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Covance (CVD - Analyst Report) reported earnings per share (EPS) of 69 cents per share in the third quarter of 2012, up from the year-ago quarter EPS of 67 cents. The result included losses from facilities in wind-down, restructuring costs and other charges and favorable income tax developments. However, excluding the impact of the one-time items from both the periods, adjusted EPS in the reported quarter came in at 72 cents, beating the Zacks Consensus Estimate of 67 cents as well as surpassing the third quarter 2011 adjusted EPS by a penny. However, adjusted EPS was in line with the company’s guidance. Net revenue in the third quarter edged up 0.3% to $544.8 million, but missed the Zacks Consensus Estimate of $548 million.

Segments

The company primarily derives its revenues from two segments, Early Development and Late-Stage Development. Proforma revenues from Early Development declined 9.3% year over year to $217.8 million during the quarter, mainly due to a decline in toxicology, research products and clinical pharmacology, sale of environmental services (which contributed $2.0 million in quarterly revenue) and the inclusion of the Chandler, Honolulu and Basel sites in the year-ago results. Also unfavorable currency movement had a negative impact of 90 basis points (bps) on year-over-year sales comparisons.

However, proforma revenues increased 1.1% on a sequential basis (in line with the guidance), mainly on the back of a rebound in toxicology combined with a faster-than-expected increase in savings from cost reduction actions, which more than offset a disappointing clinical pharmacology performance.  

In the reported quarter, Early Development pro forma operating margin was 12.4%, down from 14.6% in the year-ago quarter. However, it expanded 370 bps sequentially, based on a return to profitability in North American toxicology. 

However, revenues from the Late-Stage Development grew 6.9% year over year to $324.1 million although unfavorable foreign exchange headwinds impacted year-over-year growth by 620 bps. The positive growth in this segment was attributable to persistent strong performance in clinical development, offsetting a decline in market access revenue. Moreover, central laboratory services registered 2.3% growth (up 10.7% at CER) for the quarter reflecting the fourth consecutive quarter of increase in kit volume.

Adjusted operating margin expanded 70 bps year over year but declined 110 bps sequentially to 20.0%. The year-over-year increase in operating margin was attributable to improved results from clinical development and central laboratories, while the sequential decrease was primarily driven by increased spending on strategic IT projects, lower profitability in market access services and increased hiring and staff costs in clinical development.

At the end of the reported quarter, Covance’s backlog remained at $6.37 billion, up 4.8% year over year. Sequentially, backlog was marginally down 2.2%. Foreign exchange favorably impacted sequential backlog growth by $69 million. Adjusted net orders (net orders adjusted for dedicated capacity contracts) were $701 million in the quarter, representing an adjusted book-to-bill ratio of 1.29.

Covance exited the quarter with cash and cash equivalents of $441.4 million compared with $389.1 million at the end of fiscal 2011. Free cash flow in the third quarter of 2012 was $35 million, while capital expenditures were $36 million.

Outlook

For the fourth quarter, Covance expects adjusted EPS to be around 70 cents, reflecting the impact of increased IT spending on Late-Stage Development tools as well as the corporate data center initiative. The current Zacks Consensus Estimate for the fourth quarter 2012 is 69 cents per share, which remains below the guidance. Moreover, pro forma revenue for the next quarter is expected to be sequentially up. Currently, the Zacks Consensus Estimate for the quarter remains at $550 million.

Moreover, the company narrowed its earlier provided adjusted EPS guidance range for 2012 to a new band of $2.50–$2.65 (from $2.50–$2.70). The Zacks Consensus Estimate of $2.63 falls within the guided range.

Recommendation

We are concerned about the continued downside of the Early Development segment of Covance, which is currently linked with the disappointing clinical pharmacology performance. Moreover, unfavorable foreign exchange and economic uncertainties were the main spoilers for the overall business of the company. Despite sales growth in Late Stage Development, the decline in fiscal 2012 guidance indicated that near-term challenges will persist. Presently, Covance retains a short-term Zacks #3 Rank (Hold rating).

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