Covance, Inc. Q2 2008 Earnings Call

Covance, Inc. (CVD)

Q2 FY08 Earnings Call

July 31, 2008, 9:00 AM ET

Executives

Paul Surdez - VP of IR

William Klitgaard - Corporate Sr. VP and CFO

Joseph Herring - Chairman and CEO

Analysts

Sandy Draper - Raymond James

Randall Stanicky - Goldman Sachs

David Windley - Jefferies and Comapny

John Kreger - William Blair

Douglas Tsao - Lehman Brothers

Jon Wood - Banc of America Securities

Todd Van Fleet - First Analysis Securities Corp.

Presentation

Operator

Good day, ladies and gentlemen, and welcome to this Covance Second Quarter 2008 Investor Conference call. We will note that today's call is being recorded. At this time for opening remarks and introductions, I would like to turn the conference over to the Vice President of Invest Relations Mr. Paul Surdez. Please go ahead sir.

Paul Surdez - Vice President of Investor Relations

Good morning, and thank you for joining us for Covance's second quarter 2008 earnings teleconference and webcast. Today, Joe Herring, Covance's Chairman and CEO, and Bill Klitgaard, Covance's Chief Financial Officer, will be presenting our second quarter financial results. Following our opening comments, we will host a brief Q&A session.

In addition to the press release, 21 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 would like to turn it over to Bill Klitgaard for a review our financial performance, which begins on page four of the slide show.

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

Thank you, Paul. Before reviewing our second quarter results, I'd like to point out that year-on-year comparisons for Q2 are affected by the sale of our Cardiac Safety business, which occurred in the fourth quarter of 2007. That sale included contingent consideration relating to the transferred backlog, some of which was resolved in the second quarter, giving rise to an additional $949,000 or a penny a share in the second quarter. My discussions and comments around net income and earnings per share will be to our results excluding the impact of this gain recognized in the second quarter of 2008.

The sale also reflects... also affects comparability of revenue growth between periods. And I will highlight those factors in my presentation as well. Please refer to the reconciliation in the slide show on slide 15.

Now let me move to the numbers. Net revenues for the second quarter were $437 million, an increase of 14.6% over last year. Excluding the impact of the sale of our Cardiac Safety business, revenue growth was 16.5%. The impact of foreign exchange on revenue growth was 3.8% for the quarter, primarily relating to the substantial appreciation of the Swiss franc and the euro against the dollar. The FX impact was disproportionately weighted towards late-stage development services.

Operating income in the second quarter was $67.5 million, which is up 21.5% from the second quarter of last year. Operating margin was a record 15.4%, which is up 80 basis points year-on-year and 20 basis points sequentially. Net income was $50 million, which is up 21.1% in the second quarter of last year.

Earnings per share was $0.79 per share in the quarter, up 22.7% compared to the second quarter of last year. And finally, I would like to note that due to a favorable tax resolution, the effective tax rate in the second quarter was 28.8%, which is down from a 29.6% rate last quarter. We expect the effective tax rate will return to the 29.5% range in the back half of the year.

Now please turn to five of the slideshow. In the second quarter of 2008, early development delivered 49% of our net revenues and late-stage development contributed 51%. Our geographic bases, the U.S. accounted for 58% of revenue while the rest of world accounted to 42% of revenue.

Now please turn to page six for the discussion of segment results. In early development, net revenues in the quarter grew 11.5% to $213 million. Revenues increased a strong 5.5% sequentially based on increased study starts in clin pharm and the addition of nuke factory [ph] in North American toxicology.

Operating income in the quarter was $54 million, an increase of 10.7% over last year and our operating margins expanded 40 basis points sequentially to 25.4%.

Now turn to late-stage development. Net revenues in the quarter were $224 million, which is up 17.8% over the second quarter of last year. Excluding the impact of the sale of Cardiac Safety, revenue growth was 21.6%. The impact of foreign exchange on revenue growth in this segment was approximately 6.7% in the quarter.

Operating income in the quarter was $43 million, which is up an outstanding 34.8% over the second quarter of last year. Operating margin was exceptional as well, reaching 19.2%.

Now please turn to page seven to recap the backlog numbers. Backlog at June 30, 2008 grew 28.3% year-on-year to $3.01 billion compared to $2.48 billion at the end of the second quarter last year. Sequential backlog growth of $149 million or 5.2% was driven by record second quarter net orders of $611 million.

I would like to add some color relative to backlog orders and often referenced book-to-bill metric. Covance's portfolio of services and contacts is unique in the industry. We've always said that backlog is not necessarily a good predictor of future results and our increase in strategic relationship has further decoupled this relationship, even as it has improved our competitive position.

For instance, in early development, due to short duration studies and product sales, we typically have a book-to-bill near to 1.0 to 1, because a significant portion of early development orders over the last two years include large dedicated capacity contracts. Revenue from those orders will come from conversion of backlog and not be associated with new bookings. As a result, the book-to-bill relationship will be diluted and the metric was likely to become less meaningful in early development segment in the future.

