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Covance (CVD - Analyst Report) reported an EPS of 60 cents in the first quarter of 2012, up 12.3% year over year but in line with the Zacks Consensus estimate. The quarter’s EPS came in at the lower end of the company’s guidance. Net revenue in the first quarter rose 5.7% to $531 million missing the Zacks Consensus Estimate of $532 million.

Segments

The company primarily derives its revenues from two segments, namely Early Development and Late-Stage Development. Revenues from Early Development declined 5.5% year over year to $211.7 million during the quarter and were significantly below the company’s expectation. This was mainly due to low volumes in North American and European toxicology services and discovery support services which resulted from slow start from the company’s larger clients. This led to poor performance in the first two months of the quarter.  

Additionally, Revenues in clinical pharmacology increased compared to the year-ago quarter but were sequentially down due to higher than expected level of study delays and cancellations.

In the reported quarter, Early Development pro forma operating margin were 5.3%, a huge 650 basis point (bps) contraction year over year. Sequentially, it contracted 860 bps. The steep decline in operating margin was primarily driven by poor sales in toxicology and discovery support services, as well as weakness in clinical pharmacology services.  

However, revenues from the Late-Stage Development jumped 14.8% year over year to $319.2 million attributable to strong performance of clinical development services. Moreover, revenue in central laboratory services marked the third consecutive quarter of revenue growth on a constant currency basis.

Adjusted operating margin expanded 250 bps year over year and 270 bps sequentially to 22.7%. The year-over year increase in operating margin was due to improved results from clinical development and central laboratories, while the sequential increase was primarily driven by clinical development results.

At the end of the reported quarter, Covance’s backlog inched up 2.3% to $6.28 billion. Foreign exchange positively impacted sequential backlog growth by $48 million. Adjusted net orders (net orders adjusted for dedicated capacity contracts) were $704 million in the quarter, representing an adjusted book-to-bill ratio of 1.33.

Covance exited the quarter with cash and cash equivalents of $440 million compared with $389 million at the end of fiscal 2011. The company currently has $340 million in debt outstanding associated with borrowings under the share repurchase program of $277 million in the first quarter. Free cash flow in the first quarter of 2012 was $15 million, with capital expenditures of $30 million.

Outlook

Covance provided its outlook for second quarter of fiscal 2012. The company expects mid-single-digit revenue growth in the quarter with sequential increase in net revenues in both segments. Accordingly, it expects second quarter EPS to be significantly above the first quarter level.

The current Zacks Consensus EPS Estimate for the second quarter 2012 is 64 cents. For the next quarter, Covance expects a sequential increase in revenue and operating margins for the Early Development segment with higher volumes in toxicology and discovery support that will offset an anticipated weak clinical pharmacology performance. 

For fiscal 2012, the company reiterated its mid-single-digit revenue growth. EPS for the year is expected to be in the range of $2.50–$2.80 (unchanged). The Zacks Consensus Estimate of $2.65 falls within the guided range.

Moreover, Covance also announced restructuring actions in Early Development to support its preclinical market demand and further improve profitability going forward. These actions include closing of its Chandler, Arizona facility and further reduction in Early Development cost structure. The company expects all these to experience annualized profit improvement of roughly $20 million, of which approximately one-third is expected to be realized in 2012.

Management Change

In a separate press release, Covance also announced that it has made two executive appointments. The company promoted its current Corporate Senior Vice President and Chief Financial Officer Bill Klitgaard to the post of Corporate Senior Vice President and Chief Information Officer. The company’s current Vice President, Global Financial Planning and Analysis, Alison Cornell will accordingly be promoted to Klitgaard’s position.

Recommendation

Presently, Covance retains a short-term Zacks #4 Rank (Sell rating). Based on the company’s strong market leadership position, broad service offering, increasing geographical footprint, economies of scale and growing biotechnology and pharmaceutical customer base, we have a long-term Neutral recommendation on the stock.

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