix and how you view kind of what places you need to be like when you just said you divested an asset regionally versus maybe longer-term where it doesn't make as much sense from a capital return perspective.

Joseph L. Herring

Well, I think strategically, we like the fact that we are a mirror image of what pharma does in R&D. And back to Greg's question earlier, a very minute fraction of our profit comes out of toxicology these days. But the outstanding performance that we delivered for this client, not the Bayer comments I made but for the second client, put us in position where now we're going to be their primary central lab supplier and a whole bunch of other early development work. And if I'm a betting man, that thing is going to spill into clinical. And they have the chance to be a $100 million-plus just in clinical. If it wouldn't been for the Early Development business, we wouldn't have the footprint that we have at Lilly and Sanofi. And I could give you literally dozens of examples where we cross-sell and that's why our clinical -- a part of why our clinical and central lab businesses are doing so well. And ultimately, for the pharmaceutical industry to survive into the future, and they will, they will have to start replenishing the Early Development pipeline, albeit it'll be at a different way and we don't expect to have the peak levels of 2007 or '08 again. We think that, that comes back and we think there's some innovative ways that biotech is going to be funded in the future that will bring more the work our way. So I hear your point. It is a strategic question we continue to ask ourselves. But I like sitting at a table with a major decision in the pharma company and having a lot of cards in my hand to help them solve their problems. And our key, Ross, is to get the cost structure and capacity in line with this new normal level of demand and have Early Development become a more significant contributor to our profit and earnings growth on a go-forward basis. And sitting here today, we think that, that's very important strategically.

Operator

And Ricky Goldwasser with Morgan Stanley.

Andrew Schenker - Morgan Stanley, Research Division

This is Andy Schenker in for Ricky. Early Stage visibility seems to continue to decline. At this point, how much visibility do you really have in the segment? And what will it take to improve that?

Joseph L. Herring

Well, if ongoing operations increased sequentially and we called it increasing sequentially for the next 2 quarters. The average Early Development project lasts about 30 or 40 days, so visibility is 30 or 40 days.

Andrew Schenker - Morgan Stanley, Research Division

Okay. But your expectations had come down versus -- previously versus the year so one could argue your outlook for the year lack clear visibility. I mean is there any thoughts on what would improve that over time?

Joseph L. Herring

I think we clearly stated that, that growth was not as fast as we had hoped, but that it continues to grow.

Andrew Schenker - Morgan Stanley, Research Division

Okay, fair enough. Kind of related to that, could you break out by segment what percentage of revenues and earnings are related to your preferred provider in CMV agreements?

Joseph L. Herring

No, we do not. Although there is a backlog page that gives you get that from backlog in the deck.

Operator

And Garen Sarafian with Citi.

Garen Sarafian - Citigroup Inc, Research Division

Joe, I guess to follow up on the comment you made a little bit earlier, you mentioned aggressively managing capacity on, I believe, you had mentioned toxicology, or broader, Early Development. But I guess, so with this additional reduction, how does it -- additional reduction in toxicology capacity, how does that impact your overall utilization rate? Is it still at the -- and then if you could quantify and then also just is it at 2007 levels still or has it gone down to 2005 levels?

Joseph L. Herring

Yes. Well, capacity levels are roughly to 2007 range. We think from a staffing level, we're probably a little bit below that. We do not comment on capacity fill in our toxicology facilities. But suffice to say, it's lower than we would like and certainly lower than '07 levels.

Garen Sarafian - Citigroup Inc, Research Division

Good. And how does that contemplate the remaining ability to distill the one large client conversation that's ongoing?

Joseph L. Herring

We think we can handle all of their work if they decide to flip the switch.

Garen Sarafian - Citigroup Inc, Research Division

Got it. And then just switching gears to the smaller biotech firms. I think it was mentioned in the prepared remarks, as well as during Q&A, impacting the Early Development business. And also on the slide deck, on the last page, it's declined to -- on a combined financial partnership levels, it's pretty low, it's sort of multi-year low, I believe. So I'm just wondering, one is can you quantify the impact this had on the Early Development side? And also, in Late-Stage, you guys clearly did very well. But what impact you are or not seeing in that segment as well?

