Covance Manufacturing Divestment To Fund $20 Mil. Toxicology Expansion

Covance will use cash generated from the divestment of its biomanufacturing business to fund capacity expansion for its Madison, Wisc., toxicology facility, CEO Chris Kuebler told analysts.

The sale of the manufacturing unit to Akzo Nobel - a transaction valued at $190 mil. -should yield about $100 mil. in net proceeds, Kuebler said during Covance's first quarter earnings conference call April 26.

The biomanufacturing divestment, along with a $137.5 mil. packaging business divestment to Fisher Scientific in February, was targeted at improving margins following the financial downturn experienced by most contract research organizations early last year.

After post-sale refinancing, "Covance will have access, certainly, to sufficient funding to pursue expansion of our lab-based businesses, particularly expansion of toxicology," Kuebler noted.

The CRO plans to invest $10 mil. to $20 mil. in the toxicology testing facility.

Covance's North American toxicology capacity will be expanded by about 20%, Kuebler indicated, most of which will be in the form of a "significant addition" to the Madison facility. Work is slated to start in the third quarter and should take about a year to complete, he added.

The toxicology testing market is small but profitable, Kuebler suggested. "Less in [the tox] business is outsourced probably than the clinical businesses are - I guess it's always been around 15%," he said.

The toxicology "business is doing very well, margins are climbing....[and] we're able to raise prices and have very significant price increases stick...and have been doing that for maybe the last six months," Kuebler said.

The expansion is necessary because demand for the CRO's toxicology service is so high that "people are clamoring to get into our unit," Kuebler declared.

But "tox growth...could be greater if we had more capacity. We have sent several million dollars of business to our competitors, unfortunately," he said. "We're obviously selective about that and pick what we want them to have."

The CEO expressed hope that toxicology outsourcing will increase as more molecules move through development. "We...think that the industry will not respond [to generating more molecules], at least universally, with increase of its own capacity."

Covance and other CROs may be reaping another benefit from the abundance of molecules in industry pipelines as more agents seep into early clinical development: Phase I gains for the quarter were reported by several of the larger contract research organizations.

"There's been some noise in the industry about things being very robust [in Phase I]," Kuebler said, noting that Covance is "pleased" with its Phase I results for the quarter.

However, "I don't think any one company has a big enough share of Phase I to declare as a predictor of the future of Phase II/III, necessarily," he added. "For us, that's a pretty small part of our operations, so I don't think it's driving...results."

Covance's first quarter early development revenues, which include toxicology, increased 2.6% to $74 mil. from $72.2 mil. in the same period last year, although quarterly operating margins dropped from 15.3% in 2000 to 12.8%.

The margin decline was due to the impact of start-up expenses for the company's bioanalytical facility BioLink, which totaled $1.6 mil. for the quarter, Covance explained.

Quintiles appeared to be more optimistic about the prospects offered by Phase I contracts. "Our four Phase I units currently have an unusually high booking rate," new CEO Pamela Kirby, PhD, indicated during the company's first quarter earnings call.

"And if Phase I is a leading indicator of what is to come later in the pipeline, then this is going to bode very well for the pickup in new business in our industry in the second half of this year." Hailing from Roche, Kirby stepped in as Quintiles CEO in April, replacing Dennis Gillings, PhD, who is staying on as chairman (¹ (Also see "Quintiles Outsources CEO: Roche Exec Pamela Kirby Joins CRO April 2" - Pink Sheet, 19 Mar, 2001.)).

Parexel also reported positive Phase I results for the quarter. "In our case, Phase I demand has been quite healthy over the last...year," CEO Joseph von Rickenbach noted in an April 26 conference call. "I don't know quite if I would take this as a good predictor for follow-on cycle improvements in Phase II and III, but certainly that would be one interpretation."

CRO attempts to negotiate more favorable later-phase clinical contracts with pharma following the sharp drop in authorizations and influx of cancellations in late 1999-early 2000 appear to be paying off.

Although "the procurement side of the pharmaceutical industry has no less zeal than they've ever had," Kuebler said, "I think there's some appreciation on the part of [pharma] that a lot of risk was shifted to our industry. A lot of not very favorable terms were put in place."

"They were penny-wise and pound-foolish with some of that," Kuebler maintained. "They saved a few dollars in fees, but it cost them in quality, it cost them in deliverables, and I think there's at least a mild recognition that this industry is important....We can't have [CROs] all losing money and hemorrhaging - let's be a little more reasonable."

Von Rickenbach expressed similar sentiments. "I think [CRO] clients at this point...are smart, meaning they know what fair prices are. They know that CROs need to make a return, ultimately, and that that is in their interest as well," he said. "I have noticed, actually, a much more mature environment than we had in the past. And I think that's healthy."

Kuebler told analysts that the Phase II/III outlook for Covance is starting to improve as "the backlog that was detrimental and not very positive...has flown through."

The company will focus on maximizing clinical profits rather than increasing revenues, he emphasized. "If we didn't grow a dollar in revenue and brought the profitability back up in this business, that's the near-term objective."

Covance's first quarter late-stage development revenues increased 15.7% to $143.2 mil. from $123.7 mil. in the first quarter of 2000. Although late-stage operating margins for the quarter were down from 5.2% in 2000 to 2.1%, they doubled sequentially from the fourth quarter of last year.

The company's overall net revenues for the first quarter were up 10.9% to $217.2 mil., while net income was down 38% to $5.7 mil. As of March 31, Covance's outstanding debt was $130 mil.

Quintiles also experienced "new business wins" in later-stage clinical areas, with "a sharp upsurge of business coming from biotech and specialty pharmaceutical companies," Kirby reported.

Improved industry trends have likewise positively impacted Covance's central labs, Kuebler said. The "picture now has picked up very considerably, and what I call the holes in the bottom of the bucket have been plugged" for the clinical trials data processing units, he said.

"The cancellations and reductions now, for two quarters in a row, have returned to normal historical levels and...orders have picked up considerably," with pricing being "good," he added.

Kuebler attributed the changes to "the stabilization of the clinical trial market in the world generally," which, in turn, has resulted from what he sees as a change in political and business climate. "Elections are over. The Medicare threat seems to be less. Mergers are calming down," he maintained.

In a third quarter 2000 conference call, Kuebler attributed the "soft marketplace" for CRO services to "political pressures, elections, mergers [and] patent expirations" (² (Also see "Covance Clinical Trials Business Impaired By Mergers, National Politics - CEO" - Pink Sheet, 20 Nov, 2000.)).

Keubler tried to alleviate concerns that Covance's central lab business has been threatened by competitors. "We were certainly worried through the year 2000 that a lot of the proclamations by our competitors there maybe should give us reason to pause because the gross new orders in central labs were weak in 2000," he said.

But "the more we looked at...the data, we probably believe that [our competitors] are smaller than we ever thought they were, our market share is larger, and we haven't lost any share to them," he declared.

Covance estimates that one-third of all global clinical trial data is funneled through its central labs.