SELL REPORT Steven DeSouza [SPRING 2011] - Portland State ...

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SELL REPORT


Steven DeSouza





[
SPRING 2011
]

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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…………………………………………………..…………………………
..
…1
5

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

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

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




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Covance Inc.

(
CVD
: NYSE)

52
-
Week Range:
$
37.44
-
$63.86



Recommendation:
Sell 57 shares

Sub
-
Industry/GICS
:

Life Sciences Tools &
Services/35203


Current Price (
June 3
th

2011)

$
57.21

Target Price:
$
64
1

% Gain to Target:
11.87%

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 i
ts 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, pharmaceut
ical
and nutritional chemistry wh
ile its Late S
tage 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 th
rough
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

c
ompanies 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 att
empt 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 th
e
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 Ana
lysis

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 se
rvice 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 fol
lows 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 a
nd 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
Af
fordable 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
throug
h 2008 but has dipped in recent years (
Exhibit

1
).
Early sta
ge 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 anima
ls; 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.


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

Pharmaceutical Chemistry:

P
harmaceutical chemistry services determine the
metabolic profile
and bioavailability of d
rug candidates. It also provides
laboratory testing services to the
chemical and agricultural chemical industries.
6

Nutritional Chemistry:

N
utritional chemist
ry services

offer
s

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
provide
s

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 contra
ct research organizations as part of required preclinical anim
al
safety and efficacy testing.
8

Discovery and Translational Services:

These services provide
lead optimization including custom
immunology and antibody services, metabolism studies and pharmaco
kinetic screening as well
as non
-
GLP toxicology,

in vivo

pharmacology, imaging services and biomarker services.
9

Bioanalytical Services:

B
ioanalytical 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 Cov
ance 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

Wi
ndley, David. “”Company Note


CVD”
Jeffries & Company Inc.
May 2011. Viewed May 2011.


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Exhibit

1


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.
13
In 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 Tr
ial 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. Clinic
al Trial Support Services also



12

Coldwell, Eric. “CVD


Covance Inc. at Robert W. Baird and Co.”
Thomson Street Events.
Web. 10
th
, May 2011.
Viewed June 2011.

13

“Strategy, SWOT and Corporate Finance R
eport


CVD”
Data Monitor.
Web. May 2011. Viewed May 2011

14

“2010 10
-
K Covance Inc.”
EDGAR Database.
Web. February 2010. Viewed May 2011.

0
200000
400000
600000
800000
1000000
1200000
2005
2006
2007
2008
2009
2010
Early Stage
Late Stage

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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

there
fore

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 diversif
ied 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
C
ovance’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 S
tage and another accounts for over 10% in

the Late

S
tage.
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 potenti
al 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 Covanc
e Inc.”
EDGAR Database.
Web. February 2010. Viewed May 2011. Page 2


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Exhibit

2



Source: “Strategy, SWOT and Corporate Finance Repor
t


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 f
or a 5 year deal for Early
S
tage se
rvices. 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 h
igher than
expected revenue in t
oxicology, a service that is one of Covance’s original reasons for purchase
and that has been hit especially hard in the last two years. Fo
r 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 twelv
e 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 reve
nue 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 un
til it begins to taper off into

a terminal growth assumption. Because
of Covance’s emphasis o
n overseas expansion, and

the

higher costs associated with large

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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 me
chanical medical devices like pace makers
,

p
lastic
hips along with

synthetic compound pharmaceuticals. Recently the lifecycles for these products
is
coming to a clsoe

as patents ex
pire 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 Product
s
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 o
f 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 Covanc
e 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
r
evenue, 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 logical
ly 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.


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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 impa
ct 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



Wide global presence reducing
depen
den
cy risk



Weak performance in Early stage



High Reliance on certain facilities



Stagnant Central Lab revenue

Opportunities

Threats



Growth in R&D
Outsourcing continues



Strategic alliances & acquisitions
boosts growth prospects



Growing demand of services in
Emerging markets



Global competition increasing



Global presence puts pressure on
margins



Reduced Barriers to Entry

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 condu
cts 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


11

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simultaneous testing is for large multinational firms, Covance’s recent emphasis on global
expansion allow
s 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
mostl
y 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 infrastructur
e 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 w
ith the passage of healthcare reform in the U.S.

and the pressure to adopt
Health Economic
s 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 Paci
fic
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 compe
tition 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 Corpor
ate Finance Report


CVD”
Data Monitor.
Web. May 2011. Viewed May 2011


12

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in
-
house R&D, which accounts for 70% of all R&D.
26

Covance must balance its competitive
environment wit
h 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 ass
ets, 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 3
1

28

“2010 10
-
K Covance Inc.”
EDGAR Database.
Web. February 2010. Viewed May 2011. Page 31

29

Yahoo! Finance. “Company Summary


CVD, ICLR, CRL, PPDI” Web. June 4
th

2010


13

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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 o
f
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 equ
ity
,

all other things being equal.

If the premium paid for the company
is
accompanied

by large growth rate
s

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 sligh
tly above the current price. A
lso, if the future
forecasted stock prices are discounted back by the market r
eturn 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 201
1. 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 ta
king 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 t
he
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 refl
ect terminal growth assumptions (
Appendix

B
).

Working Ca
pital:

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 fluctu
ations 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 grow
th 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 a
cquisitions 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 3
rd
, 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 impor
tant 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 rais
e 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.
Web. 2
nd
, June 2011. Viewed June

3
rd
, 2011


17

|
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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 large
st 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 com
pany 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 i
n 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 2
nd
, 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 pr
ice might be delayed for
the near future, providing the portfolio with no rates of return since the company provides no
dividend.


Exhibit 8



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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. Strategi
c 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 pers
pective, 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 val
ue 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.



19

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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
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



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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%