Joseph L. Herring

Well, I would say the impact of Early Development study. I think we estimate something like 20% roughly of our revenues or we're down 20% in revenues based on the biotech funding issue. I think if you step back and take a broader view, there was a very frothy environment. There were a lot of molecules at biotech company that were funded that probably shouldn't have been funded with the benefit of hindsight. But there's still a fair amount of work coming from smaller biotech companies that are excellent products and we continue to perform well in that segment. It's just -- it's not at those frothy levels. Looking to Late-Stage, 80% of all clinical programs are run by the top 30 pharmaceutical companies. And so there are some smaller and midsized companies that do actually run large clinical trials, but it's a smaller percentage of the market. We do well in that segment. And -- however, the big volume of projects are in the top 30 clients. And that's why we work so incredibly hard on operational and service excellence. We want our clients to know that you can sleep at night when you get to Covance and we'll pick the right sites, we'll ramp the trial early, we will -- if there are issues, we bring them together -- forward quickly with solutions and are a good partner over time. And that is playing very, very well with our clients. Once we have a client, we tend to grow the relationship continually over time.

Garen Sarafian - Citigroup Inc, Research Division

So but on the Late-Stage or late phase, have you felt an impact from the smaller firms? And I guess what are you -- what's included in guidance, sort of same as what you thought this quarter? Or...

Joseph L. Herring

Well, revenue is growing greater than 25% consistently. So if it's an impact, it's very, very minimal.

Operator

And we'll now go to David Windley with Jefferies.

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

Joe, in the Late-Stage business, the margin, obviously, has performed quite well. It's not totally clear to me how much of this IT project spending is now flowing into your Late-Stage segment reporting. I'd be curious if you could answer a 2 things for me: one, to give us a sense of maybe how much of an impact the IT projects are having to help us understand what that underlying margin looks like; and then two, the comment on over, say, multi-years, where you see the kind of opportunities and pressures on that underlying margin and the sustainability of that margin?

Joseph L. Herring

Well, I think we've characterized the annual impact this year and next year, Dave. As you know, we have a chart in our deck for several quarters and it's ramping up now. We expect it to get bigger in the next few quarters by several million each quarter. And then the longer-term margin question, part of that IT investment is in productivity and efficiency and automation. It is very difficult to build a model that shows just how much of a productivity impact it will have, but we think it is substantial. So we hope that, that underpins our margins over a longer-term basis. We think we have strong competitive advantage. I think we know how to pick the right molecules and we really preferentially invest in the right kind of client relationships. So we feel like we have a good chance at maintaining those margins.

Alison Cornell

And just commenting on the margins further for later in the year. Beyond IT, there are couple of moving parts, one being FX; second, being hiring; and then the third, being normal seasonality. And so you'll see part of the margin declines through the rest of the year that forecasted is really just a result of normal seasonality.

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

Okay. And Joe, thinking bigger picture and longer term, on those productivity and automation types of things, how much of those are going to require you to engage clients and kind of convince them to evolve their thinking about clinical trials albeit adaptive clinical trials, less than 100% monitoring, things like that, that are -- have some FDA risk to them, I suppose. How much of that is stuff that you can drive the productivity yourself? And how much of it is dependent on changes and thinking that the sponsor -- an agreement with a sponsor on changes and strategy

Joseph L. Herring

The things that we're thinking about will not require engaging with clients at all. There are some things that Bill's working on, on a more informatics space that are very strategic and beyond anything that you're thinking about what Covance could do right now and that would require a lot of that type of engagement. But in terms of, I think your question, these are things that we absolutely control and can do and can't wait to do, to be honest with you.

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

Okay. If I could just ask one more clarification. You said in your prepared remarks the wind downs of these facilities, that the new restructuring and the 1/3 of the new restructuring that you'll be able to benefit from in 2012 do not include the exclusion of the wind down facilities. Is the exclusion of those wind down facilities, does that basically represent the cost savings from the first version of the first $20 million of the restructuring? Is that how we should think about that?

