Covance Inc by linzhengnd

VIEWS: 8 PAGES: 21

									               SELL REPORT
               Steven DeSouza




[SPRING 2011]
[Type the abstract of the document here. The abstract is typically a short summary of the contents of
the document. Type the abstract of the document here. The abstract is typically a short summary of the
contents of the document.]
Table of Contents
Summary……………………………………………………………………………………………….3

Industry…………………………………………………………………………………………………4

Services…………………………………………………………………………………………………4

Marketing and Customers……………………………………………………………………..7

Business Operations………………………………………………………………………………7

Life Cycle……………………………………………………………………………………………….8

Competitive Environment………………………………………………………………………9

SWOT…………………………………………………………………………………………………….10

Capital Expenditures………………………………………………………………………………11

Comparison to Competitors…………………………………………………………………..12

Valuation Model…………………………………………………………………………………….13

Valuation……………………………………………………………………………………………..…14

Sensitivity Analysis…………………………………………………..…………………………..…15

Conclusion…………………………………………………………………………………………..….16

Appendix A……………………………………………………………………………………………..19

Appendix B………………………………………………………………………………………………20




                                                       2|Page
Covance Inc. (CVD: NYSE)
52-Week Range: $37.44-$63.86                                             Current Price (June 3th 2011) $57.21

Recommendation: Sell 57 shares                                                            Target Price: $641

Sub-Industry/GICS: Life Sciences Tools &                                           % Gain to Target: 11.87%
Services/35203



Summary
I recommend the sale of Covance Inc. (CVD) from the Portland State University CFASP on the
basis of its overvalued stock price, both relative to competitors and a consensus of estimated
forecasted future stock price, its recent hovering around previous analyst’s target price and the
company’s divergence from its original reason for purchase.

Covance Inc. (CVD) is a Medical Laboratories & Research (MLR) company that “provides early
and late stage development services primarily to the pharmaceutical, biotechnology, and
medical device industries worldwide.”2 Early Stage services include toxicology, pharmaceutical
and nutritional chemistry while its Late Stage services include central laboratory services,
clinical development services and clinical trial support services. The company grows its revenue
through increased contracts with customers whom it obtains through acquisitions that better
the quality or geography of its services or long-term contract agreements ranging from three to
ten years. In the future it is expected that an increasing percentage of Covance’s earnings will
come from emerging markets where middle-class growth and the resulting increase in demand
for healthcare products and services will increase demand for Covance’s services, increased
regulation of developed countries that makes it more cost-effective for pharmaceutical and
biotechnology companies to contract out R&D and strategic acquisitions that quickly meet the
changing needs of customers.

Currently Covance is coming from a poor fiscal year in 2010. Due to restructuring charges from
acquisitions along with lackluster performance in its Early Stage segment, Covance reported a
loss of $32 million in the segment, squeezing its 2010 EPS to $1.08 and a resulting swelling P/E
ratio of 60. While the acquisition involving the purchase of French pharmaceutical company
Sanofi-Aventis was in an attempt to boost revenues and margins in the Early Stage segment, it

1
    Yarnell, Jeff. “Healthcare Sector/Products & Supplies Summary Sheet – CVD “
2
    Yahoo! Finance “Company Profile – CVD” Web.

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has failed to meet expectations in the past two years. Signs of issues in its Late Stage segment
were reported in the first quarter of 2011 and are expected to remain soft to stagnant for the
near future. The cause for the lack of revenue growth comes from delays and cancelations in its
central lab services, typically one of Covance’s core competencies along with one of the reasons
for the company’s additions to the portfolio.

Qualitative Analysis
Industry
Covance operates in the MLR industry worldwide. Recently the industry has been impacted
greatly by two events: economic recession and healthcare reform. The economic recession has
impacted MLRs from the bottom up. Hospitals and healthcare service providers were hit hard
during the recession from lower hospital inpatient and outpatient utilization. This resulted in
trimming in capital expenditures along with a pooling of purchasing power with other hospitals
and healthcare providers.3 This follows through to the healthcare products and services
industry as their demand for products decreased along with pressure to reduce pricing
increased. While the former can also negatively impact MLRs, the latter provides opportunity as
healthcare products and services companies find it more cost effective to contract out R&D
services to the MLR industry. This trend of R&D outsourcing is also enhanced through recent
healthcare reform. In 2010 President Barak Obama signed into law the Patient Protection and
Affordable Care Act (PPACA). Among many of its provisions, one relevant impact is the
imposition of a 2.3% excise tax on all sales of medical devices. This will further incentivize
medical device manufacturers to try to reduce costs wherever possible, including R&D. It is
expected that the industry will grow in 2011 by 6-8% fueled by domestic economic recovery
and continued emerging market growth in the next several years.4

Services
Covance’s services fall under its two segments: Early Stage and Late Stage. Early stage makes up
44% of its revenue. In the past this segment has accounted for up to 50% of revenue in 2006
through 2008 but has dipped in recent years (Exhibit 1). Early stage services are described
below as stated in Covance’s 2010 10-K.

