Covance: Solidifying It’s Place in a Drug Discovery Niche

Much like the wave of multinationals who have turned to low-cost offshore outsourcing to help trim costs—IT companies turning to Bangalore India and manufacturers moving operations to lower-cost China, for example—Big Pharma and biotech companies are increasing tapping the talent and resources of contract research organizations (CROs) to shave expenses, accelerate the discovery process and free up resources to find new products—allowing them to be more competitive in an industry with some of the stiffest competition in the world.

According to Kalorama Information, publishers of Outsourcing in Drug Discovery, using CROs, who conduct clinical trials and improve efficiency in the drug discovery process, can speed up early-stage testing by 20% to 30%, saving their clients two to four months of valuable time (they also quicken the pace of enrollment in human clinical trials by as much as 6 to 12 months). Ultimately, CROs help cut product-development timelines, which help drug companies make faster decisions about whether to proceed with urgency or cut their losses by killing the development process altogether.

Princeton, N.J.-based Covance Inc. (NYSE: CVD) is a drug development services company that provides a range of early- and late-stage product development services globally to the pharmaceutical, biotechnology and medical device industries. The company also offers various lab testing services to the chemical, agrochemical and food industries (such as performing FDA-mandated tests to put nutritional values on package labels). Covance operates in two segments: early development services, which encompass pre-clinical services and clinical pharmacology services, and late-stage development services, which is made up of central laboratory, clinical development, peri-approval and market access services. With offices in over 20 countries (serving over more than 300 clients), Covance derived 62% of its 2007 revenue from the U.S., 15% from the U.K. and 10% from Switzerland.

In late July Covance reported second-quarter earnings growth just shy of 23%, net revenue growth of 14.6% and record operating margins of 15.4%. Early Development net revenues for the second quarter grew 11.5% year-on-year and 5.5% quarter-over-quarter to $213.1 million. The following week, the company reaffirmed its full-year 2008 earnings-per-share and revenue guidance, looking for EPS of $3.18 and expecting revenue growth in a mid-teens percentage.

In a significant development, Covance recently announced it inked a $1.6 billion contract with drug giant Eli Lilly & Co. to control its 450-acre research-and-development facilities in Greenfield, Ind. for $50 million. Under the agreement, Convance will employ over 250 Lilly employees and provide the Indianapolis drugmaker with a broad-range of drug development services over the next ten years starting this October.

And Wall Street and the firms' top brass are bullish on the partnership, to say the least. Since the companies have a long-standing history of collaboration spanning two decades, experts predict a smooth transition and relationship that will be mutually beneficial. Eric Coldwell, an analyst with Robert Baird who expects Covance to see revenue growth of 20% in 2009, calls the deal "astounding."

Joe Herring, Covance Chairman and CEO, figures the deal should add roughly $150 million in revenue in first year alone, about 9% of its total earnings ($1.6 billion) in 2007. Herring says Covance has been in talks with several of its larger clients about the possibility of striking similar deals in the future. He added in a statement: "This industry-pioneering alliance will provide Lilly access to Covance's broad and efficient drug development platforms. In addition, this collaboration will help us make our fixed cost infrastructure more flexible and continue to grow our portfolio of best-in-class and first-in-class pharmaceutical products."

Drug makers have been under increasing pressure to develop innovative pharmaceutical products at a time when many firms are being confronted with impending patent expirations on potentially groundbreaking drugs and are struggling with their drug pipelines.

While Covance is hardly the only company to capitalize on the drug discovery services outsourcing trend, as U.S. and European companies alike rush to trim costs and save much-needed time, Covance, which has had a solid track record for many years, stands out in the growing crowd.

The global drug discovery market reached an all-time record of $5.4 billion in 2007, a 15% increase over the previous year. Pundits expect the market to experience robust growth over the next few years, exceeding $8 billion in 2010 and reaching $14 billion in 2013.

That trend should ensure that Covance continues to clock steady profit growth that will reward long-term investors for quite some time.

Our recommendation: Buy shares of Covance Inc. (NYSE: CVD) at or near $94.89 and hold on tight.

Shannon Roxborough
Analyst, Medtech Millionaire