Covance Falls Off the Growth Track

By Brian Graney (TMF Panic)
September 8, 1999

Pharmaceutical contract research organization (CRO) Covance (NYSE: CVD) bought a one-way ticket to Lowerville this morning after announcing that its third quarter earnings would fall a nickel short of the First Call mean estimate of $0.26 per share. The new forecast excludes a $4 million to $5 million restructuring charge during the quarter related to the dismissal of 150 employees, or roughly 2% of the company's worldwide workforce. Fiscal 1999 earnings are now seen in the $0.91 to $0.93 per share range with fiscal 2000 earnings growth in "the low teens." With the Covance growth train clearly jumping the tracks, analysts bailed out like irritated hobos with downgrades and reduced price targets.

Covance indicated that most of the shortfall is company-specific and tied to the cancellation of a "major" Phase III clinical trial contract and the scaling back of another large program. However, the bad news accelerated the recent share price slippage throughout the CRO sector, which has pretty much been a major train wreck all this year. Prior to today's Covance commotion, industry leader Quintiles Transnational (Nasdaq: QTRN) had lost 35% so far this year while Pharmaceutical Product Development (Nasdaq: PPDI) was down 33%. For its part, Covance had been off 47% and failed merger mate Parexel (Nasdaq: PRXL) was picking up its teeth after a 60% pummeling.

The severe pull-back throughout the sector is a reminder that investors should look both ways before crossing the CRO tracks. The latest downturn is nothing new to long-time passengers of this railway, as share price appreciation has been anything but smooth for these companies over the past few years. That's largely due to the fact that projecting revenues has become a much harder challenge for not only analysts but also for the companies themselves, as Covance brutally reminded everyone today.

With the pharmaceutical outsourcing trend chugging along like a Union Pacific Big Boy, the drug developers that collectively make up big pharma are handing off more responsibilities to the CROs. This leads to more revenue streams from earlier in the development and approval process for the CROs, but it also extends the number of accounting periods during which revenues can be booked.

Like most of its rivals, Covance typically relies on the percentage of completion accounting method while also sometimes recognizing revenues as services are rendered or products are delivered. This gives the company lots of "flexibility," for lack of a better word, in the revenue accounting department. The company's balance sheet snapshot at the end of Q2 showed plenty in the more "flexible" accounts, namely $53.4 million in unbilled services and $52.5 million in unearned revenue. Those two figures work out to about 25% of quarterly net revenues. That's not out of line for other companies in the sector but it is an industry-wide trait that investors should take into proper consideration.

When revenues are hard to project, estimating the future cash flows that underlie a company's share price becomes even more of a challenge. However, the CRO business is becoming more of a strategic than tactical cog in the drug development mountain railway, as noted by another Fool recently. Investors interested in taking advantage of the excellent demographics and outsourcing growth optimism that took many of the CROs to their highs late last year and earlier this year should bear this in mind when looking for investment opportunities with the companies' shares now at their lows.

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