Toxicology: Preclinical toxicology services include in vivo toxicology studies, which are studies of
the effects of drugs in animals; genetic toxicology studies, which include studies of the effects




3
 Saftlas, Herman. “Healthcare: Pharmaceuticals” S&P NetAdvantage. Web. Updated June 2011. Viewed June 2011.
4
 Loo, Jeffrey, “Sub-Industry Survey: Life Sciences Tools and Services” S&P NetAdvantage. Web May 2011. Viewed
May 2011.

                                                                                                 4|Page
of drugs on chromosomes, as well as on genetically modified mice; and other specialized
toxicology services.5

Pharmaceutical Chemistry: Pharmaceutical chemistry services determine the metabolic profile
and bioavailability of drug candidates. It also provides laboratory testing services to the
chemical and agricultural chemical industries.6

Nutritional Chemistry: Nutritional chemistry services offers a broad range of services to the
food, nutriceutical and animal feed industries, including nutritional analysis and equivalency,
nutritional content fact labels, microbiological and chemical contaminant safety analysis and
stability testing.7

Research Products: Covance provides custom polyclonal and monoclonal antibody services for
research purposes and purpose-bred animals for biomedical research. The purpose-bred
research animals are required by pharmaceutical and biotechnology companies, university
research centers and contract research organizations as part of required preclinical animal
safety and efficacy testing.8

Discovery and Translational Services: These services provide lead optimization including custom
immunology and antibody services, metabolism studies and pharmacokinetic screening as well
as non-GLP toxicology, in vivo pharmacology, imaging services and biomarker services.9

Bioanalytical Services: Bioanalytical testing services, which are conducted in Indianapolis,
Indiana and in their immunoanalytical facility in Chantilly, Virginia, as well as in laboratories in
Madison, Wisconsin, Harrogate, United Kingdom and Shanghai, China, help determine the
appropriate dose and frequency of drug application from late discovery evaluation through
Phase III clinical testing on a full-scale, globally integrated basis.10

As mentioned above, Covance’s Early Stage segment has dipped in recent years. This is
primarily due to a softening of the toxicology service revenue along with restructuring and asset
impairment charges from the acquisition of facilities from Sanofi-Aventis. While in the most
recent quarter toxicology generated $224 million in revenue, it still fell short of expectations
around $226.7 million.11



5
  “2010 10-K Covance Inc.” EDGAR Database. Web. February 2010. Viewed May 2011. Page 3-4
6
  “2010 10-K Covance Inc.” EDGAR Database. Web. February 2010. Viewed May 2011. Page 3-4
7
  “2010 10-K Covance Inc.” EDGAR Database. Web. February 2010. Viewed May 2011. Page 3-4
8
  “2010 10-K Covance Inc.” EDGAR Database. Web. February 2010. Viewed May 2011. Page 3-4
9
  “2010 10-K Covance Inc.” EDGAR Database. Web. February 2010. Viewed May 2011. Page 3-4
10
   “2010 10-K Covance Inc.” EDGAR Database. Web. February 2010. Viewed May 2011. Page 3-4
11
   Windley, David. “”Company Note – CVD” Jeffries & Company Inc. May 2011. Viewed May 2011.

                                                                                              5|Page
Exhibit 1

     1200000


     1000000


       800000


       600000                                                            Early Stage
                                                                         Late Stage
       400000


       200000


             0
                  2005    2006    2007    2008    2009    2010


Source: Data for graph extracted from Covance, Inc. 2010 10-K




Covance’s Late Stage segment makes up 56% of revenue in 2010 and as little as 50% of revenue
in 2006-2008. The services within the segment are discussed below.

Central Laboratory Services: Covance is the world’s largest provider of Central Laboratory
services which it provides internationally with facilities in the U.S., Switzerland, Singapore, and
China.12 These different facilities allow simultaneous testing on the same product in order to
pursue approval in the distributing countries. 13In 2009 Covance expanded this operation with
the purchase of drug manufacturer Merck Co. gene expression lab for $9.75 million in exchange
for a service contract worth $145 million over 5 years.14

Clinical Trial Support Services: The majority of Covance’s clinical trial services come from Phase
II and Phase III clinical trials. Covance will design, model, coordinate and monitor the trials
along with logistical data to help its clients monitor progress. Clinical Trial Support Services also

12                                                                                                      th
  Coldwell, Eric. “CVD – Covance Inc. at Robert W. Baird and Co.” Thomson Street Events. Web. 10 , May 2011.
Viewed June 2011.
13
     “Strategy, SWOT and Corporate Finance Report – CVD” Data Monitor. Web. May 2011. Viewed May 2011
14
     “2010 10-K Covance Inc.” EDGAR Database. Web. February 2010. Viewed May 2011.

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includes Periapproval service in which it helps its clients progress through approval by
authoritative bodies in the countries of product distribution. As both developed and emerging
markets increase the complexity, and therefore the time and cost of product approval,
Periapproval may be a growing source of revenue in the future.