In late-stage development, we tend to place more emphasis on the more stable 12-month book-to-bill number instead of the quarterly book-to-bill figure. This is because orders can and do bounce around from quarter-to-quarter. The trailing 12-month book-to-bill for our late-stage segment is 1.4 to 1 and that's above that [ph].

On a consolidated basis, we believe a trailing 12-month book-to-bill figure of 1.15 to 1.20 to 1 to deliver low to mid-teens revenue growth going forward.

Now please turn to page eight for a review of our cash flow data. DSO at June 30th was 39 days, a 7 day improvement over the second quarter of last year. This is our third consecutive quarter with DSOs under 40 days, reflecting a continued focus by our finance leaders and their staff on improving cash flow. Cash at the end of the quarter was $196 million, which is down $37 million from the end of the first quarter. In the second quarter, operating cash flow was $50 million and capital expenditures were $81 million, resulting in negative free cash flow of $31 million.

In 2008, due to the acceleration of spending relative to the Chandler facility, we now anticipate capital spending to be approximately $265 million and free cash flow to be approximately $25 million, which assumes we end 2008 with DSO at the same level of last year.

Approximately 90% of the capital that we spent year-to-date represents expenditures related to ongoing significant facility expansions and transformational IT for technology projects that have not yet been placed in service, which is why our depreciation expense has not increased proportionate with our spending levels.

Finally, corporate expenses totaled $30 million in the quarter or 6.8% of revenue, as we continue to make investments in infrastructure that will enhance our ability to manage future growth. We continue to expect corporate spending to be approximately 6.5% of revenue, plus or minus 50 basis points.

Now I'll turn it over to Joe for his comments, which begin on page 9 of the slide show.

Joseph Herring - Chairman and Chief Executive Officer

Thanks, Bill, and good morning everyone. The second quarter was very exciting for Covance as we continued to see expanding benefits of our growth investments. Covance posted strong financial results in Q2 with net revenue growth of 14.6%, record operating margins of 15.4%, and earnings growth of 23%. On the sales front, we achieved record net orders of $611 million. We filled our backlog up [ph] more than 21% to over $3 billion for the first time. And to further enhance our service portfolio, we announced our proposed joint venture with WuXi PharmaTech to bring Covance as market-leading toxicology services to China in 2009.

Let me first comment on our commercial success. Including our second quarter net orders was the previously announced $66 million dedicated capacity toxicology contract. Also in the second quarter orders were significant Phase III clinical wins from the client which awarded us the primary provider relationship in April, as well as substantial new business in Central Laboratory.

Our unwavering commitment to operational and service excellence helped drive strong repeat business and further development of strategic client relationships. I am pleased to announce that two of our clients recently recognized our service excellence with very special recognition. Our Clinical Pharmacology team was recognized by Eli Lilly and Company and was awarded Lilly's prestigious 2008 Global Supplier Award. This award recognizes outstanding contribution to Lilly's innovation and technology.

In addition, our Central Laboratory team received Merck's Outstanding Strategic Collaboration Award for 2008. We are honored that these two very important clients have recognized Covance out of their thousands of suppliers for the value we bring to their drug development process.

Let me now comment on the segment results this quarter, which begins with early development on slide 10. As we expected, our early development team delivered strong sequential revenue growth and expanded operating margins in the second quarter. Keys of sequential growth were newly renovated toxicology rooms in Madison, which came on line during the second quarter and we expect to see continued strong sequential revenue growth as we see more of the benefit of our Madison expansion.

Construction in Chandler, Arizona, also remains right on track, as you can see from the photo on slide 10. And we expect to open the initial phase of that facility in the first half of 2009. Finally, in Harrogate, UK, the toxicology capacity is expected to come on line by the end of this year. All of these construction projects are on or ahead of schedule.

In the quarter, we also announced the proposed joint venture with WuXi PharmaTech, which will bring our world-class preclinical services to China. This JV will create a powerful partnership between China's leading provider of discovery and development services with world-leading toxicology provider, Covance. Covance WuXi share a common commitment to quality, people and building client relationship on trust and performance. This JV will enable us to provide superior drug development solutions to our global pharmaceutical and biotech clients in this region. This announcement has been done with great enthusiasm for our clients as well as Chinese government and regulatory officials.

In clinical pharmacology, several Phase I projects that were delayed out in the first quarter were initiated during the second, which drove very strong sequential growth. Midway through the quarter, we also opened our purpose-built 80 bed clinic in Evansville, Indiana on the campus of Deaconess Hospital.

