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Get Four
|  | JANUARY 25, 2005
 FOCUS STOCK By Jeffrey Loo, CFA A Drug Tester's Winning Formula [Page 2 of 2] PREMIUM VALUATION. We see earnings per share of 43 cents for the 2004 fourth quarter and full-year 2004 EPS of $1.52. Based on our view of double-digit sales growth and improved operating margins, we see 2005 EPS increasing 21%, to $1.84. We believe the quality of Covance's earnings is high. After a series of adjustments made to the net income from continuing operations under generally accepted accounting principles (GAAP) and before extraordinary items to conform to S&P Core Earnings methodology, 2003 net income per share of $1.21 would be reduced 12%, to $1.06. We are projecting 2004 S&P Core EPS of $1.35, 11% lower than our estimated operating EPS of $1.52. The reduction for estimated option-expense accounts for the majority of the 17-cent difference in 2005. We attribute some of the recent pullback in Covance's share price to the significant run-up the stock had in 2004, when it increased almost 45%. However, we think there is more room for share appreciation, as we see Covance as a leading provider in a growing and healthy industry. The shares are currently trading at 19.6 times our 2005 EPS estimate of $1.84, in line with Covance's industry peers, and a price-earnings-to-growth (PEG) ratio of 1.0, below its peers. We think Covance deserves a premium valuation due to our view of its superior revenue and earnings growth potential. The stock is trading about 25% below our 12-month target price of $48, which is based on our discounted cash-flow analysis and PEG analysis, using a PEG ratio of 1.3. SMART CONTRACTS. There are several risks to our recommendation and target price, in our opinion. The CRO industry is subject to projects and trials being cancelled. A CRO typically does not have much control over cancellations, as sponsors may scrap a trial for a variety of reasons, including regulatory issues, the strategic decision to terminate development of a particular compound, or the inability to recruit a sufficient number of appropriate patients to conduct a trial. We believe the industry cancellation rate is about 15% to 25%. A significant cancellation rate in any one quarter can adversely affect revenues over the next several quarters. Covance's dedicated, multiyear, take-or-pay contracts help alleviate some of the quarterly variations in cancellations. Pharmaceutical research and development spending has increased at an average annual rate of about 10% over the past decade. Essentially all of a CRO's revenue is generated from pharmaceutical research and development spending. If R&D budgets are reduced, Covance would most likely be adversely affected. The trend of pharmaceutical companies increasing their outsourcing development needs may slow or reverse. Pharmaceutical companies lose some control of the development process when they outsource a trial and may begin to internalize more of the development process. Rising personnel costs may reduce operating margins, as increased demand is resulting in higher turnover and higher salaries.
 Analyst Loo follows shares of diversified health care companies for Standard & Poor's Equity Research Services. All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report. Standard & Poor's Regulatory Disclosure Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc. Get BusinessWeek directly on your desktop with our RSS feeds.  Add BusinessWeek news to your Web site with our headline feed. Click to buy an e-print or reprint of a BusinessWeek or BusinessWeek Online story or video. To subscribe online to BusinessWeek magazine, please click here. Learn more, go to the BusinessWeekOnline home page  | | |
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