Marketing & Customers
Covance provides diverse service offering domestically and internationally through offices and
laboratories in 60 countries to small start up firms to large multinationals.15 Domestic revenue
accounts for 56% of revenue while international makes up the remaining 44%. Within the
international revenue 17% of all revenue comes from emerging markets. Its geographic spread
and diversified service offerings lends itself to be marketed as a full service provider by
conducting testing through most stages of product development while also guiding clients
through the approval process simultaneously through different countries. According to
Covance’s 2010 10-K, while no one customer accounts for more than 10% of revenue, their top
five customers account for 36.1% of revenue and one single customer accounts for over 10% of
revenue in the Early Stage and another accounts for over 10% in the Late Stage.16

Business Operations
While Covance operates internationally it relies heavily on four facilities for its central
laboratory services. These facilities are in the U.S., Switzerland, Singapore, and China. The
company has undergone multiple strategic agreements and acquisitions in the last 5 years to
grow its potential market and increase efficacy of certain services. Exhibit 2 displays the
number of deals (defined as acquisitions, alliances, partnerships) Covance has entered into
from 2005 to May 2011.




15
     “Strategy, SWOT and Corporate Finance Report – CVD” Data Monitor. Web. May 2011. Viewed May 2011
16
     “2010 10-K Covance Inc.” EDGAR Database. Web. February 2010. Viewed May 2011. Page 2

                                                                                                        7|Page
Exhibit 2




Source: “Strategy, SWOT and Corporate Finance Report – CVD” Data Monitor. Web. May 2011. Viewed May 2011


In 2010 the three deals cited all involve the agreement with Sanofi-Aventis which includes asset
and facility purchases in the U.K. and France, along with a contract for a 5 year deal for Early
Stage services. In 2011 the 2 deals involve Takeda Pharmaceuticals worth an undetermined
value in the late stage segment. While the goal of the 2010 deals have been to boost revenue
and margins, progress remains slow with revenue from the segment missing estimates by less
than $3 million. However, in the first quarter of 2011 Covance experienced higher than
expected revenue in toxicology, a service that is one of Covance’s original reasons for purchase
and that has been hit especially hard in the last two years. For the late stage deals in 2011,
revenue is expected to not be recognized for the next one to two years as the deal becomes
complete and services begin. This will be necessary for future success of Covance. The central
lab work involved in the deal is also one of Covance’s core competencies and another reason
for purchase. However excess capacity in the facility has plagued the company in the trailing
twelve months and management expects it to remain stagnant or experience slight attrition for
the next twelve months. This will hamper margins both from revenue in the large segment and
economies of scale. Since it relies so much on the four facilities for central lab services, air
transport is heavily relied upon to bring results, specimens and deliverables to customers. A
reduced distribution pipeline drives up the average cost per deliverable as the average
deliverable per flight falls down. As such revenue growth is expected to remain slow in 2011
and 2012 as logistics of operations and contract revenues are worked out and then increases
from 2013 through 2019 until it begins to taper off into a terminal growth assumption. Because
of Covance’s emphasis on overseas expansion, and the higher costs associated with large

                                                                                                           8|Page
geographical spread, after-tax EBITDA will increase slightly for next upcoming years as past
acquisitions begin to increase margins as expected from management, and then remain steady
for the declining growth phase.

Life Cycle
While the MLR industry or contracted research in general is a very mature industry, new and
revamped products add growth elements to the Life Cycle. As an example, in the past few
decades, majority of MLR work was for mechanical medical devices like pace makers, plastic
hips along with synthetic compound pharmaceuticals. Recently the lifecycles for these products
is coming to a clsoe as patents expire and obsolescence impedes on product utility. This will
correlate to the lifecycle of the research and testing MLRs conduct for said products. However,
the introduction of biotechnology and its application for both medical devices and
pharmaceuticals provides new product lifecycles with new patents to open up the pipeline for
R&D that is contracted to MLRs.17

Competitive Environment
Covance operates in the MLR industry with global competitors in its own industry, while also
competing with in-house R&D by potential customers. The majority of the competitive forces
will come from other MLRs as the trend to outsource R&D by healthcare product and service
companies continues in order to reduce cost and increase efficiency.18 Some of Covance’s main
competitors are Icon (ICLR) Charles Rivers Laboratories (CRL) and Pharmaceutical Products
Development Inc. (PPDI). Icon is Covance’s only international competitor based out of Ireland
with 2010 revenue of $910 million, market cap of $1.5 billion and net margin of 8.04%. Charles
Rivers Laboratories (CRL) is based out of Massachusetts with 2010 revenue of $1.13 billion,
market cap of $2 billion and a negative net margin in 2010. Pharmaceutical Product
Development Inc. (PPDI) is based out of North Carolina and accumulated 2010 revenue of $1.51
billion, market cap of $3.27 billion and net margin of 9.7%. While Covance is the largest by
revenue and market cap, $2.06 billion and $3.61 billion respectively, its profit margin in both
fiscal year 2010 (3%) and the first quarter of 2011 (6.2%) falls short of PPDI (9.7% and 9.8%
respectively. While Covance may not be the most profitable, it may be partly due to its large
global presence. Exhibit 3 shows Covance and competitor’s revenue by U.S., International, and
Emerging markets. While Covance and PPDI have very similar mixture of U.S. and International
revenue, within the International revenue, a larger portion come from Emerging markets for
Covance compared to PPDI. The stability of developed countries and the lesser geographical
spread may partly account for PPDI’s higher net profit margin. Icon logically has a higher