Since we opened, the Evansville team has hosted over 15 client site and QA [ph] visits. Even though this clinic has only been open for two months, our clients have already recognized the value of this facility, including a full Code Blue coverage, experienced staff, laboratory capabilities on site, cGMP pharmacy, cardiac safety capabilities, and a deep pool of volunteers. This facility had an incredible June performance, well ahead of our highest expectations with revenue and OM records in just its full... first full month of operations.

Finally, in early development, our chemistry services continue post fantastic results in both revenue and profit. Please turn to slide 11 to discuss late-stage development. Late-stage had an excellent quarter as revenue growth in this segment accelerated for the fifth consecutive quarter to 17.8% and over 20% when excluding centralized ECG services from 2007 base comparison. In addition, late-stage achieved exceptional operating margin of 19.2%, a record by 60 basis points.

Central Laboratory Services again made an outstanding contribution to Covance results this quarter. Revenue growth was nearly 30% year-on-year and it was up 9% sequentially. That's up sequentially for the fifth straight quarter. Operating margin was also up significantly from last year.

On the business development front, the Central Lab team delivered towering new orders, which were 23% higher than the previous quarterly record.

Clinical development revenue growth was over 20% in the quarter and operating margin grew both year-on-year and sequentially. Clinical orders in the quarter were robust, including two awards totaling $70 million from top 10 pharmaceutical companies, which named us their primary provider earlier in the quarter. One of the projects was $40 million win covered under the primary provider agreement. And the other project worth $30 million was a competitive win outside of the five primary... five therapeutic categories revenue.

Now we ordinarily do not provide order details on individual customers' agreement, but I want to give a flavor for the business that's already beginning to flow through this unique agreement. For competitive reasons, we do not intend to provide further update of new awards related to primary provider contract. But needless to say, we expect substantial upside with this client on a go forward basis.

Please turn to slide 12 for review of our market opportunities. There has been a lot of talk recently about the dramatic shift of work that will come to CRO industry over the next five to 10 years. Sponsor companies are increasingly seeing the value of replacing their high fixed cost of infrastructure with a more flexible cost model of drug development. Based on the combination of both tactical and strategic outsourcing of R&D, we see outsourcing rates increasing from 27% today to more than 50% in the coming years.

On slide 12, we present a number of potential growth scenarios for our industry, which are determined by two variables. The first variable is the rate of R&D spending over the next five years and the second variable is the 2012 outsourcing penetration rate.

There are a number of scenarios which would result in a five-year mid-teen compound annual growth rate for the CRO industry, effectively doubling the size of our market opportunity from $18 billion in 2007 to more than $36 billion in 2012.

With this chart, you can pick your own assumptions to determine the future market growth rate of our industry. Today we choose three examples for illustration. The example A show the continuation of how the market played out in 2007. That was 10% R&D growth and a 200 basis point increase in outsourcing. If this scenario continues in each of the next five years, outsourcing will increase from 27% to 37% and our industry will have a five-year 17.6% compound annual growth rate. The size of the CRO market in this scenario goes from $18 billion last year to over $40 billion in 2012. We consider this to be optimistic, yet certainly a very plausible outcome.

On the very conservative end, example C, shows an outcome if R&D spending to slow down substantially and grow just 1% a year for each of the next five years. Now we note that growth in pharmaceutical R&D spending has averaged 10% per year over the past three decades, with the slowest year being in the 6% range. So this indeed is a very conservative prediction. It is our view that if R&D spending slows to this growth rate, outsourcing will accelerate as large R&D organization must create more cost-effective solution and possibly transfer more assets to CROs.

In this example, we assume outsourcing might increase by 400 basic points a year reaching a total of 47% in 2012. And that would lead to a five-year compound annual growth rate of the industry at a very respectable 13.3%.

Finally, example B shows another conservative example as R&D spending would have to slow to 5% for five straight years, again, lower than the slowest annual spending growth rate in any of the last 30 years.

In this scenario, we predicted outsourcing might increase 300 basis points annually to 42% in 2012 and that would result in 15.2% compound annual growth rate. And that would bring a little more than a doubling of the market opportunity over the next five years.

So under almost any realistic scenario, the future outlook of our industry is very bright. Based on Covance's operational performance, expanded strategic client relationships, investments in state-of-the-art facilities and IT systems, and our unwavering commitment to becoming the employee of choice in the industry, we like our chances in this market. Frankly, it is a very exciting time to be in this industry and especially at Covance.

Please turn to slide 13 for our outlook. Given our strong revenue performance so far this year, combined with our forecast for the remainder of 2008, we now believe we will achieve mid-teens revenue growth in 2008 versus our previous guidance of low to mid-teens revenue growth.

With regard to earnings, we have continued confidence in our ability to deliver 20% annual growth in EPS to $3.18 per diluted share in 2008 while continuing to significantly invest for the long-term growth. Included in the $3.18 EPS will be the impact of the start-up costs related to our joint venture in China, which was not included previously.

Thank you for your time this morning. Now I would like to turn it back over to the operator for our Q&A session.

