US-based contract research organisation (CRO) Covance has raised its financial guidance for the rest of the year, despite reporting an 11.1% decline in operating income for the second quarter ended 30 June 2009.

Both revenues and earnings per share were significantly above analysts’ estimates for the quarter. The investor response to the financial results and to Covance’s parallel announcement of a long-term outsourcing deal with Merck & Co for genomic analysis services was muted, though. The CRO’s shares dipped slightly in regular trading on the news, then gained around 3% to US$51.50 after hours.

Operating income for the second quarter was US$60.0 million, compared with US$67.5 million in the same period last year, and the operating margin narrowed to 12.9% from 15.4% in Q2 2008.

More encouragingly, net revenues were up by 6.7% to US$466 million and Covance said the increase would have been 13.1% without the impact of currency translation. However, total costs and expenses grew by 8.9% to US$429.3 million in the quarter.

Operating income in the Late-Stage Development segment was 52.4% ahead but in the smaller Early Development business it fell by 50.0% against the second quarter of 2008. Net income company-wide slumped 15.5% to US$43.0 million and Covance reported diluted earnings per share of US$0.67 for the latest quarter, 16.0% lower year on year.

Stripping out a US$0.01 per share gain on the sale of Covance’s centralised electrocardiogram (ECG) business in 2007, diluted EPS for the quarter were US$0.66. This was markedly higher than the analysts’ consensus of US$0.63 quoted by Reuters. On the revenue front, analysts had been expecting a net figure of US$448 million for the second quarter.

Early Development

Net revenues from Early Development services dropped by 6.3% to US$199.8 million for the quarter, which Covance blamed on lower demand in toxicology. On a quarter-to-quarter basis, Early Development revenues were up by 3.8%, driven by a rebound in demand for clinical pharmacology, analytical chemistry and research products.

Operating income in this segment fell to US$27.1 million from US$54.2 million in the second quarter of 2008, while the operating margin was 13.6%, down from 25.4%. According to Covance, margins were diluted by a lower level of study activity, costs relating to the staffing and validation of the new US preclinical drug development facility in Chandler, Arizona, and severance costs for retiring a building on the CRO’s US campus in Vienna, Virginia.

Nonetheless, Covance added, staffing levels have been maintained above current needs at the company’s five other preclinical campuses “to support expected increases in revenue generation in the second half of the year”.

Late-Stage Development

In the Late-Stage Development segment, net revenues jumped 19.0% to US$266.3 million year on year and were 7.1% higher than in the first quarter. Covance cited an “exceptional” performance from its central laboratory business as well as strong contributions from clinical development and commercialisation services.

Operating income in the segment was US$65.5 million compared with US$43.0 million in the second quarter of 2008. Record profitability in both the central laboratory and clinical development businesses took the operating margin for Late-Stage Development up to 24.6% from 19.2% a year earlier and 22.6% in Q1 2009. Covance expects the operating margin in Late-Stage Development to “moderate closer to first quarter 2009 levels in the back half of the year”.

The company registered a backlog of US$4.66 billion as of 30 June 2009, 54.7% more than at the same time last year and slightly ahead of the US$4.42 million backlog recorded at 31 March. Adjusted net orders for the second quarter of 2009 were US$516 million, giving an adjusted book-to-bill ratio of 1.11 to 1.

The US$145 million minimum contract commitment that was part of the deal with Merck & Co was included in Covance’s backlog but not in its adjusted net orders.

Reflecting a weaker US dollar and a “slightly lower” tax rate, Covance has raised its target for revenue growth in 2009 to the “mid- to upper-single digits”, while earnings per share are now projected at US$2.60 to US$2.80. That excludes gains on the sales of Covance’s centralised ECG and IVRS (Interactive Voice & Web Response Services) – the latter acquired by Phase Forward for US$10 million in July.

Covance had lowered both its expectations for revenue growth and its EPS forecast in the first quarter. The guidance then was for single-digit revenue growth in 2008 and for EPS of US$2.50 to US$2.70.

Growth prospects

Speaking at the CRO’s second-quarter earnings call (transcript provided by Seeking Alpha), chairman and chief executive officer Joe Herring said Covance remains “very optimistic” about growth prospects for the long term.

Publicly quoted pharmaceutical and biotechnology companies are spending more than US$100 billion on research and development, of which around US$74 billion falls on the development side, he noted. At the moment, some 29% of that total is outsourced but, going by discussions with key clients, “we believe up to 60% or perhaps 70% of those dollars could be outsourced over time”, Herring commented.

Moreover, the official figures exclude dozens of private companies that do not report R&D spending, he added. One of these clients has placed over US$150 million in orders with Covance over the last year.

“We also believe that total global CROs will take market share as pharmaceutical companies narrow their list of preferred providers over the coming years,” Herring commented.
Moreover, he cited deals such as the discovery support service contract with Merck that are boosting Covance’s involvement in the ‘R’ part of the equation – “which happens to be a $36 billion spend”. This “is a very large market and is right in our wheelhouse”, Herring said.