17
   Saftlas, Herman. “Healthcare: Pharmaceuticals” S&P NetAdvantage. Web. Updated June 2011. Viewed June
2011.
18
   Loo, Jeffrey, “Sub-Industry Survey: Life Sciences Tools and Services” S&P NetAdvantage. Web May 2011. Viewed
May 2011.

                                                                                                    9|Page
portion of International revenue as it’s a foreign company and is also the closest to Covance’s
Emerging market presence. In this case, the geographical spread caused from participation in
emerging markets somewhat offsets the negative impact on margins as Icon has almost 11% of
revenue from emerging markets and has the second highest net margin of 8% relative to
Covance’s 3%.


Exhibit 3

                      CVD        ICLR         CRL        PPDI


US %                  56%        42.3%        47.3%      56%

Intl %                44%        57.7%        52.7%      44%

Emerging %            17%        10.8%        1.4%       5.3%




SWOT

                       Strengths                                                 Weaknesses
          Broad service portfolio                                    Weak performance in Early stage
          Wide global presence reducing                              High Reliance on certain facilities
           dependency risk                                            Stagnant Central Lab revenue
                    Opportunities                                                  Threats
          Growth in R&D Outsourcing continues                        Global competition increasing
          Strategic alliances & acquisitions                         Global presence puts pressure on
           boosts growth prospects                                     margins
          Growing demand of services in                              Reduced Barriers to Entry
           Emerging markets
Source: “Strategy, SWOT and Corporate Finance Report – CVD” Data Monitor. Web. May 2011. Viewed May 2011

Strengths: Covance has a large array of services for its customers including pharmaceutical,
biotechnology, and medical device companies. It even conducts research and testing for the
chemical, agricultural and food industries in order to offering itself as a full service company.19
From early testing all the way to navigation through complex approval processes Covance can
retain and add customers through its wide array of offerings while also conducting testing in
different countries simultaneously to release products in parallel to each other. While

19
     “Strategy, SWOT and Corporate Finance Report – CVD” Data Monitor. Web. May 2011. Viewed May 2011

                                                                                                        10 | P a g e
simultaneous testing is for large multinational firms, Covance’s recent emphasis on global
expansion allows it to offer services to customers of all different sizes and regions. As
mentioned above it has one of the strongest international and emerging market presences.

Weaknesses: Covance has seen revenue contraction in its Early Stage segment since 2009
mostly on preclinical testing and toxicology, leading the segment to fall short of growth
estimates by almost $3 million.20 As a market leader in toxicology, this hampers on their
competitive advantage and has been the motivation for recent acquisitions and strategic
alliances with companies such as Sanofi-Aventis in order to boost revenue and margins in these
areas.21 Covance relies on four facilities for all Central Laboratory work which reside in the U.S.,
Switzerland, Singapore, and China. Their purposes are very specific and costly, including uses
for biomarker, biotechnology and pharmaceutical work. The large infrastructure costs and any
lag in work would quickly turn it unprofitable. Also, because of the large infrastructure costs, it
would be very difficult to change facilities if necessary and therefore limits the company’s
flexibility.22 In 2010 and the first quarter of 2011, revenue in Central Labs only grew .2% and is
expected to remain stagnant or experience slight attrition for the next 12 months. 23

Opportunities: As pharmaceutical, biotechnology and medical device manufacturers are
pressured to reduce pricing and thus costs; outsourcing R&D provides a cost-effective and
efficient way of bringing products to market. Approximately 30% of drug development spending
is outsourced and with the passage of healthcare reform in the U.S. and the pressure to adopt
Health Economics Outcomes Research in an attempt to prevent diminishing returns of new
product releases and global presence on healthcare costs, this trend is expected to continue.24
Opportunities for growth also remain internationally and in emerging markets such as Pacific
Asia which is currently the primary outsourcing destination for drug companies world-wide due
to cost advantages and extensive human capital.25 Covance has the ability to capitalize on these
markets through its own start-up facilities, or by continuing strategic alliances and acquisitions
in these regions. Since 2005 Covance has entered into roughly 3 such deals yearly and their
ability to do so successfully can provide growth geographically or through more service
offerings.