Question And Answer

Operator

Thank you. [Operator Instructions]. And we'll go first to Sandy Draper with Raymond James.

Sandy Draper - Raymond James

Thank you very much and congratulation on a very, very strong quarter. I've got two questions, one early stage and one late-stage. Joe, on the later stage side with the primary provider agreement, obviously really strong results and nice to see you've already extended out beyond that. Do you think there is any sense that the sort of an early bolus of business that you've been awarded and you'd expect that to moderate? And I certainly appreciate not giving any quarterly update. Or do you think that strength we see in this is just going to be a continued very strong quarter-to-quarter type of business?

Joseph Herring - Chairman and Chief Executive Officer

On the primary provider, I would not call this a bolus. As a mater of fact, we are still meeting with and organizing how is going to work and we remain very bullish about that, Sandy.

Sandy Draper - Raymond James

Okay, great. That's helpful. And then on the early state side, obviously nice to see a pickup there sequentially. Would you expect... as a new capacity comes on line, how would you sort of quantify what's coming online, ability to maintain a similar sequential growth rate or do you think there is going to be some slowdown and then a pick back up, just trying to understand over the next three to four quarters how I should be thinking about the trajectory of that sequential improvement?

Joseph Herring - Chairman and Chief Executive Officer

Well, I think year-on-year growth rates are up from here and certainly sequentially in the third quarter. So, we have capacity available in Madison, coming in Harrogate, and not too long after that, coming in Chandler. So, I think we're in good shape coming out of six or nine months of being sort of full.

Sandy Draper - Raymond James

Okay, great. Those were my two questions and again congratulations on a great quarter.

Joseph Herring - Chairman and Chief Executive Officer

Thanks, Sandy.

Operator

[Operator Instructions]. Next we'll go to Randall Stanicky with Goldman Sachs.

Randall Stanicky - Goldman Sachs

Great, thanks very much for the questions. Just sort of a follow-up to the last one, is there any catch up that takes place [indiscernible] strategic provider deal with move towards more of, what I'd call, normalized industry outsourcing growth rate or just I think what you answered in the last question, should this be viewed as a steady state process from here? And then I have a follow-up.

Joseph Herring - Chairman and Chief Executive Officer

Randall, I am not totally sure I understand your question. But let me just say this. Both of these agreements that we have in our second quarter earnings, dedicated capacity tox agreement as well as this primary provider is new demand for the industry. Neither company were historical outsourcers and so I see this as not just good for Covance, but good for the industry.

But, I guess, I pause and I am not sure I answered your question.

Randall Stanicky - Goldman Sachs

Let me rephrase it. I mean, is this 611 million in net bookings, is this in the range of what we should expect from Covance going forward? I mean, have we seen a new level of bookings that maybe have provided a boost by this recent strategic provider deal?

Joseph Herring - Chairman and Chief Executive Officer

Well, keep in mind, there is a $66 million dedicated capacity tox deal in there and we've been doing one of those about once every three or four quarters. So I don't forecast orders, we're very bullish about how things look. But I wouldn't go that far.

Randall Stanicky - Goldman Sachs

Okay. And then just on WuXi, how do we think about the timing for that equity item line to turn positive as the new capacity fills? Is there a certain way that you guys are thinking about it or a certain capacity or fill percentage that we can think about as that moves into the positive territory? I am trying to just get a sense of how that would... could be in the back half when it closes?

Joseph Herring - Chairman and Chief Executive Officer

I have two-word answer. [indiscernible] We haven't signed in descended agreement yet, Randall. And so that's the work to do there. We have teams on the ground there quite a bit over the last month and we're just sizing up exactly where the facility is and what work needs to be done. And I would say I wouldn't get too carried away on the WuXi thing until; A) we get a definitive agreement signed and B) we can come back to with more specific details.

Keep in mind that spending until the definitive agreement is signed, which we are starting to spend in terms of staffing and legal and other things is all above the line. Once agreement is signed then those substantial expenses will be shared 50:50 or I should say, losses leading up to revenue will be shared 50:50 below the line. And when exactly revenue growth is going to come on, I think it's a little bit premature. We are fairly confident, highly confident it'd be some time in 2009. But I guess that's all I can say at this point.

Randall Stanicky - Goldman Sachs

Any more narrow view on when that would be signed?

Joseph Herring - Chairman and Chief Executive Officer

I' rather not say right now. But it's certainly before the end of the year. And if you want to put something in your model, I think you put a penny or two of dilution in the back half of the year and certainly we consider that in our guidance.

Randall Stanicky - Goldman Sachs

Okay, that's very helpful. Thank you.

Joseph Herring - Chairman and Chief Executive Officer

Thanks, Randall.

Operator

And from Jefferies and Company we will go to David Windley.

David Windley - Jefferies and Comapny

Hi. I was wondering how much we need to allow for 3Q corporate expense for Paul's bonus for slide 12.