Alison Cornell

No. Actually, how you should think about the first $20 million with more streamlined -- with streamlining and downsizing, so we're very focused on -- we had built a-- the 2x infrastructure to support ED labs business. And what we did was we essentially rightsized it. And so that had more to do with reorganization and streamlining and really nothing to do with backing out of losses. Included in that, however, is the positive benefit of the work moving from Chandler to Madison, having to do with the higher contribution margin, higher utilization in the Madison site. So that piece was incorporated, but the losses were not.

Paul Surdez

I'll just add a comment, and with Bill in the room, you could please correct me if I'm wrong. As far as the cycling of the IT spend, essentially we said an incremental $20 million this year and a little more than another incremental $20 million next year, $22 million, perhaps, the math might be. This year, that incremental $20 million is a little more weighted towards Late-Stage. And next year, the incremental $20 million is more weighted towards corporate as we do the data projects. So if that helps with the modeling at all between Late-Stage margin and corporate expense over the next 2 years.

Operator

Todd Van Fleet has our next question with First Analysis.

Todd Van Fleet - First Analysis Securities Corporation, Research Division

Thanks for that color, Paul, because my question the thing about 2013 and beyond. Just based on everything that you guys have discussed regarding the cost savings action this year that are going to yield savings now and into the future, so $23 million of incremental savings, I think, next year based on the actions that you've discussed to this point. Largely, it sounds like offset by the IT, an incremental $20 million next year so more or less kind of all things kind of offsetting one another in 2013. I'm trying to -- again thinking about the build for the business -- building the business in 2013 and beyond, you've talked about the Bayer relationship. You say it's a long-term relationship, is it a 3-year, is it a 5-year relationship? And I'm just trying to understand you said you think it's going be at least another $100 million over the next several years. So would it be fair to think about the incremental revenue from that relationship as being kind of in the $30 million, $35 million range each year for the next 3-plus years?

Joseph L. Herring

Well, I think your earlier math is approximately correct. Keep in mind that FX is a headwind and that may not be reflected for the full year 2013. Also, we have a little bit lower jumping off point for Early Development. From the Bayer standpoint, I guess, we really hesitate to predict things like that. We gave you some rough ballpark numbers and we would encourage you to model that yourself because an individual project or individual client is not always predictable as we would like. Having said that, the relationship is very healthy and growing and we -- I think we'd characterized it as well as we can.

Todd Van Fleet - First Analysis Securities Corporation, Research Division

Just one quick follow-up on that then, Joe. So the -- is it the expectation that Bayer will be expanding the amount of work that it gives the vendors, of course, Covance is getting more of what it does outsource, but is the expectation that Bayer will be outsourcing more moving forward?

Joseph L. Herring

Well, Bayer held a supplier day roughly a month ago and Covance was the only invited supplier to make a presentation of what a strategic partnership is, how it's built, how it should be structured, how it should be governed. And I think every senior executive at Bayer was a part of that. And I think they laid out their plans and I think it's safe to say that they want to significantly improve the speed and productivity of their R&D organization, and I think they're committed to doing that.

Operator

We'll continue on to Steve Unger with Lazard Capital Markets.

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

So let me ask a question quick. Joe, you mentioned at the beginning of the call that you're not satisfied, obviously, with the profit level of Early Development and that you're continuing to sort of prune in those areas to get to a certain level of profitability. I was curious if you could sort of articulate where you would like to see at least like the lowest bar of profitability in the Early Development segment in the near term that you're comfortable with.

Joseph L. Herring

Well, low to mid-teens. I mean, as you know, Steve, this is a capital-intensive business and to drive the returns that we expect for the whole company, we want to be in the low to mid-teens. Hopefully better, but that takes a lot of work and a return to the health of the overall market. But that's where we're trying to get to.

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

Got it. And just a follow up. As far as the research products business, that's typically been sort of an extremely profitable business for you and I was wondering why that's now producing losses. Is there nobody out there buying large research models?