Threats: There is vast competition in the MLR industry around the world. Covance must not
only compete with other MLR, but also healthcare product and service companies that conduct

20
  Windley, David. “”Company Note – CVD, ICLR, CRL, PPDI” Jeffries & Company Inc. May 2011. Viewed May 2011.
21
  Torsoli, Albertina. “Sanofi to Pay Covance as Much as $2.2 Billion in 10-Year Contract” Bloomberg.com.
September 2010. Viewed May 2011
22
     “Strategy, SWOT and Corporate Finance Report – CVD” Data Monitor. Web. May 2011. Viewed May 2011
23
 Windley, David. “”Company Note – CVD, ICLR, CRL, PPDI” Jeffries & Company Inc. May 2011. Viewed May 2011.
24
 Loo, Jeffrey, “Sub-Industry Survey: Life Sciences Tools and Services” S&P NetAdvantage. Web May 2011. Viewed
May 2011.
25
     “Strategy, SWOT and Corporate Finance Report – CVD” Data Monitor. Web. May 2011. Viewed May 2011

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in-house R&D, which accounts for 70% of all R&D.26 Covance must balance its competitive
environment with the higher costs of doing business as the geographical spread of its
businesses will make research more costly and time-consuming, potentially decreasing the
value of business.

Capital Expenditures
Covance relies heavily on capital expenditures to grow its operations and relies heavily on its
cash to do so. Capital expenditures averaged 10.63% of sales in the last three years, higher than
all competitors.27 While Capital Expenditures are necessary for companies that make large
investments in different assets, Covance among other MLRs, also rely heavily on funds for
acquisitions, working capital and to a lesser extent stock buybacks.28

Quantitative Analysis
Comparison to Competitors
Covance operates in the MLR industry among competitors such as Icon (ICLR) Charles Rivers
Laboratories (CRL) and Pharmaceutical Products Development Inc. (PPDI). While Covance is the
largest by revenue, they are by far the most overvalued in terms of the P/E ratio compared to
competitors. The P/E ratio for Covance is 58.32 (TTM), a start contrast to Icon’s 2010 P/E of
20.89 (TTM) and PPDI’s 22.62 (TTM) (Exhibit 4).29

Exhibit 4

Competitors                            CVD                ICLR              CRL                    PPDI

Market Cap ($B)                         $ 3.61             $ 1.5             $     2.00            $      3.27

Revenue ($B)                            $ 2.06             $     .910        $     1.13            $      1.51

Net Margin                             3.0%               8.04%             NA                     9.7%

P/E                                    58.32 [95.35] 20.89 [120]            NA [62.3]              22.62 [85.37]

ROA                                    6.05%              5.32%             5.20%                  6.87%

Beta                                   1.13               0.34              1.01                   0.57



26
     “Strategy, SWOT and Corporate Finance Report – CVD” Data Monitor. Web. May 2011. Viewed May 2011
27
   “2010 10-K Covance Inc.” EDGAR Database. Web. February 2010. Viewed May 2011. Page 31
28
   “2010 10-K Covance Inc.” EDGAR Database. Web. February 2010. Viewed May 2011. Page 31
29                                                                     th
   Yahoo! Finance. “Company Summary – CVD, ICLR, CRL, PPDI” Web. June 4 2010

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While much of this can be accounted to Covance’s Early Stage operating loss in 2010 and the
resulting plunge in EPS, the story remains when comparing each company’s most recent
quarterly P/E. If each company’s current price is divided by their quarterly EPS then we see that
Covance has the second largest with P/E of 95.35 compared to Pharmaceutical Product
Development Inc.’s 85.37 and Charles River Laboratories’ 62.3, leaving Icon with the largest
quarterly P/E of 120.30 Covance also has the highest beta compared to competitors causing it to
have a higher cost of equity, all other things being equal. If the premium paid for the company
is accompanied by large growth rates in earnings, then the price can be more or less justified.
Exhibit 5 displays Covance and other competitor’s forecasted P/E ratio for 2011 compared to
their historical growth rates. What we see is that for the second highest premium paid, it is also
tied for worst earnings growth.



Exhibit 5




Forecasts for Covance’s future stock price paints a similar picture. The average forecasted price
target for 2011 is $59.78 which is roughly the same as forecasted 2012 stock price.31 What this
shows is that the future prices are just slightly above the current price. Also, if the future
forecasted stock prices are discounted back by the market return of 8.31% then the present
value of 2011 is $55.40 and 2012 is $51, making the current price today of $57.21 over valued.

30
     Windley, David. “”Company Note – CVD, ICLR, CRL, PPDI” Jeffries & Company Inc. May 2011. Viewed May 2011.
31
     Windley, David. “”Company Note – CVD” Jeffries & Company Inc. May 2011. Viewed May 2011.