Joseph Herring - Chairman and Chief Executive Officer

Well, we have about 15 bio [ph] statisticians helping him. Bill Klitgaard handle the idea of isocurve [ph] something out of Cal Berkeley and... but overall, I think it's a very helpful construct.

David Windley - Jefferies and Comapny

So, seriously though, Joe, on slide 12, help me... give me some insight into the company's market research and thinking and feedback from clients about why you believe or at least the things puts [ph] in the way the slide is built, that you believe that R&D spend an outsourcing penetration rate might very well be inversely correlated? So, if R&D spend in you A, B, and C examples, if R&D spend is high, outsourcing penetration increases at a slower rate and vice versa.

Joseph Herring - Chairman and Chief Executive Officer

Yeah. I would not say this is based on heavy market research. Myobloc [ph] particularly used to say show me a pharmaceutical client, and I will show you one pharmaceutical client. They all thinking that differently. But what we have seen is as economic model of our client, as the platform gets harder, they start talking about outsourcing in a much, much bigger way. And it's because it's very straight forward. They have very high fixed cost and inconsistent demand across their drug development capabilities. And it doesn't take a genius to look at that and say when we're busy, we don't enough, and when we're not busy we've got people sitting around with their hands in their pockets. That just isn't a good business model. And we're also seeing a lot of turnover in the C [ph] suite of our client organizations. I mean, you can name five or without thinking very hard. And these new people are coming in with... I don't know what their career expectations are five, 10, 15 years. They are going to have to live with these decisions. And they're also willing to take some [indiscernible] out. So, the harder it gets for a pharma at least for the foreseeable future the better it is for CRO. So, that's sort of a thinking that goes into that.

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

And one of the things I like about it is you can make your own assumptions. And Paul call this magic 8-ball [ph] slide because sort of you can make your decision about what you think about R&D growth and penetration rates, but it's pretty clear that under almost any reasonable scenario, the growth rate in the industry is pretty strong.

David Windley - Jefferies and Comapny

Okay. So Paul, you have to pay a trademark royalty on the bonus. The second question I have is on duration of backlog. Bill, you made some comments in your prepared remarks about kind of a decoupling of backlog as a predictor of revenue. So that's, I guess, one thing to take into account. You are also announcing your record bookings and the dedicated capacity agreement and some decent sized late-stage contracts as well, it sounds like. I am just wondering if you have a basic expectation as to over the next year or two, should we expect that, say, backlog will continue to grow faster than revenue or is that conversion rate starting to normalize because of perhaps some of these offsetting forces?

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

Well, I think what I am trying to indicate here is that the math has kind of become harder to connect. And we've always said historically that backlog is not a great predictor, particularly for a company where half the revenue comes from early development, which are shorter contracts or even including product sales, which don't have a backlog component.

So we've always been a little bit careful and wanted to caution the community to be careful about using backlog. I think the fact we have more long-term dedicated capacity agreements makes that even more troublesome at the metrics. And then for our late-stage, what we're trying to indicate here is that you see volatility movement from quarter-to-quarter in terms of orders. I mean, pharma just had a very good quarter after following a couple of bad quarters. And we've had a very good quarter after following kind of a modest quarter in Q1. We kind of look at it on a four quarter rolling basis and we think that's a better metric to use for us and for the industry.

David Windley - Jefferies and Comapny

Okay. Thank you.

Operator

And next from William Blair, we will move to John Kreger.

John Kreger - William Blair

Hey, thanks very much. Joe, question about this primary provider model. Do you believe that that could start to become a trend with other larger pharma companies?

Joseph Herring - Chairman and Chief Executive Officer

John, I really can't say for sure. I would say the broader trend that we definitely see is that large sponsors are finding it unyielding to deal with five or 10 CROs. And pricing is competitive out there. You don't have to have 10 define at their price. I think more and more clients are seeing the value of narrowing their providers and having more executive engagement, executive relationships, metrics with the new escalation process, and doing that was more than a couple of CROs really doesn't make sense.

I think the other thing that's narrowing the landscape of that is that more and more sponsors can only really justify working with larger CROs that have a global footprint, because a higher percentage, as well know, John, of patients coming into clinical trial are in emerging markets. And dealing with a local CRO that's sort of West of the Mississippi river are in... UK only are Western Europe, really doesn't allow then to complete a complex global study. So I think just many, many variables are leading them to narrow. Whether we see primary as a trend, I think it's a new idea, incredibly well thought through. But I think only time will tell. But I'm not sure that that's all important. I think what's more important for the top five or six CROs is the fact that the markets climbing up with their taking share away from small and regional companies that do not have necessarily the service that or the footprint that the clients need.

John Kreger - William Blair

Great, thanks and my second question relates to your ability to continue to drive margin leverage. My perception is historically clinical was probably a lower margin business for you across the portfolio compared to tox or central lab. As that business starts to ramp up and grow faster, have you figured out a model that allows that to have margins more comparable to your corporate average or do we need to worry about any sort of a negative margin mix over the next year or two as this growth accelerates?

