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Get Four
|  | JANUARY 25, 2005
 FOCUS STOCK By Jeffrey Loo, CFA A Drug Tester's Winning Formula As Big Pharma increasingly outsources analysis of new medications, Covance's secure contracts and booked business are without peer Biotech and pharmaceutical companies are under intense pressure to discover and develop new therapeutic drugs more rapidly and efficiently. As a result, there is more outsourcing of development activities to increase the number of compounds being analyzed -- and to enable more of its scientists and personnel to focus on the discovery phase. We at Standard & Poor's Equity Research Services believe the outsourced drug-development industry is poised for significant growth over the next several years, and we see demand primarily benefiting the larger contract research organizations (CROs) with global operations. The CRO market is estimated to be approximately $11 billion, representing about 22% of pharmaceutical R&D spending, and has been growing at a compounded annual rate of about 10%. GLOBAL STRENGTH. Drug-development services outfit Covance (CVD; recent price, $36) is well positioned to benefit from this growth, in our view, and should grow faster than the industry based on its leadership position, global operations, and operational efficiency. Based on these factors, along with a recent pullback in its share price, we expect significant share appreciation over the next 12 months. Covance carries Standard & Poor's highest investment recommendation of 5 STARS, or strong buy. Covance is one of the largest providers of outsourced drug-development services. It has operations in over 30 locations in 18 countries, which enables it to conduct simultaneous global clinical trials. Its client base consists of over 300 biotech and pharmaceutical firms ranging from small startups to the world's largest pharmaceutical companies. The company provides pharmaceutical services in two business segments: early-stage development, which includes preclinical toxicology and chemistry services and Phase I trial testing; and late-stage development, which includes Phase II-IV testing, and the world's largest central laboratory. WELL POSITIONED. We believe increased outsourcing by pharmaceutical and biotech companies will continue throughout 2005 and into 2006. The CRO market has been growing at a compounded annual rate of about 10% over the last several years. This rate of growth has moved in parallel to the growth of pharmaceutical R&D spending. However, we believe the growth in the CRO market will begin to accelerate above the R&D expenditure growth rate. Why? Clinical trials are getting more complex and are increasingly being conducted simultaneously in numerous countries, at times with trials ongoing in over 15 different countries. Pharmaceutical companies do not have the infrastructure (i.e. staff, equipment, worldwide facilities, etc.) to conduct trials on the increasing number of compounds. Big Pharma is realizing that the cost effectiveness and efficiency of outsourcing may outweigh its desire to maintain complete control of the development process. In our opinion, Covance is well positioned to benefit from this demand and should grow faster than the industry. We believe it has a well-balanced and healthy mix of early stage development services (about 47% of revenue), including preclinical toxicology and chemistry services and Phase I testing, as well as late-stage development services (about 53% of revenue), including Phase II-IV and central-lab testing. With operations in so many countries, Covance is one of the few CROs with the ability to conduct simultaneous global clinical trials, the sort increasingly demanded by pharmaceutical concerns. HEFTY BACKLOG. This diversification has proven prudent, in our view, as softness in late-stage development and central lab services in 2003 and early 2004 was partially offset by strength in early-stage development. We see a pickup in late-stage development and central labs along with continued strength in early-stage development work, setting the stage for healthy, double-digit sales growth in 2005 and 2006, despite some capacity constraints in the company's early-stage development facilities. However, new facilities are expected to come on line in late 2005 and mid-2006. Space has been secured for additional build-outs if demand warrants. Also, we believe the softness in Phase I testing in Covance's U.K. operations, due to European regulatory changes, will improve as the industry adjusts to the new requirements. Robust demand drove Covance's backlog of business to a record $1.32 billion, as of Sept. 30, 2004. Net new business signings in the third quarter of 2004 were a healthy $320.3 million, while the book-to-bill was 1.25. We believe Covance is winning longer-term, more complex projects that should provide a solid revenue base. It has also been on the forefront in offering exclusive dedicated space to pharmaceutical firms in exchange for multiyear "take or pay" contracts. Operating margins have improved sequentially every quarter since the first quarter of 2001 through the third quarter of 2004, with the one exception being the 2003 first quarter (which saw a small 20 basis-point decline). Over this time, operating margins have improved from 7.7% in the 2001 first quarter to 14.1% in the 2004 third quarter. We expect operating margins will continue to improve on strong demand leading to reduced pricing pressure, and resulting in higher gross margins combined with continued improvement in operating efficiency and operating leverage. We see 2005 operating margins approaching 15%.
BW MALL
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