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Valuation Model

WACC: Covance has been valued using a DCF analysis to derive their FCFF and FCFE. Details of
the evaluation can be found in Appendix A. To arrive at Covance’s discount rate for the
valuation the following parameters were used:

      Rf = 4.31%
      Rp = 4%
      Beta = 1.02
      Ke = 8.4%
      Kd = 4.81%
      Tax rate = 29%
      Debt ratio = 6.91%
      WACC = 8.05%

The CAPM was used to arrive at the cost of equity (Ke). The cost of debt (Kd) resulted from a
modified interest coverage ratio. Covance had a modified interest coverage ratio including
capital leases and purchase obligations of 8.9 when averaged since 2005. According to Aswath
Domadaran’s website, a company with interest coverage greater than 8.5 was AAA rated and
derived a spread of .5%. When added to the Rf rate of 4.31%, Covance’s pre-tax cost of debt is
4.81%. The after-tax cost of debt resulted from taking out Covance’s 29% effective tax rate that
was a historical average for the company and resulted in after-tax Kd of 3.4%. Finally, to arrive
at Covance’s portion of debt, Covance’s total debt found within their 10-K was treated as a
single coupon bond with a coupon set to their interest expense. Once added to their portion of
equity, Covance’s 6.91% portion of debt was derived, resulting in a WACC of 8.05%.

Capital Expenditures: Covance states in its 10-K its need for strong capital expenditures.
However capital expenditures as a percent of revenue has shrunk from as high as 17% to as low
as 1%. This is a similar story to competitors and as many companies, including Covance, in the
MLR industry grow in different markets, capital expenditures should follow. Therefore, Capital
expenditures remains at roughly 8-9% to smooth out fluctuations then beings to decline in 2020
to reflect terminal growth assumptions (Appendix B).

Working Capital: As mentioned above the company makes continuous deals with customers
which involve initial cash outlays in working capital at the beginning of a contract which are
usually returned back to Covance at the end of the contract. To smooth out the fluctuations of
changes in working capital it remains steady throughout the DCF (Appendix B).

Revenue Growth: Revenue growth was slowed down in 2010 to just 3%. Overall growth is
expected to remain slow in next couple years and so for 2011 and 2012 revenue growth is 6 and

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5% respectively as issues with both business segments are resolved then picks up to roughly
10% annual growth from 2013 through 2018. This is in line with their CAGR since 2005
(Appendix C). Revenue growth slowly drops annually until it reaches terminal growth
assumption of 4% in 2021.

After-tax EBITDA: The after-tax EBITDA for Covance is set at 15%. Past years were as high as
18% and as low as 8%. In high-growth phase, this increases to roughly 17% to reflect the
positive impact on deals and acquisitions made in 2008-2010 that management expects to
increase margins, especially in Early Stage segment.

Valuation
Exhibit 6 shows the intrinsic value of Covance’s FCFF and FCFE. As of June 3rd, Covance traded
for $57.21 a share. Their intrinsic value for equity holders is $75.14, making Covance
undervalued by 31%

Exhibit 6

 Terminal growth rate assumption                4%
                                       FCFF              FCFE
 Cost of capital                          8.05%            8.4%

 Cash flow in 2023                  378,669.30   379,746.07
 Terminal value at 2013               $9,718,961 $8,983,575
 Present value of Terminal Value      $3,551,332 $3,149,680

 Present value of intermediate CF   1,646,820    1,647,520
 Total                                $5,198,152 $4,797,200

 Add Cash                           543,890          -

 Subtract value of debt             298,283
 Equity value                         $5,443,759     $4,797,200

 Shares outstanding                 63,840.45
                                              $
 Value per share                          85.27           $75.14
 Current Price                           $57.21           $57.21
 Undervalued by                               49%           31%


Sensitivity Analysis



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Because Covance uses such a large portion of equity (93%), Exhibit shows a sensitivity of
Covance’s FCFE to changes in Ke. What we see is that just over a 1% increase Ke will drop
Covance’s FCFE from $75 to $58.54, close to its trading price. This is important because interest
rates remain at historical lows and are expected to increase. This will cause the Rf and Rp to
increase, thus increasing Ke. Recently, concern over U.S. debt ceilings poses an immediate
threat of this nature. If the U.S. does not raise debt ceilings, credit rating agencies have stated
they will lower the U.S. credit rating which will drive up the required rate of return on U.S. debt
(Exhibit 7).32



Exhibit 7

Ke               FCFE
                        $75.14
              $
         6.0% 175.54
              $
         6.5% 138.58
              $
         7.0% 113.99
              $
         7.5% 96.48
              $
         8.0% 83.38
              $
         8.4% 75.07
              $
         9.0% 65.13
              $
         9.5% 58.54
              $
        10.0% 53.06
              $
        15.0% 26.21


Conclusion
I recommend the sale of Covance Inc. (CVD) from the Portland State University CFASP on the
basis of its overvalued stock price, both relative to competitors and consensus estimates of


32
 Puzzanghera, Jim. “Moody’s warns of U.S. credit rating downgrade if no debt ceiling deal comes soon” LA Times.
      nd                         rd
Web. 2 , June 2011. Viewed June 3 , 2011

                                                                                                  16 | P a g e
forecasted future stock price, its recent hovering around the purchasing analyst’s target price
and the company’s divergence from its original reason for purchase.