Joseph Herring - Chairman and Chief Executive Officer

Thanks, John. As you know, we have a number of ways to continue drive margin. It's been a huge part of our story and we continue to see it that way. We didn't comment on six sigma, but we continue to open new projects appointing Black Belts, train new Green Belts and utilize and expand a tool set in six sigma. And certainly the results this year are going to be, at least as we see it today, record results from process improvement. Mix helps us. As you well know, our fastest growing businesses tend to be our most profitable. And are still... predominantly laboratory footprint gives us incremental margins on the upsides as we grow revenue.

The final piece of that really is our clinical business, approaching both company average margins and industry average margins. I think we have a very clear line of sight to getting there at this point. And frankly we don't think we're done. So we continue to see both margin expansion opportunities in clinical development as well as the entire portfolio.

John Kreger - William Blair

Great. Thanks very much.

Joseph Herring - Chairman and Chief Executive Officer

Thanks John.

Operator

[Operator Instructions] And we'll move on to Douglas Tsao with Lehman Brothers.

Douglas Tsao - Lehman Brothers

Hi. Good morning. Just to start with a housekeeping question. Bill, you referenced that a lot of the FX impact this quarter was with the Swiss franc. Is that largely limited to the central lab business?

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

Yeah, Swiss franc and the euro. I think I mentioned both. But yeah, clearly with Geneva being one of our central laboratories, it's closely [ph] Swiss franc.

Douglas Tsao - Lehman Brothers

Okay. And then in terms of IT investments that you referenced, are those primarily focused on the clinical development Phase II, Phase III business?

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

No, we have five different transformational investments. But then some of them are in divisions, some of them are company-wide. For example, we're doing an implementation of PeopleSoft, which is company-wide.

Douglas Tsao - Lehman Brothers

Okay. And then just quickly turning the Phase I business, Joe, you reference in the past that a lot of the capacity is getting utilized for Phase IIa study rather than just pure... first and then Phase I studies. I was wondering if you could provide any kind of what percent of the work now being done in the clin pharm units are actually patients rather than healthy volunteers.

Joseph Herring - Chairman and Chief Executive Officer

Yeah, Doug, it's still a low percentage. I mean, that is certainly growing and it's a part of the investment thesis from our rating acquisition a couple of years ago. It's certainly where we see the markets heading, but it's still a relatively low percentage of our total revenues.

Our clin pharm revenues are largely kind of first in human drug-drug interaction, radio label food effect studies, all high science hire in, but not as much of the early patients as A) we would like to see or B) what we're planning to build.

Douglas Tsao - Lehman Brothers

And so would that be in the neighborhood of 10% or 20%?

Joseph Herring - Chairman and Chief Executive Officer

I don't have that number and we've not disclosed this, so stay tuned.

Douglas Tsao - Lehman Brothers

Okay. Thank you very much.

Joseph Herring - Chairman and Chief Executive Officer

Alright, Doug.

Operator

And from Banc of America Securities, we'll go to Jon Wood.

Jon Wood - Banc of America Securities

Hey, thanks a lot. Bill, can you just comment on same contract collection terms? So in other words, adjusted for mix, are contracting terms getting more competitive or less competitive?

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

I wouldn't say they are becoming more competitive or less competitive. I think actually a lot of what's going on is we are trying to be more interactive with our clients and trying to discuss with them our business model and how we want to be cash flow neutral. And that's necessarily the a bank for them. And I think that's a lot of the reason we are having better performance on DSO. Particularly in our central lab business and in our clinical business, our two heads of finance in those divisions have really led this effort and are still bringing results for our company.

Jon Wood - Banc of America Securities

And so is there material difference between the late-stage DSO and the early stage DSO? Are you... you basically go in, as you said, neutral on both divisions?

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

I think the challenge is that the contract is longer term for late-stage, of course. They longer burn backlogs, if you will, the longer order terms. And so you have to engage much more proactively with clients. In early development, the contracts shorter. But even so, I'd say that the focus is intense for both parts of our company in terms of trying to keep DSO at reasonable levels.

Jon Wood - Banc of America Securities

Okay. Can you give us a range, an estimate for depreciation and amortization for the year?

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

I think we are running around 4... between 4 and 4.5. I think we are at 4.2 right now percent of revenue, something like that. And a lot of what's going to happen is as these new assets come into service, then they'll drop from being constructing in progress into actively depreciated assets. We'll take a look at that and try to give you a better guidance as we go into our guidance for next year. How about that?.

Jon Wood - Banc of America Securities

Okay.