Joseph L. Herring

Well, I wouldn't say nobody. It's at a lower level and these businesses are unique in our portfolio and it requires long-term inventory and capacity planning. And the decisions that you make today, particularly in a large model segment really don't bear fruit for a number of years and the changing direction is an expensive process and a challenging process. So it's not at all demand has gone away, but it has been a sustained and persistent tick-down in demand, which is evidenced in all preclinical businesses that you're seeing.

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

Okay. Can that loss or raise quickly?

Joseph L. Herring

Well, sure. It went from a loss in Q4 to a profit in Q1, nice profit in Q1 to a loss in Q2.

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

Okay. So a little bit lumpy.

Operator

Lauren Migliore with MorningStar.

Lauren Migliore - Morningstar Inc., Research Division

Along those lines, I'm wondering about how much more room there is in the market for additional large scale deals like the Lilly and Sanofi arrangements? And the overall news flow has somewhat died down recently, so I'd appreciate your take on the opportunities that are remaining or you feel like for the most part drug makers and 0s have largely paired off.

Joseph L. Herring

Well, first of all, I don't think they've paired off at all. The biggest announcements that have ever been made are for $160 million, and call it, $200 million a year in volume out of the average large pharma with $4 billion, $5 billion, $6 billion, $8 billion in R&D spend. So I think we're far from done and we're coming up on the renewal of some of the short-cycle agreements that some of our competitors have struck 2- or 3-year types of deals. And we know some of those are coming available. So again, our effort is to try to strike 5- and 10-year deals because it generally takes several years to ramp them up and get the team to working together and the governance in place and sort of everything lined up. And that's really what we target as a longer-term deal. But I still think we're in a maybe 25% or 30% range in terms of pairing off. And you can pick a client and say, oh, well they have a deal with so-and-so. Well, what percentage of their R&D is in that deal and how long is the agreement and how strategic was it versus the pricing exercise or something like that. So I think there's a tremendous room for the pharmaceutical industry becoming much more strategic and how they outsource it again. If it were me and I was making the decisions, I would downsize my fixed cost R&D by 60% -- I'd start with 50%, and get to 60%, 70% relatively short order because the CR industry eclipses their capacity. It has the specialties covered. It has global flexibility and you could buy it by the shelf. And every study that I've seen, there are many -- a lot of them, but my experience is, is the quality is the same or better and faster. And I think as there's continued pressure on industry, I think they'll do that. And I think the more experience they have, the more willing they're going to be -- are to have a couple of key strategic partners and leverage that going forward.

Operator

We'll take our final question from Doug Tsao with Barclays.

Douglas D. Tsao - Barclays Capital, Research Division

Speaking to the theme of strategic partnerships. I know last year, you transitioned the Amgen relationship from sort of a guaranteed minimum deal to a more variable structure, although you had confidence that the numbers would come in higher. I was just curious if we can get an update on where things stand there.

Joseph L. Herring

Well, we don't comment on individual clients like that and where they are specifically, Doug. I think you know that.

Paul Surdez

There's no CMVs anymore involved in that relationship. There's no minimum to hit. It's a -- it was a longer-term target.

Douglas D. Tsao - Barclays Capital, Research Division

Okay. And then, Joe, just stepping back in terms of what we've seen in the Early Development business recently, do you have a sense or have you gained any insight recently if the pullback in terms of demand has been driven by a shift in a clients' clinical spending or spend -- their R&D spend away from Early Development, or what has been the impact of perhaps changes in how they are designing their early stage programs in terms of sequencing studies, potential studies they're running sort of what perhaps might be sort of a structural change in Early Development.

Joseph L. Herring

I'd say all the above, more spending in late and resequencing early.

Operator

And I'll now turn things back over to our presenters for any additional or closing remarks.

Paul Surdez

Everyone, thank you very much for joining us for today's call. If you have follow-up questions, I will be available throughout the day, and enjoy the rest of your morning. Thank you.

Operator

Thank you. Ladies and gentlemen, once again, that does conclude today's conference. Thank you for your participation.

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