As mentioned above (see Comparison to Competitors) we are paying the highest premium for
the lowest earnings growth. We can also see that while Covance is the largest by revenue, it has
one of the lowest margins in the industry along with the highest beta. From the relative
valuation, competitor PPDI appears to be more of a value company for their high margins, low
premiums paid, low beta and competitive ROA.

The company also is overvalued when looking at forecasted future stock prices for the next
couple years. Forecasted stock price is roughly $60 for 2011 and 2012. If we discount these by
the market return of 8.31%, then their present values are is $55.40 and $51 in 2011 and 2012,
making the current price of $57.21 overvalued. In terms of long-term growth, based on current
costs of capital and growth forecasts, Covance has an intrinsic value that’s undervalued by 31%.
If interest rates increase, and the resulting Ke derived from CAPM formula increases by 1.1%,
Covance’s intrinsic value drops to $58.54, making Covance’s intrinsic value highly elastic to
interest rate levels.

Exhibit 8 shows Covance’s stock price from March to May 2011. On May 2nd, Covance traded
for $63.23, hovering just below the previous analyst’s target price of $64. Their share price later
dropped as a result of market movements but this does signal that Covance has come to a
selling point, especially considering any increased increases in stock price might be delayed for
the near future, providing the portfolio with no rates of return since the company provides no
dividend.

Exhibit 8




                                                                                       17 | P a g e
Source: Yahoo! Finance. “Interactive Charts 3M – CVD”. Web. June 2011




Finally, in Spring of 2009 analyst Joseph Genduao recommended the purchase of Covance for
reasons including it being a market leader in toxicology and central labs. While in terms of
revenue, this is true, Covance has also experienced difficulty in these two segments recently
and remains a threat for their operations. Toxicology has had excess capacity in facilities and
while the first quarter of 2011 showed positive growth, the entire Early Stage segment in which
toxicology is categorized under has shrank in revenue in the past few years. Strategic alliances
and acquisitions completed in order to boost revenues and margins in this segment have fallen
short of estimates and have been named a potential threat to the company by analysts. In the
Late Stage segment, Central Laboratory work has been plagued with project delays and
cancelations. It is also expected to have stagnant growth I n 2011 and partly in 2012.33

From a macro perspective, the industry is expected to have positive future outlook as economic
trends provide opportunity. While Covance seems a good selection within the industry because
of its size and diversification, other companies within the industry provide more value for the
portfolio such as PPDI and considered with Covance’s operational trouble and its forecasted
stagnant stock price, the portfolio should lock in the gains received from purchase and move
funds to a more value based security.




33
     Windley, David. “”Company Note – CVD, ICLR, CRL, PPDI” Jeffries & Company Inc. May 2011. Viewed May 2011.


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                                                                                                               Appendix B
Forecast of Free Cash Flows for Covance, Inc.
First 4 columns are reversed from the FCFF-FCFE spreadsheet                                                                Short run                 Intermediate high growth period         Declining growth period (this is to assure that the model phases into a constant-growth model)
                                                Forecast