Joseph Herring - Chairman and Chief Executive Officer

And, Jon, it's also a blend. A lot of the highest percentage are strategic investments in facilities, which have very long depreciable life. So, you don't see the commensurate depreciation pick up... tick up. And you have to balance that against these IT investments, which normally are more five-year depreciable life. And so it's sort of the blend of those two. And we certainly have depreciation coming through on these transformational IT projects.

Jon Wood - Banc of America Securities

Understood, thanks, Joe. And then just one last one, the 240 basis point increase in the late stage margins. Joe, can you just tease [ph] out which was the larger driver there; was it the central lab mix shift or central lab becoming larger in the mix or was the clinical development margin improvement more material there?

Joseph Herring - Chairman and Chief Executive Officer

Clinical.

Jon Wood - Banc of America Securities

Okay. Thanks a lot.

Joseph Herring - Chairman and Chief Executive Officer

Okay John.

Operator

[Operator Instructions]. And from First Analysis, Todd Van Fleet.

Todd Van Fleet - First Analysis Securities Corp.

Good morning guys. On the two Phase III wins, they totaled $70 million. Just to understand the nature of the relationship that you have there with the sponsor; is that a new relationship entirely to Covance or had you been doing other work with them prior to these two Phase III wins? And then I have a follow-up on Paul's [indiscernible] the chart. Thanks.

Joseph Herring - Chairman and Chief Executive Officer

Yeah, Todd, it's not a short answer. We have... gave great detail of that last quarter. And I'd refer you to Paul. But the short answer it's a new client, they are new to outsourcing, they named us their primary provider across five therapeutic categories where basically everything is said is just the work flows directly to Covance. And then outside of those five therapeutic categories, we compete as a preferred provider. But again, there is a lot of commentary there. And I'd refer you back to Paul.

Todd Van Fleet - First Analysis Securities Corp.

Okay, great. And then just kind of one big picture question. I think it's... obviously the industry dynamics, I think, are well known and understood in this chart on page 12, really draws it out quite nicely. I am just wondering as you guys think about the growth for the industry and the growth for Covance over the course of the next five years or so, I mean, growth isn't free in your business. And so I am wondering if you've given in-depth thought to how much is required to actually meet those growth targets. Let's say it is 17% CAGR over the course of the next five years. What's the type of CapEx commitment required on the part of the company year in and year out to achieve those targets? This year we're going to have free cash flow of about 25 million. If you weren't growing, presumably that free cash flow would be close to... closer to 300 million. So, what's the trade-off there and how should we think about that from a free cash flow standpoint?

Joseph Herring - Chairman and Chief Executive Officer

Well, there are a lot of variables there. Let me just try to sort of reflect here for a couple of minutes for you. First of all, if you think about an industry going from 18 billion in size to 40 billion in size in five to seven years, substantial capacity needs to come to the key providers. And so, you're right, it is not free. I would look back over the last five years, Todd, and look at our investment history, our acceleration in CapEx, and then what that has driven in terms of return on assets, or return on equity. We built 40-year asset which does not hit to that hard in depreciation. We built shell [ph] capacity, we don't hire staff until we have the revenue. And even though we've invested over $500 million in the last probably 2.5 or 3 years with expanded ROA, with expanded margins, we've been able to take market share. So we really, really like our model.

Looking forward, I think we've signaled that we see a new segment of the market emerging that we are calling asset transfer. And what that is is large pharmaceutical clients who have high quality internal facilities and capabilities that aren't fully utilized, that are starting to talk to CROs, not just Covance, about potentially taking over some of their capacity or taking other assets, human assets, in either FTE arrangement or off-loading that staff to CROs.

So I'd just stop by saying looking back over last five years, I think we have invested more than any other CRO by a wide margin and that result has been continually expanding margin and return on investment.

Looking forward, I could easily look on Bill [ph] LIFO curves, Paul to get [ph] credit progress and come up with a scenario that says our industry growth rate could be 20 or 25%, to be very easy. I don't want to do that on the call today because we don't want to try to be conservative about it. In that scenario, Todd, I don't see us going to $1 billion a year in CapEx. I see us doing the same old Covance thing, thoughtful, add capacity sort to behind the curve, and then having new opportunities to maybe get assets on for $0.20, $0.30, $0.50 on $1, including staff so that we do not have to stick our neck out like so far and I think we'll be rewarded for taking those type of assets on with guaranteed or long term work.

The last thing I would say is that Covance is not a company that is sitting here today wringing our hands thinking about mid-teen revenue growth in the back half of '08. What our executive team is worried about is how do we scale this company to be the two or three extra size that it's going to be in the years down the road, and how do we put together a combination of talent, facilities, and make the kind of IT investments that we're making right now so that we get high quality data faster and more economically than pharmaceutical companies can do it today.

And frankly I sit here today very proud of a management team that is making unprecedented investments and not calling out special charges, not apologizing, not taking time out, and absorbing things like new JVs, new IT investments, and sticking right with our model of 20% plus EPS growth.