                                                                                                                                                                                                                                                                                                                  20 | P a g e
Parameters used in forecast                     Parameters         2006        2007        2008         2009        2010          2011        2012         2013         2014        2015            2016        2017         2018         2019        2020         2021        2022            2023        2024
Growth rate of revenues                                            12%         15%         12%           8%          3%            6%          5%            7%          9%            11%           9%           9%          9%           7%           5%          4%           4%             4%          4%
After-tax EBITDA as a percent of revenue             15.0%         14%         16%         17%          17%          8%           11%         15%           18%         17%            15%          15%          15%         15%          15%         15%          15%          15%            15%
Deprec and amort as % net P&E                        10.5%       11.5%       10.2%         8.3%         9.9%      12.2%         12.0%       11.0%         10.5%        10.5%       10.5%          10.5%        10.5%        10.5%       10.5%        10.5%       10.5%        10.5%           10.5%
Net working capital less cash as % revenues             8%         10%          6%          6%          10%          6%          7.5%        7.5%            8%           8%          2%            -2%          -2%           1%          4%           8%          8%           8%              8%         5%
Net P&E as % revenue                                   45%         37%         42%         50%          49%         44%           45%         45%           45%          45%         45%            45%          45%          45%         45%          45%         45%          45%             45%        45%
For FCFE calculations
Debt to Total Liabilities and Net Worth                 8%          4%          4%          3%           3%          8%            8%           8%           8%           8%          8%             8%           8%           8%          8%           8%          8%           8%              8%
Interest rate                                         5.0%         0.5%        0.8%        3.9%         2.5%        1.0%           2%         3.5%         4.4%         4.4%        4.4%           5.0%         5.0%         5.0%        5.0%         5.0%        5.0%         5.0%            5.0%
Effective tax rate for interest*                    29.00%      28.51%      29.60%      28.95%       26.43%      -54.02%        29.0%        29.0%        29.0%        29.0%       29.0%          29.0%        29.0%        29.0%       29.0%        29.0%       29.0%        29.0%           29.0%
* Here defined as income taxes/pre-tax income
Free cash flows to the firm (FCFF) *                               2006        2007        2008         2009        2010          2011        2012         2013         2014        2015            2016        2017         2018         2019        2020         2021        2022            2023        2024
Revenue Forecasts                                             1,340,203   1,546,419   1,728,098    1,867,634   1,925,630    2,041,168    2,123,007    2,271,618    2,476,063   2,748,430      2,995,789    3,265,410    3,559,297   3,808,447    3,998,870   4,158,825    4,325,178    4,498,185      4,678,112
After-tax EBITDA                                                186,038     240,541     286,627      315,509     151,996      224,528     318,451       408,891     408,550     412,265         449,368      489,811     533,895      571,267      599,830     623,824      648,777     674,728
Change in net working capital                                      -3%         -2%          0%           4%         -4%            2%          0%            1%          1%          1%              1%           1%          1%           1%          0%           0%           0%          0%
 Net working capital less cash                                 130,052      99,312     106,561      185,459     114,414       163,293     169,841       181,729     198,085     219,874         239,663      261,233     284,744      304,676     319,910      332,706      346,014     359,855
 Prior year net working capital less cash                      166,867     130,052      99,312      106,561     185,459       114,414     163,293       169,841     181,729     198,085         219,874      239,663     261,233      284,744     304,676      319,910      332,706     346,014
   Change in net working capital less cash                     (36,815)    (30,740)      7,249       78,898     (71,045)       48,879       6,547        11,889      16,356      21,789          19,789       21,570      23,511       19,932      15,234       12,796       13,308      13,841
Gross capital expenditures
 Net P&E                                                       500,057     646,040     860,957      921,995     843,983       918,526     955,353     1,022,228    1,114,228   1,236,794      1,348,105    1,469,434    1,601,684   1,713,801    1,799,491   1,871,471    1,946,330    2,024,183
 Prior year Net P&E                                            410,665     500,057     646,040      860,957     921,995       843,983     918,526       955,353    1,022,228   1,114,228      1,236,794    1,348,105    1,469,434   1,601,684    1,713,801   1,799,491    1,871,471    1,946,330
  Change in Net P&E                                             89,392     145,983     214,917       61,038     (78,012)       74,543      36,828        66,875       92,001     122,565        111,311      121,329      132,249     112,118       85,690      71,980       74,859       77,853
 Add depreciation                                               57,388      66,197      71,571       91,289     103,024       101,278     101,038       100,312      107,334     116,994        129,863      141,551      154,291     168,177      179,949     188,947      196,504      204,365
   Gross capital expenditures                                  146,780     212,180     286,488      152,327      25,012       175,820     137,865       167,187      199,334     239,559        241,175      262,880      286,540     280,295      265,639     260,926      271,363      282,218
FCFF                                                            42,471      59,101       (7,110)     84,284     198,029          (171)    174,038       229,816     192,860     150,916         188,405      205,361     223,844      271,040      318,957     350,101      364,105     378,669
Free cash flows to equity (FCFE)**                                2006        2007          2008        2009        2010          2011        2012          2013        2014        2015            2016         2017       2018          2019        2020         2021         2022        2023
FCFF                                                            42,471      59,101       (7,110)     84,284     198,029          (171)    174,038       229,816     192,860     150,916         188,405      205,361     223,844      271,040     318,957      350,101      364,105     378,669
Debt and other non-current liabilities                          53,627      59,275       47,059      62,251     156,016        72,125      75,595        81,896      90,564     102,113         112,601      124,033     136,493      147,057     155,131      161,913      168,967     176,302
Prior year debt and other non-current liab.                     21,769      53,627       59,275      47,059      62,251        62,251      72,125        75,595      81,896      90,564         102,113      112,601     124,033      136,493     147,057      155,131      161,913     168,967
   Net increase (add)                                           31,858       5,648      (12,216)     15,192      93,765         9,874       3,470         6,301       8,668      11,548          10,488       11,432      12,461       10,564       8,074        6,782        7,053       7,336
Interest before tax                                                245         468        1,843       1,556       1,531         1,442       2,646         3,603       3,985       4,493           5,630        6,202       6,825        7,353       7,757        8,096        8,448       8,815
Subtract after-tax interest expense                                175         329        1,309       1,145       2,358         1,024       1,879         2,558       2,829       3,190           3,997        4,403       4,846        5,221       5,507        5,748        5,998       6,259
  FCFE                                                          74,154      64,419      (20,635)     98,331     289,436         8,678     175,630       233,558     198,700     159,274         194,896      212,390     231,459      276,384      321,524     351,135      365,160     379,746
                    Appendix C




Sales Growth
           Sales             % growth
    2010           1925360         3.09%
    2009           1867634         8.07%
    2008           1728098        11.75%
    2007           1546419        15.39%
    2006           1340203        12.34%
    2005           1192950        16.91%
    2004           1020429


CAGR                10.05%




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