So, I look out on the future and say wow! Huge opportunity, but there are ways to do it better or affordable, that mitigate risk and that will drive shareholder value and higher return in light of unprecedented investments.

Todd Van Fleet - First Analysis Securities Corp.

Thanks for that. Do you view asset transfer on a risk-adjusted basis being a better kind of opportunity for the company than, say, kind of greenfield side thinking about, I guess, preclinical? More specifically, is asset transfer on a risk-adjusted basis, are those returns better than greenfield?

Joseph Herring - Chairman and Chief Executive Officer

Well, we haven't caught all those fish yet, so I can't tell you for sure. But I think if you take a theoretical model, there is no question that it should be a better outcome. And again, you are talking about a sponsor who is staring at a non-core assets that is not helping financially in the short term. And any expansion or renovation, let's just say it takes three years to bring up new space or a good year or 18 months to expand space.

Today you put staff and projects in that facility. You are 10 to 12 years away from seeing revenue from any of those projects and there is a 90% chance that every project you start will never see the light today.

So at some point in time you say stop the madness, let me hand these facilities off to somebody that has shown us with metrics that they can do it faster, cheaper and with at least as high quality as we do it. And I think if you look at Covance's program management, 44 INDs last year, 275 molecules, and we're documenting with client after clients that we can get them to IND proof-of-concept or first effective human dose in half the time that they are doing it. I like our chances.

Todd Van Fleet - First Analysis Securities Corp.

Thanks.

Operator

And we'll take a follow up from John Kreger.

John Kreger - William Blair

Thanks very much. My question relates to the longer term growth opportunity that you see on the early development part of your business. If we look back over the last three years or so, the growth rates that you guys have put up has had a pretty wide range. How do you think about that in terms of a longer term normalized trajectory? And the variance, Joe, [indiscernible] should we attribute that more towards just how much capacity you had available in any given year or shifts in demand?

Joseph Herring - Chairman and Chief Executive Officer

Your look back over the last five years capacity, no capacity. Capacity 20% growth, limited capacity 10% growth. And we get that through managing our mix, stacking our capacity tighter and so, yes, that's it.

John Kreger - William Blair

So from a longer term demand growth perspective, do you have a view on what that number is?

Joseph Herring - Chairman and Chief Executive Officer

Well, I would say no. I think there are a lot of other variables. It's also related to staffing. I mean, I think our view is that in preclinical and toxicology largely, but also to in degree in chemistry, sustained revenue growth of higher than 15 to 20% put an extraordinary amount of pressure on your ability to hire and train board-certified toxicologists and pathologists and principal investigators. And so there is a little bit of an upper limit. And we cannot make these capacity investments until we have a very strong line of sight to where the revenue growth is going to come from to fill that. As you well know, John, we've been turning away 30 plus, up to $50 million a year in tox work. So, it's pretty complex, it's not all scientific and quantitative, some of it's real Kentucky Vintage.

John Kreger - William Blair

Great. Thanks very much.

Joseph Herring - Chairman and Chief Executive Officer

Sure John.

Operator

And Douglas, we'll go back to you.

Douglas Tsao - Lehman Brothers

Hi, Joe, I just wanted to ask a question regarding central lab where the results have obviously been very strong. I was just wondering if you could provide us an update on the revenue per kit. I obviously am not looking for a specific number, but how much is the strength now attributed to an increase in revenues per kit versus the straight increased volume?

Joseph Herring - Chairman and Chief Executive Officer

Revenue per kit has improved throughout this year. And Doug, as you well know, that has somewhat to do with complexity of the testing and to some degree transportation from emerging markets.

Douglas Tsao - Lehman Brothers

And so when we think about this spread, I mean, the business is up close to 20% on a year-on-year basis. Should we be thinking that half of the growth coming from revenue... increased revenue per kit or versus volume?

William Klitgaard - Corporate Senior Vice President and Chief Financial Officer

I think, Doug, the way look at is there is international component to trials and that that's part of what's going on here for central labs as a shift towards international. That resulted higher transportation costs, Joe mentioned it, it also disproportionately impacts our Geneva lab or you have FX impact. FX, transportation as well as kit volumes as well as revenue per it. We haven't broken out all different elements of it, something we are quite ready to copy it up right now. But that's more than one factor.

Douglas Tsao - Lehman Brothers

Okay.

Operator

Doug, is there anything further?

Douglas Tsao - Lehman Brothers

No, that's it, thank you.

Operator

And Mr. Surdez, there are no further questions at this time. I'll turn the conference back over to you.

Paul Surdez - Vice President of Investor Relations

Thank you operator. And I would like to thank everyone, particularly David Windley for their questions and comments today. If you have more questions throughout the quarter, feel free to give me a call and look forward to seeing you on the road during the third quarter.

Operator

Ladies and gentlemen, that does conclude today's conference. We thank you for your participation. Have a great rest of your day.

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